Beating the Market - The essential characteristic of traditional investing (often called active investing or stock-picking) is identifying individual mispriced securities deemed likely to exceed market expectations. This amounts to predicting the performance of individual securities. It assumes that the market is wrong about the current price, but will be right about price in the future, at which time the security will sold for a market-beating profit. There are two sides to every trade, a buyer and a seller, and therefore the market as a whole has an average return. Transactions have costs, managers have fees, and sales have tax consequences. Nearly all peer-reviewed research shows that the chances of exceeding market averages through active trading has no better than a random chance of success after costs. What the data shows for active managers.
Earning the Market Return - A belief in the futility of trying to beat market averages with a traditional investing strategy has led to the rise of index investing (often called passive investing.) If you can't reliably beat market averages, why not seek out the market return of the specific indexes? There are several important advantages to index investing. One advantage is that there are no fees paid to stock pickers. Another advantage is that indexes change slowly, leading to low turnover and low transaction costs. A third advantage comes from the low turnover: annual taxes on profits from the sale of individual securities within the portfolio are lower. Research shows that it is exceedingly difficult for traditionally-managed portfolios to overcome these index-investing advantages and beat the market. Vanguard is a leading provider of low-fee index funds and Lyon Park includes their index offerings in its recommendations.
Academic research has identified specific dimensions for equity and fixed income investments which point to differences in expected returns. Investors can pursue higher expected returns by structuring their portfolio around these dimensions.
Market: Equity premium— stocks vs. bonds
Company Size: Small cap premium— small vs. large companies
Relative Price: Value premium—value vs. growth companies
Profitability: Profitability premium—high vs. low profitability companies
Fixed Income Dimensions
Term: Term premium—longer vs. shorter maturity bonds
Credit: Credit premium—lower vs. higher credit quality bonds
Dimensional Fund Advisors (DFA) is a leading global investment firm that has been translating academic research into practical investment solutions since 1981. DFA funds are available only through selected investment advisors. Lyon Park is pleased to offer and recommend DFA funds to its clients.
Risk vs. Return - Generally speaking, risk and potential return are related. This is the risk/return trade-off. Higher risks are usually taken with the expectation of higher returns at the cost of increased volatility.
Nature of Risk
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. A fund's investment objective and its holdings are influential factors in determining how risky a fund is. Reading the prospectus will help you to understand the risk associated with that particular fund.
It is important to note that no methodology or investment strategy is guaranteed to be successful or profitable. Investing in securities involves the risk of loss that clients should be prepared to bear. In the past, equity markets have declined dramatically without warning. Prudent investors account for this possibility when constructing their portfolios.