Why a buy-and-hold approach beats speculation
Technology and investing have many parallels.
Both constantly improve.
Both evolve over time.
Newer versions constantly replace what was once seen as the best.
And both are passions of mine.
Some have even described one particular type of fund as having a ‘cult-like status’.
Fans of Apple can certainly relate to this.
The type of fund I refer to is called a passively managed fund.
And in particular, Dimensional Fund Advisors.
Personally, I’m currently investing that way.
Let's use an analogy.
Imagine if this were printed on the back of your driving license:
“This driver is qualified to independently operate every brand of car with the exception of a Mazda. If he or she chooses to drive a Mazda, he or she must be accompanied by a professional Mazda-approved driver.”
If that were the case, Mazdas would have been mythic.
He says that when we can’t have something (or it’s tough to get) we often want it badly.
Cialdini calls this the scarcity effect.
Dimensional Fund Advisors’ mutual funds are a lot like that.
They can't be purchased directly by retail investors.
Instead, they are only attainable through a DFA approved financial adviser.
DFA’s funds have performed well.
But their scarcity might have given them cult-like status.
Between 2008 and 2012, investors pulled $535.7 billion from U.S. mutual funds.
But Dimensional was different.
During that same time period, investors added $34.4 billion to DFA’s funds.
Perhaps it's all in clever marketing, but could this outcome also boost returns for investors?
During the ten-year period ending December 31, 2015, the typical index fund investor beat the average investor in actively managed funds by 2.39 percent per year.
Actively managed funds charge higher fees than low-cost index funds.
That’s one reason investors in index funds did better.
But there’s another.
Investors in actively managed funds buy and sell a lot.
To beat the market.
Unfortunately, this causes many people to buy high and sell low.
They buy funds after a strong winning streak.
They sell funds that lag.
Most index fund investors don’t jump from fund to fund.
They do far less trading and market timing.
In some cases, they even beat the posted performances of their index funds.
This is probably down to dollar-cost averaging, or in other words, investing the same amount every month, allowing them to add fewer units when the fund price rose and more units when it fell.
Its index is made up of specific types of stocks.
For example, a small cap index contains only smaller stocks.
How do these investors perform?
Do they jump around like investors in actively managed funds?
Or do they mostly stay put, like disciplined broad market index fund investors?
I would guess they are more like active fund investors.
After all, most of them likely chose factor-based funds because they wanted to beat the market.
Morningstar doesn’t provide performance data for many of DFA’s funds.
But Vanguard does for factor-based indexes.
Retail investors can buy these funds directly.
Vanguard’s U.S. Value Index (VIVAX) earned a compound annual return of 5.81 percent during the ten-year period that ended January 31, 2017.
The typical investor in this fund averaged a compound annual return of just 1.81 percent during the same time period.
Investors in Vanguard’s Growth Stock Index (VIGRX) averaged a compound annual return over ten years of just 5.22 percent.
The fund itself?
So what about Dimensional Fund Advisors?
These funds are also factor-based.
Most of DFA’s investors probably hope to beat the market.
But they won’t win every year.
It's clear that investors in actively managed funds jump around a lot.
Investors in Vanguard’s factor-based funds appear to do the same.
But DFA promote a buy-and-hold approach instead of speculation.