Swedroe: Heed Buffett & Ignore Forecasts

This article is the third of a four-part series containing 12 lessons that prudent investors could learn from the markets in 2014. The first and second articles appeared here and here.

Earlier this week, we discussed the first six of a total 12 lessons that the markets taught us in 2014 about prudent investment strategies. To recap:

• Lesson 1: Active management is a loser’s game
• Lesson 2: The economy and the stock market are very different things
• Lesson 3: Diversification is always working; sometimes you like the results and sometimes you don’t
• Lesson 4: Sell in May and go away is the financial equivalent of astrology
• Lesson 5: Even with a clear crystal ball ...
• Lesson 6: Inflation wasn’t, and isn’t, inevitable

Many of these lessons make repeat appearances over the years. Unfortunately, a lot of investors fail to learn from them. So here are lessons seven through nine in hopes that maybe 2015 will be different.

Lesson 7: Ignore All Forecasts—All Crystal Balls Are Cloudy

Each month, Bloomberg does a survey of economists, asking them about the direction of interest rates. In January 2014, 97 percent of the economists surveyed expected interest rates to rise within the next six months. In February, 95 percent had that expectation. In March, the figure was back up to 97 percent. With the yield on the 10-year Treasury note at 2.7 percent, the April survey showed that 100 percent of the 67 economists surveyed expected rates to rise within the next six months. But six months later, the yield on the 10-year Treasury note was just 2.2 percent. Yes, 100 percent of economists were wrong.

How About Oil Forecasts?

The following is another great example of why you should ignore all forecasts. In early 2014, Bloomberg’s survey of the “most accurate” oil price forecasters yielded a prediction for the year of $105 per barrel. And a January 2014 survey of economists by The Wall Street Journal produced a year-end forecast for oil of $95 per barrel. We actually ended the year at about $53.          

Maybe oil companies were more prescient in their forecasts? If you believe so, you would be dead wrong. Early in 2014, Chevron announced that its budgeting would be based upon oil prices of $110 per barrel. In fact, John Watson, the company’s CEO, said: “There is a new reality in our business… $100/bbl is becoming the new $20/bbl in our business.”

And if you think the so-called smart money got it right, then you’d also be wrong. Hedge funds were among the largest losers in oil stocks. Big names like Carl Icahn and John Paulson led the way with major money-losing bets.

The fact that so many were so wrong shouldn’t come as a surprise. A wealth of research shows that, when it comes to the financial markets, there really aren’t any good forecasters.

Listen To Buffett

These examples demonstrate why Warren Buffett warns investors to ignore all forecasts. They tell you nothing about where the market is headed, though they do tell you a lot about the person making the forecast. Keep this in mind the next time you’re tempted to act based on the forecast of some “guru.”

Lesson 8: Last Year’s Winners Are Just as Likely to Be This Year’s Dogs as They Are to Repeat

The historical evidence demonstrates that individual investors tend to be performance chasers. They watch yesterday’s winners and then buy, but after the great performance. Similarly, they watch yesterday’s losers and then sell, but after the loss has already been incurred.

Performance-chasing causes investors to buy high and sell low, which is not exactly a recipe for investment success. This behavior explains the findings from studies that demonstrate investors actually underperform the very mutual funds in which they invest.

Unfortunately, a good return in one year doesn’t predict a good return in the next. In fact, great returns lower future expected returns, and below-average returns raise future expected returns.

Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well: It adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation). Sticking to one’s plan doesn’t mean just buying and holding. It means buying, holding and rebalancing, which is the process of restoring your portfolio’s asset allocation to the plan’s targeted levels.

Looking At Real-World Returns

The following table compares the returns of various asset classes in 2013 and 2014 using the passive asset class funds from Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) As you can see, sometimes the winners and losers of 2013 repeat in 2014, but other times they change places.

For example, in 2014, the DFA Real Estate fund, which ranked 10th out of the 14 funds listed here in 2013, was far and away the best performer in 2014. It outperformed the second-place fund by 17.6 percentage points. In third place in 2014 was the DFA International Real Estate fund, which had finished in 9th place the year before. And the top-performing fund in 2013, the DFA U.S. Small Value Fund, fell to the middle of the pack a year later.

Lesson 9: The Road to Riches Isn’t Paved With Dividends

Over the last few years, we’ve seen a dramatic increase in the interest surrounding dividend-paying stocks. This heightened interest has been fueled both by media hype and the current regime of interest rates, which are well below historical averages.

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

How did a dividend strategy work in 2014?

The 423 dividend-paying stocks within the S&P 500 Index (equal-weighting them) returned 14.0 percent. The 79 nondividend payers returned 14.4 percent, outperforming the dividend payers by 0.4 percentage points. It’s worth noting that this was a repeat of what occurred in 2013, when the dividend-paying stocks within the index (again, equal-weighting them) returned 40.7 percent versus the 46.3 percent for the nonpayers.

Admittedly, these results are for a very short period. So we’ll take a look at some long-term data from a study by the research team at DFA. As you review the results, recall that classic economic theory says dividend policy should be irrelevant to stock returns.

The March 2013 study, “Global Dividend-Paying Stocks: A Recent History,” examined data from 23 developed markets over the period from 1991 through 2012. Following is a summary of the authors’ findings:

• Simple average annual returns were 9.1 percent for dividend payers and 11.1 percent for nonpayers. However, the standard deviation of the returns for nonpayers was higher than for dividend payers. The net result was that the annualized returns were the same—7.6 percent for dividend payers as well as nonpayers. However, by focusing only on dividend payers, an investor would exclude about 40 percent of firms, thereby sacrificing diversification benefits.
• Although less volatile than the capital gain component of stock returns, the aggregate stream of dividend payments is subject to the same broad, macroeconomic risks that affect capital gains. For example, in 2009, 14 percent of firms around the world eliminated their dividend, and 43 percent of firms reduced their dividend. In other words, dividends can provide an illusion of safety.

The evidence demonstrates that investing in dividend-paying stocks is just another example of the “conventional wisdom” on investing being totally wrong. There simply doesn’t appear to be any advantage to adopting a strategy that calls for investing in dividend-paying stocks.

Later this week, we’ll discuss the final three investment lessons we learned from the markets in 2014. Here’s a sneak peak: We’ll shed some light on hedge funds and talk about what it means to be a disciplined investor.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.