Trying to pick the next hot stock or decide when to get in and out of the market is a losing game. As this becomes increasingly accepted, traditional active money management is losing ground to lower cost alternatives. For many investors, this means using low-cost index funds in order to capture the market premium. Peer-reviewed academic research points to an alternate approach.
Evidence-based investing stems from the work of Eugene Fama, who won a Nobel Prize in 2013. His hypothesis suggests that financial markets are efficient. In other words, the market prices of securities reflect all relevant information, and the only way to have an information advantage is to accurately predict the future.
Rather than trying to predict the future, you can take insights from decades of research to improve portfolio construction. The evidence has demonstrated that, over the long-term, the market can be expected to outperform a risk-free asset, small stocks can be expected to outperform large stocks, value stocks can be expected to outperform growth stocks, and more profitable stocks can be expected to outperform less profitable stocks.
Portfolios can be structured to capture these higher expected returns while keeping costs low. Portfolio structure and costs are both things that you can control. It is logical to optimize them.
Investing this way means being slightly different from the market in terms of the portfolio weights of some asset classes. This inevitably leads to differences in performance, or tracking error. Most investors are not emotionally equipped to endure periods of tracking error. If behaviour can be managed, the door is opened to a statistically more reliable long-term investment outcome.
The outperformance of the market over a risk free asset (market premium), small stocks over large stocks (size premium), value stocks over growth stocks (value premium), and high profitability stocks over low profitability stocks (profitability premium) has persisted across multiple geographic regions, and over varying periods of time. The following data shows the historical outperformance of each premium in Canadian, U.S., Developed Excluding U.S., and Emerging Market stocks for overlapping 15, 10, 5, and 1-year periods. With longer holding periods, the historical likelihood of successfully capturing the premiums increases. Across all premiums, 15-year periods have resulted in a positive outcome most of the time.
Developed excluding U.S. Markets
Information provided by Dimensional Fund Advisors LP.
Canadian results In CAD, all else in USD. Indices are not available for direct investment. Past performance is not a guarantee of future results.
1. Profitability is a measure of current profitability, based on information from individual companies’ income statements.
Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return differences.
Fama/French data provided by Fama/French. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. MSCI data copyright MSCI 2017, all rights reserved. Index descriptions available upon request.