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Separating Good Behavior from Bad Behavior
Emotion may be the biggest obstacle to investment success. In fact, removing emotion from the investment process through systematic rebalancing and adhering to a scientifically engineered asset allocation strategy is the most valuable service we provide.
Indeed, a highly disciplined DFA-based investment approach may add more value than you think.
Morningstar, Inc. (an independent third party analytics firm), produced an interesting internal study some years ago that compared investors' actual investment returns over a 10-year period with the returns of the mutual funds they were invested in.
Not surprisingly investors in actively managed funds performed relatively poorly all the way around. But oddly, even (presumably) educated do-it-yourself index investors didn't do as well as they could have. In other words, they failed to capture 100% of the returns that their own funds had to offer.
The table below shows that index mutual funds produced an aggregate annualized return of 8.94%, yet the average return index investors actually realized in their own portfolios was only 7.06%. The question is why.
This sub-optimal performance was simply due to the poor timing of cash flows into and out of the funds, i.e. they engaged in "bad behavior." Specifically, they pulled money out as investments went down in value and invested more as prices rose - pretty much the exact opposite of what you want to do. Thus they needlessly missed out on what they could have (and should have) achieved.
In contrast, DFA-advised investors realized an aggregate annualized return of 12.81% during the period. This was actually even better than the 12.37% average return the funds themselves produced.
This extra performance was simply due to good behavior, i.e., instead of investing less when the funds went down in value, they invested more and then rode the wave back up - which is exactly what you want to do.
The Morningstar study concluded:
Consider that over the past decade the dollar-weighted return of all index funds was just 79% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns - suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors.
In a world where investment managers are fighting to add a fraction of a percent of additional return each year, perhaps avoiding bad behavior is the most important factor of all when it comes to successful investing and the most valuable service we provide.
More Good Behavior vs. Bad Behavior
The graph above shows the profound difference in discipline between DFA-advised investors and the retail mutual fund marketplace. Historically, investors have been well-rewarded for this discipline.