Speaker of the Month: Imperfect Perfection

Gene Fama Jr., vice president of Dimensional Fund Advisors Inc. in Santa Monica, California, is DFA’s “weird idea guy. I used to do graphic design work for DFA and gradually I started reading what I was doing,” he says. After 17 years of cultivating Dimensional’s investment philosophy, he now works with advisors and helps implement concepts of multifactor investing. He has even worked with the privatized social security system in Chile, helping to develop its long-term investment structure.

Investment Advisor’s August speaker of the month, Fama will be presenting some of his “weird” ideas on “risk dimensions of the market” at the NAPFA Midwest Region Conference in Chicago on September 12-14. We spoke with Fama recently about asset allocation, market efficiency, and the significance of diversification.

What will you be covering at the NAPFA Conference in September? If you look at capital market research over the last 30 years or so, there is a lot we’ve learned about the sources of investment returns. People used to think returns came from simple market risk plus whatever extra return came from skill or luck. The sources of risk now seem more complex, and excess return from skill seems more insignificant and random. What this means is that we finally have a handle on what matters in investing. We know much more about the differences between investing and speculating. So, basically, I’m talking about the sources of investment returns and how these differ from speculative random returns. This is useful because the finance industry tends to focus on issues like manager selection or industry sectors that are just statistical noise and don’t generate expected returns.

How do you determine asset allocations for ideal returns? Do you have some sort of process or list of specifications to follow? I don’t believe there is an ideal allocation. I think that because markets work well, there is no such thing as a bad diversified investment. Markets price things where the risk-return tradeoff is roughly equal for any diversified strategy. But investors have different preferences and abilities to stomach risk.That’s what makes an advisor’s job tricky. The advisor has to determine an allocation based on the client’s circumstances. More importantly, the advisor has to help keep the client disciplined enough not to impulsively change the allocation. Lack of discipline causes much more erosion of wealth than subtleties in portfolio composition. So rather than advisors approaching clients like a broker, in the new model they act like an educator and coach. They help the client stick around to get the returns that compensate them for toughing out all the risk. There’s no easy answer when it comes to asset allocation or managing expectations, which is why advisors get the big bucks.

Do you favor any specific sectors? Research shows that a company’s industry does not relate to its prospects for wealth. The level of a company’s economic health is far more important than what a company makes. Companies that are healthier charge more for their stock and the earnings stream is less discounted, which means investors get lower expected returns from healthier companies. For some weird reason this is the opposite of what you always hear. Most people think more healthy companies promise stronger returns than less healthy companies, when the opposite is true. Industry groups are not asset classes, and not what investors should focus on. The relative economic health of a company matters much more to returns.

In May of 2001, in the TAM Asset Class newsletter (published by the Tiburon, California-based investment advisor firm, TAM Asset Management, Inc.), you were quoted as saying, “Markets don’t have to be right to be efficient.” Can you elaborate on that? A lot of people dismiss market efficiency, because they think it says prices are always perfect and people are always rational. Obviously this is ridiculously na?ve. But if you look at the original hypothesis, it really says that prices can be–and probably are–wrong. What matters is that they seem to be wrong randomly. Markets under- and over-react about equally. So the only thing market efficiency requires is that no more than the random amount of people profit at the expense of the others, and no more often than you’d expect to see by chance. And that’s exactly what the data show.