Pursuing a Better Investment Experience (Part 3)

Welcome to the pursuing a better investment experience series. We are going to review two topic points regarding market returns and diversification, let’s get started.

Consider the Drivers of Returns

The First Point – Consider the Drivers of Returns

There is a wealth of academic research into what drives returns. Expected returns depend on current market prices and expected future cash flows. Investors can use this information to pursue higher expected returns in their portfolios.

  • Rather than viewing the market universe in terms of individual stocks and bonds, investors should define the market along the dimensions of expected returns to identify broader areas or groups that have similar relevant characteristics.
  • This approach relies on academic research and internal testing to identify these dimensions, which point to differences in expected returns.
  • In the equity market, the dimensions are size (such as small cap vs. large cap), relative price (in terms of value vs. growth), and profitability (with high vs. low). In the fixed income market, these dimensions are term, credit, and currency. The return differences between stocks and bonds can be considerably large, as can the return differences among a group of stocks or bonds.
  • To be considered a dimension, it must be sensible, backed by data over time and across markets, and cost-effective to capture in diversified portfolios.
  • In a dimensions-based approach, capturing returns does not involve predicting which stocks, bonds, or market areas are going to outperform in the future. Rather, the goal is to hold well-diversified portfolios that emphasize dimensions of higher expected returns, control costs, and have low turnover.

Practice Smart Diversification

The Second Point – Practice Smart Diversification

Holding securities across many market segments can help manage overall risk. But diversifying within your home market may not be enough. Global diversification can broaden your investment universe.

  • Many people concentrate their investments in their home stock market. They might consider their portfolio diversified when they choose a large group of US stocks or US mutual funds. In some cases, they may hold a small group of US securities.
    Yet, from a global perspective, limiting one’s investment universe to a handful of stocks, or even one stock market, is a concentrated strategy with possible risk and return implications.
  • This slide offers a conceptual comparison of investing only in the US market, as represented by the S&P 500 Index, and structuring a globally diversified portfolio that holds assets in markets around the world, as represented by the MSCI All Country World Index (IMI). For the global portfolio, holding thousands of stocks across the world’s developed and emerging market countries broadens one’s investment universe.
  • A diversified portfolio should be structured to hold multiple asset classes that represent different market areas across the world.

Overall, the two key points to remember are:

  • Consider the Drivers of Returns and
  • Practice Smart Diversification

This concludes the third video of the Pursuing a Better Investment Experience series. To learn more, check out our other videos!

Disclosures

Relative price is measured by the price-to-book ratio; value stocks are those with lower price-to-book ratios. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Diversification does not eliminate the risk of market loss.

Number of holdings and countries for the S&P 500 Index and MSCI ACWI IMI (All Country World IMI Index) as of December 31, 2021. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. MSCI data © MSCI 2022, all rights reserved. International investing involves special risks, such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. “Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. Please click here to read the full text of the Dimensional Fund Advisor Disclaimer.

About the Author Douglas Finley, MS, CPWA, CFP, AEP, CDFA

Douglas Finley, MS, CFP, AEP, CDFA founded Finley Wealth Advisors in February of 2006, as a Fiduciary Fee-Only Registered Investment Advisor, with the goal of creating a firm that eliminated the conflicts of interest inherent in the financial planner – advisor/client relationship. The firm specializes in wealth management for the middle-class millionaire.

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