Swedroe: Final Lessons From 2018

January 25, 2019

Many investors will look at such performance and conclude that investing internationally is a bad idea. After all, 10 years is a long time to them. However, we get an entirely different view if we move back in time and look at the performance of the prior seven years, from 2002 through 2008.

During this period, and again using data from Portfolio Visualizer, the Vanguard 500 Index (VFIAX) lost 1.6%, underperforming the Vanguard Developed Markets Index (VTMGX), which returned 4.0%, by 5.6 percentage points a year, and the Vanguard Emerging Markets Index (VEIEX), which returned 10.9%, by 12.5 percentage points a year. An investor making decisions at the start of 2009 based on the prior seven years of performance would have made a very poor choice.

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 poorly 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 weren’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 10: The world isn’t flat, and the diversification of risky assets is as important as ever.

The financial crisis of 2008 caused the correlations of all risky assets to rise toward 1. This led many in the financial media to report on the “death of diversification”—because the world is now flat (interconnected); diversification no longer works. This theme has been heard repeatedly since 2008.

Yet diversification benefits come not just from correlations but the dispersion of returns as well. And wide dispersion of returns in almost every year since 2000 demonstrates there are still large diversification benefits.

 

 

Note that there were only three years of the 19 when the difference in returns between the S&P 500 Index and the MSCI EAFE Index was less than 5%. On the other hand, there were 10 years when it was at least 8%. There were also only three years when the return on the S&P 500 Index was within 10% of the return on the MSCI Emerging Markets Index. There were seven years when it was at least 20% and three when it was at least 30%. The largest gap was more than 53%.

The data presents pretty powerful evidence both that the investment world is far from flat and that there are still significant benefits in international diversification.

Lesson 11: The road to riches isn’t paved with dividends.

Despite the fact that traditional financial theory has long held that dividend policy should be irrelevant to stock returns, over the last 10 years, we’ve seen a dramatic increase in investors’ interest in dividend-paying stocks. This heightened attention has been fueled both by hype in the media and the current regime of interest rates, which are still well below historical averages.

The low yields available on safe bonds have led even once-conservative investors to shift their allocations from such fixed-income investments into dividend-paying stocks. This is especially true for those who take an income, or cash flow, approach to investing (as opposed to a total return approach, which I believe is the right one).

How did that strategy work in 2018? According to data from S&P Dow Jones Indices, the 415 dividend-paying stocks within the S&P 500 Index (equal-weighting them) lost 8.1%, underperforming the 92 nondividend payers, which returned -2.4%, an outperformance of 5.7 percentage points.

In addition, Vanguard’s High-Dividend ETF (VYM) lost 5.9%. It has also underperformed the S&P 500 in six of the last seven years (the exception was 2016). And over the last 10 years, VYM returned 12.2% per year, underperforming VFIAX (Vanguard 500 Index Fund) which returned 13.1%.

Summary

Even smart people make mistakes. What differentiates them from fools is that they don’t repeat them, expecting different outcomes. 2019 will surely offer you more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes.

You can avoid making errors by knowing your financial history and having a well-thought-out plan. Reading my book “Investment Mistakes Even Smart Investors Make and How to Avoid Them” will help prepare you with the wisdom you need. Finally, consider including in your new year’s resolutions that you will learn from the lessons the market teaches.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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