So far, we’ve covered seven important lessons that the market taught investors in 2015 about the prudent investment strategy.
These lessons, some of which repeat year after year, have addressed active management as a loser’s game; the correlation between the stock market and the economy; the “Sell in May” myth; fear about inflation; the mistake of chasing recent performance; and forecasts and issues with the strategy of investing only in dividend-paying stocks.
Today we’ll conclude our series with three additional lessons, finishing up with an even 10.
Lesson 8: They Are Called Risk Premiums for a Reason
Many investors have bemoaned the fact that the value premium—the excess return of value stocks relative to growth stocks—seems to have disappeared, turning negative for the past 10 years (although its underperformance has been relatively small).
The trouble with this line of thinking, however, is that stock returns are extremely noisy from a statistical perspective. Thus, even a time frame as long as 10 years isn’t long enough to make a definitive statement about any strategy that invests in an asset class or investment factor.
For example, consider the 10-year period from 2000 through 2009, when the S&P 500 Index returned -0.9% a year and underperformed riskless one-month Treasury bills by 3.7 percentage points a year.
Hopefully, that period didn’t prove long enough to convince you that stocks shouldn’t be expected to outperform Treasury bills. Or consider the even longer 40-year period from 1969 through 2008, when the U.S. total stock market returned 8.8% and underperformed the 8.9% return of long-term U.S. Treasurys.
Consider also the performance of international and emerging market stocks, which have underperformed over the most recent six-year period. For the period 2010 through 2015, the S&P 500 Index returned approximately 13.5% per year, outperforming both the MSCI EAFE and the MSCI Emerging Market indexes, which returned about 5.0% and -0.5% per year, respectively.
Many investors will take a look at such performance and conclude that investing internationally is a bad idea. After all, to them, six years is a long time. However, we get an entirely different view if we move back in time and look at the performance of the prior six years: 2004 through 2009.
During this period, the S&P 500 Index returned just 2.1%, underperforming the MSCI EAFE Index by 4.1 percentage points a year and the MSCI Emerging Markets Index by 15.4 percentage points a year. An investor making decisions at the start of 2010 based on the last six years of performance might have made a very poor choice.
Don’t Chase. Rebalance Instead.
Unfortunately, far too many investors put too great an emphasis on recent, short-term performance when considering investment decisions. The media tends to exacerbate the problem as opposed to helping investors stick to a disciplined strategy.
Chasing past performance can cause investors to buy asset classes after periods of strong recent performance, when valuations are relatively higher and expected returns are lower. Alternatively, it can lead investors to sell asset classes after periods of weak recent performance, when valuations are relatively lower and expected returns are higher.
In fact, investors who chase recent performance are systematically buying high and selling low. A better approach is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently, and buys what has performed relatively poor recently.
When evaluating your asset allocation, recent performance should not be a factor in the decision. Smart investors know that all investment strategies that entail risk-taking will have bad years, or even many bad years in a row. That’s the nature of risk. After all, if this wasn’t the case, there wouldn’t be any risk.
With that knowledge, smart investors know that recency is their enemy, and patience and discipline (accompanied by rebalancing) are their friends.
Lesson 9: The Markets Will Test Your Discipline
2014 saw the S&P 500 close at 2,059. The first six months of 2015 were relatively quiet for the U.S. stock market. In the first quarter, the S&P 500 Index returned 1%. By the end of May, it was up 3%. On June 18, the S&P 500 Index closed at 2,121.
But 10 weeks later, on Aug. 25, it had fallen to 1,868, a drop of almost 12%. Such sharp drops in such short periods can test the discipline of investors. They begin to fear that any current drop will turn into another 2008. That type of fear often leads to the stomach taking over the decision-making from the head. And I’ve yet to meet a stomach that makes good decisions.
Falling markets can cause even well-thought-out plans to end up in the “trash heap of emotions.” Thus, it’s critical you don’t make the mistake of assuming more risk than you have the ability, willingness or need to take.
And also make sure you don’t succumb to the all-to-human mistake of overconfidence; in this case, overconfidence in your ability to stand the stress that comes with bear markets.
If the market did teach you a lesson—even if you managed not to panic and sell, but found that you weren’t able to sleep well and enjoy your life—the best time to consider an asset allocation change is when things are going well and your stomach isn’t driving your decisions.
So, if you were tempted to get more conservative when the market dipped, ask yourself if you have the appropriate allocation to risky assets. Remember: The next market drop could look a lot more like the one we experienced in 2008.
Lesson 10: Don’t Wait Until Year-End to Realize Losses
In late August 2015, the market experienced a period of high volatility. For example, on Aug. 25, the S&P 500 ended its day at 1,868, or 9.3% below its year-end close. That drop alone provided at least some investors an opportunity to harvest losses for tax purposes.
Unfortunately, far too many investors wait until the end of the year to engage in tax management strategies. Those who make this mistake often miss out on opportunities to have Uncle Sam share some of the pain of losses. The S&P 500 closed 2015 at 2,044, almost right where it started.
It’s especially important to take losses if they are short term, when they are more valuable, because they can be used to offset any short-term capital gains (which are taxed at the higher ordinary income tax rates). The lesson here is that tax management is a full-time endeavor, not something that should be left until late in December.
Before closing, we’ll throw in a bonus lesson that investors should have learned in 2015. This lesson, which holds the title for most repeat performances, is that hedge funds are not investment vehicles. They’re compensation schemes. For the 10-year period of 2006 through 2015, the HFRX Global Hedge Fund Index returned just 0.1% a year and underperformed every single major equity and bond asset class.
This year will surely provide investors with more lessons, many of which will again be remedial courses. And the market will provide you with opportunities to make investment mistakes. But you can avoid these errors by knowing your financial history and by having a well-thought-out financial plan. My book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” can arm you with the wisdom you need to escape the worst of these pitfalls.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.