The Certainty Principle

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A frequent complaint from would-be investors is that “uncertainty” is what keeps them out of the financial markets. “I’ll stay in cash until the direction becomes clearer,” they will say. So when has there ever been total clarity?

Alternatively, people who are already in the market after a strong rally, as we have seen in recent years, nervously
eye media commentary about possible pullbacks and say, “Maybe now is a good time to move to the sidelines.”

While these kneejerk, emotion-driven swings in asset allocation based on market and media commentary are understandable, they are also unnecessary. Strategic rebalancing provides a solution, which we will explain
in a moment.

But first, think back to March 2009. With equity markets deep into an 18-month bear phase, the Associated Press provided its readers with five signs the stock market had bottomed out and followed that up with five signs that it hadn’t.1

The case for a turn was convincing. Volumes were up, the slide in the US economy appeared to be slowing, banks were returning to profitability, commodity prices had bounced, and many retail investors had capitulated and gone to cash.

But there also was a case for more pain. Toxic assets still weighed on banks’ balance sheets, economic signals were patchy, short-covering was driving rallies, the Madoff scandal had knocked confidence, and fear was still widespread.

Of course, with the benefit of hindsight, that month did mark the bottom of the bear market. In the intervening period of just over five years, major equity indices have rebounded to all-time or multi-year highs.

Exhibit 1 shows the cumulative performance of major indices in the 18 months or so of the bear market from November 2007 and then the cumulative performance in the subsequent recovery period.

You can see on the following page there have been substantial gains across the board since the market bottom. And while annualized performance over the six-and-a-half years from November 2007 is not impressive, there has been a lot less pain for those who did not bail out in March 2009.


So those who got out of the market at the peak of the crisis and waited for “certainty” may have realized substantial losses.
But keep in mind that these past five years of recovery in equity markets have also been marked by periods of major uncertainty.
In 2011, Europe was gripped by a sovereign debt crisis. Across the Atlantic, Washington has been hit by periodic brinksmanship over the US debt ceiling. In Asia, China has grappled with the transition from export-led to domestic-driven growth.

Around any of these events, there was a broad range of views about likely outcomes and how these possible scenarios might impact financial markets. The big question for the rest of us is what to do with all this commentary.

The fact is, even the professionals struggle to consistently add value using analysis of macroeconomic events, as we see repeatedly in surveys of fund-versus-index returns. And history suggests that those looking for “certainty” around
such events before investing could be setting themselves up for a long wait.

There is always something to fret about. Recently, the focus has been on low volatility, particularly when compared to 2008–09. Sage articles muse over whether risk is being appropriately priced and whether volatility is being unnaturally suppressed by central banks’ explicit forward guidance about policy.2

Just as in March 2009, one does not have to look far to find well-reasoned discussion in support of why the market has topped out, alongside equally compelling reasons of why the rally might continue for some time.

What is the average investor supposed to make of all this conjecture? One way is to debate the market implications
of news and to try to anticipate what might happen next. But whom do you believe? We’ve seen there are always
cogent-sounding arguments for multiple scenarios.

An alternative approach is much simpler. It begins by accepting the market price as a fair reflection of the collective opinions of millions of market participants. So rather than betting against the market, you work with the market.

That means building a diversified portfolio around the known dimensions of expected returns according to your own needs and risk appetite, not according to the opinions of media and market pundits about what will happen next month or next week.

It also means staying disciplined within that chosen asset allocation and regularly rebalancing your portfolio. Under this approach, shares are typically sold after a solid run-up in the market. The trigger for rebalancing is not media speculation but the need to retain your desired asset allocation.

Say you have chosen an allocation of 60% of your portfolio in equities and 40% in fixed income. A year goes by and your equity allocation has rallied strongly so that the balance between the two has shifted to 70%/30%. In this case, it makes absolute sense to take some money out of shares and move it to bonds or cash.

It works the other way, too, so that if shares have fallen in relation to bonds, you can take some money out of fixed income cash and buy shares. Essentially, this means buying low and selling high. But you are doing so based on your
own needs, rather than on what the armies of pundits say will happen in the market next.

Of course, this doesn’t mean you can’t take an interest in global events. But it does spare you from basing your long-term investment strategy on the illusion that somewhere, at some time, “certainty” will return.

1 “Five Signs the Stock Market Has Bottomed Out and Five Signs It Hasn’t,” Associated Press, March 15, 2009.
2 “When Moderation is No Virtue,” Economist, May 22, 2009.

“Outside the Flags” began as a weekly web column on Dimensional Fund Advisors’ website in 2006. The articles are designed to help fee-only advisors communicate with their clients about the principles of good investment—working with markets, understanding risk and return, broadly diversifying and focusing on elements within the investor’s control—including portfolio structure, fees, taxes, and discipline. Jim’s flags metaphor has been taken up and recognized by Australia’s corporate regulator in its own investor education program.

For more articles, visit Dimensional’s client site at

Past performance is not a guarantee of future results.

