The Best Investing Approach
“Dimensional built the firm on the idea that we could do better than indexing.” –David Booth, founder of Dimensional Fund Advisors
I spend a lot of time in these e-mails talking about active vs passive investing. You certainly know my views on this. The evidence is clear that active investing cannot beat passive indexing on any consistent basis.
What I don’t talk about very often is there are different levels of passive investing. Most people associate passive investing with an index. Under this approach the money management firm simply replicates the index by buying all the securities within that index. For example, a firm that has an S&P 500 fund would buy all 500 stocks in that index at the appropriate market capitalization rates for each stock.
This is a solid investing approach and has been proven to be a better alternative to active investing (stock picking).
However, there’s an even better approach to passive investing that Dimensional Fund Advisors employs. It’s an approach that’s grounded in economic theory and backed up by decades of empirical research. It’s been referred to as smart indexing. Rather than being a slave to a particular index, this approach gives DFA more leeway to take advantage of momentum swings and tilt their funds to areas of the market that have proven to have higher expected returns.
In my opinion, this is the best approach to passive investing and it has a long term track record of beating stock picking and traditional indexing. That’s why we invest this way.
Check out this one pager, There’s Stock Picking, There’s Indexing, Then There’s Dimensional Investing.