Investing in the stock market can be a great way to grow your wealth over time. However, even in non-inflationary years, it can also be risky. That’s why the prospect of figuring out the best approach for your specific goals and risk tolerance can be overwhelming. With so many different investment options and strategies to choose from, it can be difficult to feel confident about your selections.
That is one of the reasons why Dimensional Fund Advisors (DFA) Investing was created. This strategy aims to provide a more efficient, user-friendly way to invest in the stock market. In this blog post, we explore what DFA Investing is, how it works, and the ways in which it may potentially improve your financial life as an investor.
This article focuses on these items:
- Why DFA Investing is a great way to diversify a portfolio
- Pros and cons of DFA Investing vs. traditional investing
- Common types of DFA Investments: an overview
- Simple strategies for choosing the right DFA Investments
Why DFA Investing Is a Great Way To Diversify a Portfolio
DFA Investing can be a great way to diversify your portfolio. Similarly, it could potentially improve your returns. However, we understand if the term is new to some of you.
“DFA Investing” is a systematic, research-driven approach. Based on the principles of modern portfolio theory, it seeks to optimize your assets for netting the best possible return for your level of risk. Unlike traditional actively-managed mutual funds, which rely on individual fund managers to make investment decisions, dimensional funds are managed based on a set of rules-based strategies.
This approach helps to reduce the impact of human biases and emotions on investment decisions, providing a more consistent and disciplined approach to investing. The idea isn’t to remove human beings entirely from the process of investing, however. Instead, the goal is to help maintain a steadier, more objective approach, which can often be more conducive to long-term success.
Again, at a fundamental level, DFA Investing involves investing in a wide range of stocks across different sectors and geographic regions. This, naturally, creates a more diversified array of assets within your portfolio.
Pros & Cons of DFA Investing vs. Individual Investing
Now we can dive deeper. Let’s take a look at DFA Investing’s upsides and downsides, contrasting them with those of traditional investing.
DFA Investing: The Pros
- Improved Diversification. As we’ve seen, DFA Investing helps reduce portfolio concentration risk by diversifying investments across various factors, sectors, and regions. This helps achieve broader exposure to the market and reduces the impact of market fluctuations.
- Better Risk-Adjusted Returns. DFA Investing focuses on identifying factors that have consistently generated higher returns over time. As a result, this can result in better risk-adjusted returns than traditional investing.
- Lower Costs. In most cases, DFA Investing involves passive investing, which has lower costs than traditional actively-managed funds. This helps keep more investment returns and reduces the impact of fees on their portfolio.
DFA Investing: Possible Cons
- Limited Options. DFA Investing focuses on a set of predefined factors. This can prevent investing in some sectors or companies that are not included in the defined factors (because they don’t appear likely to perform as well, long-term).
- Lack of Flexibility. This is a rules-based approach following a specific investment strategy. So, DFA Funds will not make tactical investment decisions based on market-condition-panics or changes in your personal financial situation.
- Possible Underperformance. If observed exclusively over the short term, DFA Investing may underperform during certain market conditions (when temporary losses are widespread). This can lead to lower returns in the immediate sense. However, a long-term investment horizon often negates their impact.
Individual Investing: The Pros
- Greater Flexibility. Traditional investing lacks the criteria for screening investments. This makes for a larger variety of choices, though many of the additions may be less likely to perform well.
- Direct Control. Traditional investing has fewer guardrails. As a result, you’re free to adjust your portfolio on whims. Meanwhile, you’re far less protected against potentially self-destructive buying/selling.
- Potential Short-term Returns. Traditional investing may generate higher returns than DFA Investing during specific (sometimes rare) periods or in certain market conditions. However, DFA Investing tends to generate returns more consistently.
Individual Investing: Possible Cons
- Higher Costs. Traditional investing typically involves active management, which can reduce returns and increase the impact of fees on your portfolio.
- Greater Risk. By actively managing your portfolio, a traditional approach increases the likelihood of both underperformance and higher losses during market downturns.
- Lower Diversification. Traditional investing doesn’t always provide the same level of diversification as DFA Investing. This can increase the impact of market fluctuations on your assets.
Common Types of DFA Investments: An Overview
Exchange-Traded Funds (ETFs) are a type of investment vehicle trading on stock exchanges like individual stocks. Designed to track a specific index or asset class, they are typically low-cost and highly liquid, making them attractive to investors seeking to invest in a specific market segment or sector.
They’re also tax-efficient: Because ETFs are structured as a basket of securities that track an index, they have lower turnover than actively-managed funds. This means that they generate fewer capital gains.
Mutual funds pool money from multiple investors into a portfolio of securities. Unlike ETFs, they are not traded on exchanges. Instead, their prices are calculated at the end of each trading day based on their securities’ net asset value (NAV).
Index funds are a type of mutual fund that tracks a specific market index, such as the Dow Jones Industrial Average or the S&P 500. Designed to replicate the performance of the index they track, they are generally passively managed. This often makes them low-cost and low-turnover, which makes them tax-efficient.
Simple Strategies for Choosing the Right DFA Investments
Choosing the right DFA Investments isn’t supposed to be stressful. In fact, by following these steps, you should be able to feel confident that you’ve chosen well in pursuit of growing your wealth over the long haul.
1. Compare Possible Investments With Your Financial Goals
Before investing in anything, verify that doing so will be compatible with your financial goals. Do you want to save for a new house or comfortable retirement? Are you considering expanding your business? Once you have identified your objectives, you can choose investments that align with those goals.
2. Keep Managing Your Portfolio Over Time
Investing is a long-haul endeavor. So, rebalancing your portfolio is like maintaining a car’s engine. Rather than verifying that you have sufficient oil to keep the parts from fusing, we adjust your holdings as necessary to maintain your desired allocation.
3. Consider Possible Tax Implications
Always consider the likely tax implications of selling investments. Capital gains can be mitigated through tax loss harvesting, but that requires the necessary homework first. Now that the IRS regularly targets the financially successful for audits, caution is essential.
4. Ally With a Trustworthy Advisor
Especially in today’s economic climate, working with a vetted fiduciary is a must. TFA is a fiduciary North Carolina financial advisory firm. Our evidenced-based investing approach partners us with you as Dimensional Fund Advisors.
We’re happy to serve as your Carolina retirement planners, as well. Contact us to learn more.