One of the biggest challenges people often face in embracing evidence-based investing is figuring out what it means to them, and putting it into words to remind themselves or to explain to others. Not to worry – we’ve got that covered here at Hill Investment Group. Recently, we produced a nifty advertisement, as well as an infographic/poster (in collaboration with Wendy J. Cook Communications and Mineral Interactive), to tell it to the world. I hope you like the results! (Click on each image to enlarge it.)

Quick, what’s the difference between a market-cap-, equal- and price-weighted stock market index? Fortunately, if you’re not sure, our friends at Dimensional Fund Advisors just published an excellent piece on this very subject. We invite you to read it here, but here’s our overview.

If you think of a market as a big box, there are several ways each stock that belongs in that box might “weigh in” to help fill it:

Market-Cap Weighted – If we fill a market box according to each stock’s market capitalization (share price multiplied by shares outstanding), the stocks with the biggest market caps (e.g., Apple stock –  AAPL) weigh the heaviest, or occupy the most space, as Dimensional depicted here:

Equal Weighted – If, each security is instead given equal space in the box regardless of its market-cap, an equal-weighted market will look more like this:

Price Weighted – As described in this recent New York Times piece (which may require a subscription to access), the Dow Jones Industrial Average is the only popular index that uses price weighting, where the highest-priced stocks take up the most space. (Almost everyone agrees, price-weighting is pretty arbitrary, especially since the Dow tracks only 30 U.S. stocks to begin with. But as the world’s first and oldest index, the venerable Dow essentially gets to do as it pleases.)

So what does all this mean to you as an investor? As Dimensional’s illustrations depict:

• If you were to invest all of your money in a single market-cap-weighted index fund, you’d end up holding a much heavier allocation to large-cap stocks, be they value or growth.
• If you were to invest everything in an equal-weighted index fund, you’d end up holding more small-cap stocks than would otherwise be warranted by their cap-weighted presence in the total market.

Now, here’s where things get a little complicated, so bear with me. At first glance, you might conclude you’d be best off investing in an equal-weighted index fund, to capture more of the higher expected small-cap value premium. After all, that’s where the biggest small-cap value “blob” appears, right?

Not so fast. First, we’ve got to remember that an index is just a theoretical collection of stocks. When an investor or fund manager seeks to replicate an index by placing actual trades on those stocks, they run into real-life trading constraints. This is especially so when tracking an equal-weighted index, where far more frequent trading is likely to be the norm.

Put plainly, keeping up with the evolving components in an equal-weighted index can get very expensive, very fast.

Dimensional explains:

“[U]sing a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.”

Which brings us back to evidence-based investing as we know it. Want to know more? Here’s a past post on index- vs. evidence-based investing. Or just give me a call to continue the conversation.

End notes:
Exhibit 1: For illustrative purposes only. Illustration includes constituents of the Russell 3000 Index as of December 31, 2016, on a market-cap weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.

Exhibit 2: For illustrative purposes only. Illustration includes the constituents of the Russell 3000 Index as of December 31, 2016 on an equal-weighted basis segmented into Large Value, Large Growth, Small Value, and Small Growth. Source: Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. See Appendix (on page 3) for additional information.

Since many of the market’s long-term rewards come from the risks you’re willing to take, making serious money usually hurts — at least when it appears to be out of favor with the “consensus.” Morgan Housel’s recent blog post, “Every Great Investment Hurts,” offers a fresh perspective on the source of that pain.

To trade profitably in highly competitive markets, you not only must make the right calls on future pricing, you’re best off making them when most other investors think you’re wrong. That’s what this simple diagram from Housel’s post suggests.

How do you end up in that profitable sweet spot? You can try guessing correctly almost all the time (super hard). Or you can embrace evidence-based investing, which should guide you toward being correct more often than not … if you stick with your plans. That can still be hard, but at least the odds are stacked in your favor.