This excellent article contains three key graphics illustrating how average investors flow into and out of investments at the wrong times and contrasts this with the average DFA investor who remains much more consistent and disciplined.

1. Northern Exposure: Active vs. Passive: Moving Beyond the Debate Page 1 of 3
December 2, 2009
Active vs. Passive: Moving Beyond the Debate Client Ready
Brad Steiman, Northern Exposure
Director and Head of Canadian Financial Advisor Services and Vice President
The first two columns in this series offered answers to frequently asked questions about active vs.
passive investing, and explored a general set of ideas around market efficiency. The main purpose has
been to help advisors build a framework for educating clients on the debate, and hopefully the
discussion has expanded your arsenal of thoughtful responses to related questions.
Keep in mind, however, that being armed with answers does not mean you should pursue the topic if the
questions don't come up. Doing so may lead you down an unwanted path with most of your clients. The
questions of active or passive investing, and efficient or inefficient markets, will not resonate in many
cases, and too much emphasis on these issues takes the focus off what is really important: sound
advice that reinforces long-term discipline. The question of active or passive investing matters a great
deal to you as an advisor, but may not matter at all to a significant number of your clients. What should
matter most to them is the value you bring to the relationship.
There are other good reasons to approach the topic carefully. Market efficiency and its offspring,
passive investing, are counterintuitive for many investors. It is human nature to believe that one can
beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is
constantly reinforced by Wall Street and most of the mainstream media. Yet even when you are able to
firmly plant the seeds of information to overcome those beliefs and intuition, a passive investment
approach may carry the negative connotation of inactivity if not properly framed.
Furthermore, even though some may characterize Dimensional's approach as passive, it is only passive
with respect to activities that don't add value—mainly stock picking and market timing. One could argue
that Dimensional is very active, however, in managing important considerations such as frictional costs
and consistent exposure to targeted risks or asset classes. With this in mind, you might articulate the
overall philosophy without referring to "passive" or "active" investing.
Here are some examples of framing:
We don't speculate. We invest.
Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid
foundation of core principles from the science of investing.
With capitalism there is always a positive expected return on capital.
Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a
buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where
there is always a positive expected return to providers of capital. Investors would not risk their capital
without the expectation of a positive return. We invest in an approach that strives to capture a fair share
of the capital market return based on the risk assumed.
It is difficult to identify superior investment managers in advance.
Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants
competing in capital markets, it is hard to identify in advance anyone who can systematically beat the
market since past winners may have just been lucky and won't necessarily win in the future. We
eliminate the risk of choosing the wrong manager by following a broadly diversified approach that does
not rely on stock picking or market timing.
Diversification is the only antidote for uncertainty.
Although diversification neither assures a profit nor guarantees against loss in a declining market, a
properly constructed and well-diversified portfolio is a key component of a successful investment
experience. We design portfolios that attempt to capture certain risks and eliminate others, depending
on your preference and capacity for various types of risk.
There is no free lunch. Risk and return are related.
Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a
football player who chooses to play without a helmet, you should not expect to be paid more for taking
risks that can easily be avoided. We focus on eliminating risks that you should not expect a reward for
taking, such as concentrating your portfolio in just a few stocks.
Control what you can.
If speculation is futile, and trying to choose winners is more often a loser's game, what can an investor
do? The answer is to concentrate on what can be controlled: managing the transactional costs of
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2. Northern Exposure: Active vs. Passive: Moving Beyond the Debate Page 2 of 3
investing, reducing the impact of taxes, and taking a long-term view. We implement portfolios in a way
that is cost effective, tax efficient, and above all, disciplined.
Market efficiency and the active or passive decision are loaded with misconceptions that can lead to
debate and confusion rather than constructive dialogue and understanding. More importantly, it can
distract our attention from the most crucial element of all: discipline!
The studies comparing dollar-weighted returns to time-weighted returns are widely known, and
behavioral research has documented the propensity for individual investors to skate to where the puck
was. A decision to invest in an active, indexed, or Dimensional approach can often be differentiated in
basis points, while percentage points often gauge the impact of an undisciplined or emotional decision
unchecked by an advisor's sound counsel.
This type of behavior is obviously hazardous to an investor's wealth; therefore, we should attempt to
determine if one of these alternative strategies has been able to mitigate some of these actions.
The charts below show the monthly cash flow into all equity funds (foreign and domestic) in the US ,
along with the prior twelve-month global equity market return. Cash flow bars that vary with, or more
closely follow, the prior year return line could suggest more return chasing behavior among the investors
within that universe of funds.
Source: ICI
Source: ICI
Index is not available for direct investment; its performance does not reflect the expenses associated with the management
of an actual portfolio. Past performance is no guarantee of future results.
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3. Northern Exposure: Active vs. Passive: Moving Beyond the Debate Page 3 of 3
Source: Dimensional
A simple "eyeball" analysis of this anecdotal data suggests that investors in active mutual funds
apparently were more influenced by short-term performance than those who held index funds, and
advisors (and clients) who invested in Dimensional funds exhibited the most consistency.
Editor's Note: In his most recent Advisor Focus column ("The Value of an Advisor"), Dave Butler offers
additional evidence suggesting that advisors have encouraged client discipline in the market downturn.
Since the start of 2008, Dimensional has experienced seven consecutive quarters of net-positive advisor
allocations to US and international equity funds.
The biggest difference between index funds and Dimensional relating to investor behavior may be the
requirement for independent advice from a fee-based advisor. If part of the recipe for a successful
investment experience is to stay the course, you are the key ingredient to educating your clients and
keeping them disciplined through good times and bad.
The comments of Robert Dintzner are greatly appreciated.
Many thanks to Brad Barber for providing the ICI data.
Submit questions about your own client experiences.
1. Dimensional cash flow data includes US, Canadian, UK, and Australian domiciled funds.
Dimensional Fund Advisors LP ("Dimensional") is an investment adviser registered with the Securities and
Exchange Commission.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This
article is provided for informational purposes, and it is not to be construed as an offer, solicitation,
recommendation or endorsement of any particular security, products, or services.
© 2011 Dimensional Fund Advisors LP. All rights reserved. Unauthorized copying, reproducing, duplicating, or
transmitting of this material is prohibited.
https://my.dimensional.com/insight/northern_exposure/17809/ 6/2/2011