American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Dec. 2003 – Investing and the Science of Economics

We have long implored investors to do their best to ignore the hodgepodge of investment advice that saturates the modern media, and instead consider the scientific approach to investing. Below we outline the history of this science, which is rapidly gaining favor with both institutional and individual investors. In particular we hope our readers will appreciate the logic and the consistency of this approach, as opposed to the “flavor of the day” prognostications and recommendations, supported by large marketing budgets, which emanate largely from those assessing high fees or commissions.

Many of the economists at the “cutting edge” of this research began their work at the University of Chicago. Some of those individuals subsequently went on to employ the results of their findings by founding Dimensional Fund Advisors (DFA). The firm has been quite successful in creating low-cost, passively managed mutual funds. To operate efficiently, DFA only offers these funds to individual investors through investment advisors. While clients in our Professional Asset Management program have access to these funds, individual investors managing their own portfolios do not. Nevertheless, investors who do not seek professional assistance, but who wish to follow this sound approach to portfolio management can do so by utilizing the funds we recommend on page 96.

Researchers and advisors in the field of finance have long wrestled with a question that is at the heart of long-term investment pursuits: Just what is it that determines the long-term returns on different sorts of financial assets? In the field of equity research, although the matter remains far from settled, there is a broad consensus that the insights provided by the Capital Asset Pricing Model (CAPM) are the best available foundation for answering that question. Originally developed in 1964, the model asserts that the long-term returns to holding a particular stock are determined exclusively by the riskiness of that stock, as measured by the correlation of its price with the price of the entire stock market.

Building on the foundation of the CAPM, researchers have developed variations that incorporate factors other than correlation with market returns. One particularly appealing variation on the theme is the three-factor model developed by economists associated with DFA. The three-factor model explains the long-term returns to equity holdings as a function of risk, market capitalization and the ratio of book value to market value. All of the investment offerings of DFA—equity and fixed income, domestic and international—are guided by the insights of the three-factor model. As a result, it’s worth knowing about the history of the model’s development, and how its insights have been applied in our recommendations and in Dimensional’s investment products.


Also in This Issue:

Identity Theft: A Growing Threat
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield