Dimensional Fund Advisors Part V

This article is one in a long series which I hope will help explain the ins and outs of DFA – Dimensional Fund Advisors. NOTE: This is my interpretation and explanation only. For the final word, please refer to the DFA Canada Website.

A Concession

I will concede that certain investors can beat the markets, for even extended periods of time. And some investors may have tremendous outperformance (perhaps one of their original investments they made was a penny stock that is now a billion dollar company), but this is simply a reflection of the tremendous risks they may have taken. And further I will concede that there are people who exist who can flat out beat the markets (like Peter Lynch and Warren Buffett), however these people are either extremely rare or not known to the public. (Why would anyone who could beat the markets tell you about it and thereby negate their advantage?)

I believe them to be so rare that there is no point in spending time and energy in trying to identify them in advance. According to Dr. Kenneth French – 40 years of 1000’s of Ph.D.s trying to find a way to do so has proved fruitless.

An Assumption

There is one assumption that I will make that will be implied from this point forward: we are dealing with well-diversified portfolios. This is one of the free lunches in investing in that you can eliminate one type of risk that doesn’t seem to have a solid relationship to future returns: non-systematic risk.

With respect to any given securities market there exists Sytematic Risk and Non-Systematic Risk.

Systematic Risk

Systematic risk is the general ebb and flow of the market as a whole – or the tendency for all stocks to increase or decrease in value at the same time with a certain degree of positive correlation.  For example, ‘Black Monday’ on October 19th, 1987 was a Systematic event in that almost all stocks fell in value on that single day.  Macro-economic events and stimuli can be expected to have broad systematic effects on capital markets – positive or negative – on an on-going basis such as interest rate levels, political events, war, etc. It is important to note that systematic risk cannot be diversified away. In other words, you could have a portfolio that is diversified with 1000 different stocks from a given market and there will always be a base level of return variance (shown as the asymptote in the figure below).

Non-Systematic Risk

Non-Systematic risk is the element of overall portfolio risk than can be largely eliminated through sufficient diversification within a particular asset class. The best way to describe it is to build an analogy. Let us assume you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned one hundred stocks, and one company went bankrupt you would have lost 1% of your portfolio. Conversely, what if that one company doubled in value? You either doubled your money or only gained 1% if you held 1 stock or 100, respectively.  Non-Systematic risk is the individual business risk associated with the underlying stock – if this company goes bankrupt – this is a non-systematic risk event and generally has very little to do with the general ebb and flow of the overall markets.

(You can click on the graph for a larger view)

It is generally debated as to how many securities one needs to hold to eliminate non-systematic risk.  Research has shown that between thirty and forty securities are enough to eliminate non-systematic risk.

A rational investor would be expected to take measures to eliminate non-systematic risk from one’s portfolio by increasing the number of holdings within each distinct asset class – a task that is easily accomplished through asset class indexing products which may routinely hold hundreds of asset class constituents.

The non-systematic risk amounts to “noise” that an investor doesn’t necessarily get compensated for (the expected return for the random noise is zero), so it would make sense to get rid of this risk if possible. So to re-iterate: going forward the discussion assumes we are talking about well diversified portfolios in all cases.

The next part in this series will look at CAPM (the Capital Asset Pricing Model).

CLICK HERE TO GO TO PART VI

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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