For those of you who missed our event last evening with Weston Wellington, we thought we would take this opportunity to highlight several key points of the presentation. Weston Wellington is Vice President of Dimensional Fund Advisors, a 45-year veteran of the industry, and a renowned capital markets storyteller.
Weston started by reminding us of the conventional approach to investing. Perhaps some of these considerations and tactics are familiar to you.
- Concerns about what is happening on Capitol Hill and how this might affect individual stock prices
- Wondering if it is a good time to be invested at all based on recent geopolitical events
- Asking if you’re too late to the game or if it makes sense to buy stocks at all-time highs
- Attempting to identify strong individual companies that will outperform the market
- Using economic predictions and trends to inform your investment positioning
The problem with the conventional approach is that it requires you to outsmart everyone else that has the same information as you do. Weston believes (and Seaside agrees) that rather than trying to predict the future, we should study information from the past to make educated investment decisions. Instead of trying to outsmart everyone else, we can harness the wisdom and experience of all market participants and use it to our advantage.
To highlight his thesis, Weston used several real-world examples in his animated storytelling. Dr. John Cochrane was a well-known Financial Economist whose asset pricing theory was based on the fact that someone owns every stock available on the open market. There are no orphan stock certificates flowing around the streets of our cities! There are over 2,000 publicly traded companies and millions of owners constantly deciding to buy or sell. We, as investors, have choices in the companies that we choose to invest in. It is logical that stocks of wonderful companies tend to sell for higher prices than the stocks of mediocre companies that sell at lower prices. The truth of the way markets work is that prices are fair in every instance. There is no free lunch on Wall Street. Everyone is trying to find the next best opportunity using all available information. The chance of outperforming another investor with the same information is highly unlikely – not impossible, but improbable.
An analogy that Weston used was the process of betting on sports. The oddsmakers create a point spread, giving points to the underdog to help even the playing field. If the point spread did not exist, no one would bet on the underdog. In the same fashion, investors demand a higher return on riskier companies – namely small companies and value companies. Otherwise, they would never invest their hard-earned money in the underdogs.
A great example of this concept is everyone’s favorite breakfast and lunch combination, Starbucks vs. Wendy’s. As health-conscious and caffeine-starved Americans, many of us believe that Starbucks is clearly the superior company. If the total value of the two companies were the same, smart investors would purchase shares of Starbucks and expect a higher return than an investment in Wendy’s. Unfortunately, this is not the way efficient markets work. Our collective beliefs about these companies are already reflected in their stock price. Therefore, it is only new information that moves stock prices up or down. This mechanism explains why in periods like late 2015 through late 2018, a company like Wendy’s returned over 100% while Starbucks returned 10%.
By extrapolating this simple example and considering volumes of academic research, we can conclude that it is impossible to consistently identify who the obvious winners and losers will be. Therefore, investing in a broadly diversified portfolio is a better approach to investing successfully. We want to own both Wendy’s AND Starbucks because we don’t have an obvious way to pick a clear winner. This truth doesn’t only apply to individual companies; we also want to be diversified geographically. The many potential risks that cause individual company stocks to gyrate wildly will have less impact when they’re part of diversified portfolio. The truth is that stock prices are unpredictable.
One final question that Weston addressed was this: should investors purchase actively managed funds or passively managed index funds? After all – even if you and I can’t determine winning stocks versus losing stocks – can’t the smartest economists, investment analysts, and PhDs be able to do a better job? Historical studies show that actively managed funds not only underperform their benchmarks, but many of them go out of business because they are poorly managed. Even the funds that outperform the benchmark do not do it consistently, leading one to conclude that outperformance may be a function of luck.
If active management is not a consistently effective approach, why not buy a diversified basket of stocks and let it ride for 20 years? Weston describes this method as the “Rip Van Winkle Approach” (buy, hold and forget about it – i.e. passive). While not a bad strategy, the Rip Van Winkle Approach can be improved upon by focusing on dimensions of the market that have outperformed over time.
Academic research shows that there are groups of stocks that have demonstrated better performance than the market as a whole. A well-constructed portfolio can be passive in nature, low-cost, and have exposure to the types of stocks that have higher expected returns.
If you would like to hear more about how we incorporate academic research into our investment philosophy, please contact our office. We also invite you to contact us if you would like to hear about future events.