Philosophy / 
Dimensions

Investors are rewarded in proportion to the risk they take. Framing decisions around compensated risk factors in the equity and bond markets connects investors to the forces that create opportunities to build wealth over time.

Evidence from practicing investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Capital market research over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.

Three Equity Factors
Three Equity Factors

Much of what we have learned about expected returns in the equity markets can be summarized in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small/large and value/growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.

Fixed Income Factors
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Relative performance in fixed income is largely driven by two dimensions: term and credit. Longer-term bonds are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns.

 

Related content
The unpredictability of changes in interest rates has a simple implication that is the basis of Dimensional's bond strategies. Specifically, current prices of discount bonds are good estimates of the prices of bonds with the same maturities one period from now.