Fredrickson Financial

Jellybeans teach a lesson

October 31st, 2013

What can a jellybean contest tell us about the stock market? A lot, it seems.

I just returned from a regional conference for Dimensional Fund Advisors — a mutual fund company that incorporates index-like strategies in its funds. This story was told by Apollo D. Lepescu, a vice president at DFA. In a previous event that he described, a jar was filled with jellybeans. He asked everyone in the audience to write down their guess of the number of candies in the container. The guesses ranged from 409 on the low side to 5,365 on the high end. The actual number was 1,670. Guess what the average was? 1,653.

This result was not a fluke. Mr. Lepescu has replicated it a number of times. His point in telling the story is that the stock market is like the opinions of the people in that room. People state their opinion of the value of stocks by buying or selling them, and the actual value, the average of those opinions, is generally a correct reflection of their risk-adjusted earning potential. This is why it is often futile to try to time or beat the market.

However, DFA has exploited pockets that seem to give their funds an edge over the market as a whole. These include tilting their index-like exposure toward value stocks – which are stocks that are cheap relative to their peers based on measurements such as their price-to-book value and price-to-earnings ratio – and small-cap stocks.

This doesn’t mean that small-cap and value stocks are mispriced; rather, they are riskier and therefore investors demand a higher price than even their relative market risk measurement, known as “beta,” would indicate.

However, there is also some evidence that investors occasionally become too enamored of growth stocks, which could explain some of the out-performance of value stocks over time. This debate continues, as exemplified by the fact that two of the three honorees of the Nobel prize for economics this year were Eugene Fama, known as the father of the efficient markets theory, and Robert J. Shiller, who has made a career of identifying and studying speculative bubbles.

Professor Fama has been on the board of DFA from “the first day,” as he said recently in the New York Times, and his research underpins DFA’s investment approach. Interestingly, Professor Shiller, even though he is theoretically opposed to the efficient markets theory, recommended in the Times that “people might consider investing in DFA.”

Of 320,000 financial advisors in the United States, only about 2,000 are approved to use DFA funds with clients, according to Scott Bosworth, a DFA vice president. Garrett Investment Advisors, LLC, the Registered Investment Advisor firm of which I am part, is one of those. Contact me to find out if DFA funds are right for you.

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