You may recall I shared some ideas shared by Apollo Lupescu, PhD in last week’s blog. Dr. Lupescu of Dimensional Fund Advisors (DFA) was our guest speaker at a recent luncheon.
One question Dr. Lupescu addressed was the wisdom of investing in individual stocks or mutual funds. For some background, he first discussed the evolution of the markets from being driven primarily by the trading of individuals to being dominated by institutional investors with access to an ever-increasing array of research and trading tools. He says today’s markets have evolved from a place where individuals invested on “hunches and friends’ recommendations” to a highly analytical place where mom and pop investors just don’t have the tools to compete with Wall Street.
“We’ve seen an explosion in professional money management and now there are more mutual funds than stocks trading in the market,” Dr. Lupescu explained. “So, the markets are not just competitive, they are hyper-competitive. Ninety percent of trades are placed by professional investors.”
Naturally these sophisticated and highly experienced professional money management teams make it very difficult for any individual investor to have a long-term competitive advantage. “We teach our kids that hard work pays off, but that may not be true for individuals who don’t work full-time to research and find winning stocks. If a professional money manager is investing in Walmart, they will have researchers all over the country taking pictures of cars in the parking lot and of what is in shoppers’ shopping carts. An individual cannot compete with that,” Dr. Lupescu said.
Apart from losing the advantage to professionals, Dr. Lupescu points out that investing in a handful of individual stocks also concentrates your risk. In contrast, the hundreds of individual stocks a mutual fund invests in increases your diversification and, therefore, reduces your risk. Notably, in our typical portfolios of DFA funds, clients will own roughly 12,000 stocks in approximately 40 countries. As Dr. Lupescu asked, “What would it take for all of those stocks to disappear at the same time?” He also noted that legendary stock picker Warren Buffet has 90 percent of the money in his family trusts invested in mutual funds. How’s that for a recommendation for diversification?
I’ll also add that all mutual funds are not equal. It’s important to avoid funds with high expense ratios and high turnover rates. Also, there are real benefits of investing in DFA funds. Wall Street has led investors to believe in the success of “active investing,” of hiring professional managers to pick the right stocks and bonds for you. Yet, history proves that over the long term very few active mutual funds consistently outperform their benchmarks. That said, some advocate lower cost “passive investing” where investors simply own the benchmark, or the index that corresponds to each asset class they wish to invest in.
Dr. Lupescu agrees that long-term success is about investing in markets, not correctly picking high-performing individual companies. After all, asset allocation drives returns. Yet the DFA approach, while “passive” in that it follows a broad benchmark, allows for the flexibility for companies to be added or deleted from the portfolio when fundamentals change. This feature could be especially important in volatile markets.
As Dr. Lupescu concluded, “In managing how the list is created, maintained and trades, we can do better than the index. For example, over 20 years in small-cap companies, we’ve added over one percent per year annualized return. It’s not that we are better at picking the stocks, but we do better manage the portfolio.”