Ignoring Science Can Cost You
Like physics, chemistry, and math, investing is a science. The body of peer reviewed, unbiased research and evidence supporting this branch of science is vast and deep.
Some of the lessons science has taught us, such as keeping costs low (see Part 1) and diversifying, are well known. Others, not so much. In particular, the effect of investment “factors” on your portfolio, while well-established through decades of research, is widely unknown by the average investor and, consequently, widely unused.
In short, a “factor” is a source of return generated by a grouping of similar stocks or bonds. For example, the “small cap factor” represents the difference in return between small company stocks as a whole and large company stocks as a whole. Did you know there was a difference? Let’s look at that difference, along with that of two other factors: the value factor and the profitability factor.
Source: Dimensional Fund Advisors LP
These numbers are quite significant. Ignore them, and your portfolio may suffer. Consider this data from DFA (Matrix Book 2017): from 1973 to 2016, the S&P 500 returned 10.0% per year, while a diversified portfolio incorporating these factors returned 13.4% per year. In all our years, most people we’ve met had a portfolio that looks much like the S&P 500. That’s expected, as most people consider the S&P 500 to be “the market”. See the problem?
In Part 1, we learned that the hidden costs of mutual funds may add up to almost 2%. Now, we know that not incorporating factors into your portfolio may cost you even more than that. Add the two together, and…yikes. And make no mistake – not doing something beneficial is just as much a cost as doing something harmful.
Of course, if you’re a client, rest assured that factor investing is an integral part of what we do for you. And if you’re not, we’re here to help.
Stay tuned for the last installment in this series, Part 3: The Cost of Being Human
John & Bill