All expressions of opinion are subject to change without notice. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Diversification does not eliminate the risk of market loss. There is no guarantee the investment strategies will be successful.

Dimensional Fund Advisors LP is an investment advisor registered with the US Securities and Exchange Commission.

Sustainability Investing

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Investors around the world have grown increasingly aware of how certain business practices may potentially affect the environment. As a result, many individuals and institutions are asking how they can align their investment decisions with their environmental views.

Sustainability investing is one approach within the broader socially responsible investing (SRI) universe.1 While “sustainability” may have different meanings to different people, the term is often associated with general concern for the environment. The United Nations describes sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”2 With this framework in mind, business practices that are believed to exhaust resources or cause irreversible changes to the earth’s climate are considered unsustainable.

Dimensional offers investors a way to reinforce environmentally sustainable business practices while pursuing their long-term investment goals through a broadly diversified strategy.

This paper explores Dimensional’s approach to sustainability investing and explains how our patented strategy is designed to deliver the benefits of our time-tested philosophy and innovative core equity approach, while investing in companies considered to have favorable sustainability practices.3

Dimensional’s Methodology

Many SRI approaches involve the use of positive or negative screens.4 The criteria informing these screens are based on subjective standards that may be difficult to measure. Additionally, the screening methods typically are applied to business practices in absolute (or binary) terms, with a company stock being either included or excluded.

This all-or-nothing approach may result in reduced diversification and a smaller investment opportunity set. Companies with strong environmental policies might be excluded because of a single detail, or an entire category of firms might be deemed ineligible because of an industry’s environmental reputation. Since environmental business practices can vary considerably among companies, their practices are better characterized along a sustainability spectrum. An investment methodology that reflects this spectrum may better serve investors.

Dimensional has developed a way to apply environmental sustainability criteria in an investment strategy. The approach incorporates sustainability standards that are quantitative and objectively applied. We start with our core equity approach, which provides broad diversification across the equity market, and then apply an overlay based on third-party research that rates or scores companies on multiple environmental criteria.

When applying the rating methodology in the overlay, Dimensional looks at all major sectors, emphasizing investment in companies with high environmental sustainability scores and minimizing or excluding investment in companies with low scores. Weighting companies according to their relative sustainability scores results in a larger investible universe, broader diversification across industries, and a more robust application of environmental values in a portfolio. The process is illustrated in the chart below.

This combined approach gives investors a way to reinforce environmentally sustainable business practices and pursue their long-term investment goals through a broadly diversified strategy.

Core Equity Approach

Dimensional’s sustainability strategy uses the same architecture as other Dimensional core equity strategies, which seek to hold a broad and diverse group of securities across their respective markets. Rather than replicating the market weightings of an index, core engineering targets increased weighting to stocks with higher expected returns, such as small cap stocks, stocks with low relative prices, and stocks with higher profitability.5 The core approach places greater emphasis on these dimensions through multipliers that adjust the target weights of stocks relative to their natural market weights.


What are the costs of sustainability investing?

Whatever screening approach is adopted, investors should consider the explicit and implicit costs associated with sustainability and other socially responsible investment approaches:

  • The screens adopted to implement SRI policies are a cost to a portfolio.
  • Some high-performing stocks may be excluded.
  • Diversification may be reduced by screening out stocks.

Dimensional’s approach to sustainability investing aims to minimize these costs by applying a quantitative screen to its core equity investment process. The screen overweights companies with higher sustainability scores (relative to their core equity strategy weightings) and underweights or excludes companies with lower sustainability scores. The goal is to provide an environmentally sustainable strategy without compromising the benefits of Dimensional’s core equity investment approach.

The core equity approach can offer investors several advantages. It is broadly diversified to provide consistent market coverage, while focusing on the dimensions of higher expected returns. By spreading the investment gradually across the entire market, a portfolio can hold stocks for maximum efficiency, resulting in reduced turnover and lower transaction costs. Finally, the core equity structure provides opportunities for Dimensional to add value through disciplined and patient trading.

Sustainability Overylay

Dimensional applies an overlay that adjusts the core equity stock weightings according to the respective companies’ sustainability scores. The stocks of companies with higher (favorable) scores receive larger weights relative to their core equity strategy weightings; stocks with lower scores are underweighted or eliminated.

Dimensional uses a third-party firm to research and rate companies, and the company scores are reviewed periodically for companies held in the portfolios and for those being considered for investment. The ratings are based on three broad categories:

  • Climate change: Considers a company’s carbon emissions per dollar of revenue. The analysis evaluates the thoroughness and transparency of carbon reporting by companies participating in the Carbon Disclosure Project, an organization that works with companies to measure and disclose their greenhouse gas emissions. It also takes into account a company’s use or production of clean energy and alternative fuels, energy-efficient programs, and the production of goods promoting energy efficiency.
  • Environmental vulnerability: Focuses on a company’s environmental impact, particularly where that impact is causing harm. This includes issues with hazardous waste, substantial fines or penalties stemming from environmental law violations, and other concerns, including damage to natural resources and environmental controversies with an impact on communities.
  • Environmental strength: Examines a company’s processes and systems for managing and reducing overall impact on the environment. The analysis considers systems that track resource use and waste production, pollution prevention (including clearly defined goals), and regular progress reports. Scoring also reflects other initiatives, such as the substantial use of recycled materials or revenue derived from products and services with environmental benefits.

This process differs from traditional screening approaches in that it sorts companies by industry and applies gradual weighting that emphasizes companies considered to have a stronger commitment to sustainable practices while preserving core equity characteristics.

Evaluating companies at the industry level prevents the elimination of an entire industry from investment due to low sustainability ratings among companies in that sector. This approach helps ensure that the portfolio remains highly diversified across industries, and recognizes that companies engaged in the same industry can have significantly different levels of environmental business practices.

The rating methodology also considers the potential impact of company size on ratings. For example, a large company, even one operating at maximum efficiency, may have substantially higher total emissions than a small company in the same industry. To adjust for company size, variables in the climate change and environmental vulnerability analyses are weighted by revenue. Additionally, some environmental strength variables are measured in comparison to similar-sized firms because large companies typically have more resources to pursue initiatives that may be environmentally beneficial.

Putting Ideas Into Practice

Dimensional has a long history of creating custom investment solutions to address the evolving needs of clients. First introduced in the US in 2008, our sustainability strategies offer investors an opportunity to integrate environmental values into Dimensional’s core equity approach. The strategies are designed and managed to deliver consistent, value-added access to the dimensions of higher expected returns, and employ cost-effective execution.

To this end, Dimensional’s patented, research-driven approach to sustainability offers a broader strategy for investors to pursue their environmental and investment goals simultaneously.

1 Socially responsible investing, which is also known as sustainable and responsible investing, broadly refers to any investment strategy that seeks to consider both financial return and social good. The three main advocacy issues within SRI are environmental, social, and corporate governance. Sustainability investing falls within the environmental category; ethical investing falls within the social category. According to the Forum for Sustainable and Responsible Investment (formerly the Social Investment Forum Foundation), SRI is implemented mainly through investment analysis, portfolio construction, shareholder advocacy, and community investing.
2 United Nations, “Report of the World Commission on Environment and Development,” General Assembly Resolution 42/187 (December 11, 1987).
3 The implementation and management of Dimensional’s sustainability portfolios are protected by US Patent Nos. 7,569,525 B1 and 7,599,874 B1

“Dimensional” refers to Dimensional Fund Advisors LP. Mutual funds distributed by DFA Securities LLC.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at
Mutual fund investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost.
Diversification neither assures a profit nor guarantees against a loss in a declining market. Strategies may not be successful.
Past performance is no guarantee of future results.

Living with Volatility, Again

By | Dimensional | No Comments


Volatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.

There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and
even the Ebola virus.

In many cases, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.

In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied earlier this year with a low price on risk, but now they are applying a higher discount rate to risky assets.

So the increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If
they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.

As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes. We have seen the benefit of that
in recent weeks as bonds have rallied strongly.

For those still anxious, here are seven simple truths to help you live with volatility:

1. Don’t make presumptions.

Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout.

If anything, the reverse has been the case with central banks fretting about deflation.

2. Someone is buying.

Quitting the equity market when prices are falling is like running away from a sale. While prices have been
discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media
headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

3. Market timing is hard.

Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when
market sentiment was at its worst—the S&P 500 turned and put in seven consecutive months of gains totalling almost
80%. This is not to predict that a similarly vertically shaped recovery is in the cards, but it is a reminder of the dangers for
long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

4. Never forget the power of diversification.

While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit
the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.

5. Markets and economies are different things.

The world economy is forever changing, and new forces are replacing old ones. This applies both between and within
economies. For instance, falling oil prices can be bad for the energy sector but good for consumers. New economic forces
are emerging as global measures of poverty, education, and health improve. A recent OECD study shows how far the world has come in the past 200 years.1

6. Nothing lasts forever.

Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

7. Discipline is rewarded.

The market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

“Outside the Flags” began as a weekly web column on Dimensional Fund Advisors’ website in 2006. The articles are
designed to help fee-only advisors communicate with their clients about the principles of good investment—working
with markets, understanding risk and return, broadly diversifying and focusing on elements within the investor’s
control—including portfolio structure, fees, taxes, and discipline. Jim’s flags metaphor has been taken up and
recognized by Australia’s corporate regulator in its own investor education program.

1“How Was Life? Global Well-Being since 1820,” OECD, October 2, 2014.

For more articles, visit Dimensional’s client site at

All expressions of opinion are subject to change without notice. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.

Diversification does not eliminate the risk of market loss. There is no guarantee investment strategies will be successful.

The S&P 500 Index is not available for direct investment and does not reflect the expenses associated with the management of an
actual portfolio. Past performance is no guarantee of future results.

Dimensional Fund Advisors LP is an investment advisor registered with the US Securities and Exchange Commission.