Swedroe: Investment Lessons From 2014

January 14, 2015

This article is the first of a four-part series containing 12 lessons that prudent investors could learn from the markets in 2014.

 

Every year, the markets provide us with some valuable lessons about prudent investment strategies. Many times, the markets offer investors a remedial course that covers lessons it had imparted previously. That’s why I like to say there’s really nothing new in investing, only investment history you don’t yet know.

Last year provided us with 12 lessons. As you may note, many of them make repeat appearances over the years. Unfortunately, many investors fail to learn from these lessons, and instead keep replicating the same errors. It reminds me of how Einstein defined insanity. That said, one of our first lessons of 2014 is a perennial favorite. It’s that diversification is as important as ever.

Lesson 1: Active Management Is A Loser’s Game

An InvestmentNews report from January 2014 found that an astonishing 75 percent of financial advisors believed active managers would outperform, despite an overwhelming amount of research to the contrary. While the S&P 500 Index overall returned 13.7 percent last year, Figure 1 clearly demonstrates that active managers had some great opportunities to generate alpha.

There were 10 stocks in the S&P 500 that returned at least 62 percent and 10 stocks that lost at least 35 percent. To generate alpha, all active managers had to do was to overweight these big winners and underweight or avoid these big losers.

 

Figure 1: Best- And Worst-Performing Stocks

10 Best S&P 500 Performers In 2014 % Return 10 Worst S&P 500 Performers In 2014 % Return
Southwest Airlines 124.6 Transocean Ltd.  -62.9
Electronic Arts 104.9 Noble Corp.  -55.8
Edwards Lifesciences 93.7 Denbury Resources  -50.5
Allergan Inc. 91.4 Ensco PLC  -47.6
Avago Technologies 90.2 Avon -45.5
Mallinckrodt plc 89.5 Genworth Financial -45.3
Delta Air Lines  79.1 Freeport-McMoRan Copper & Gold B -38.1
Keurig Green Mountain 75.3 Range Resources -36.6
Royal Caribbean Cruises 73.8 Diamond Offshore Drilling  -35.5
Kroger Co. 62.4 Mattel -35

 

This wide dispersion of returns is not at all unusual. Yet, despite this apparent opportunity, year after year active managers in aggregate persistently fail to outperform. And 2014 was no different. The Vanguard 500 ETF (VOO | A-97) outperformed 80 percent of the active mutual funds in its category. It’s also worth noting that, in 2014, there were 125 stocks in the S&P 500 Index that fell in price. Surely that provided active managers with plenty of opportunity to generate alpha. But year after year, active managers come up with an excuse (such as increasing correlations) to explain why they failed, and then argue that next year will be different. Of course, it never is. 

Lesson 2: The Economy And The Stock Market Are Very Different Things 

The “conventional wisdom” among investors is that the economic growth rate of a country is positively correlated with its stock returns. If you want high returns, many people think, then you should invest in countries that have high rates of economic growth. While China’s economic growth has slowed from double digits, in 2014 it still grew at about 7.4 percent. That’s more than three times as fast as growth in the United States.

Despite the difference in economic growth rates, the VOO gained 13.5 percent last year while the iShares China Large-Cap ETF (FXI | B-44) gained 11.5 percent, an underperformance of 2.0 percentage points.

Perhaps even more telling is that for the five-year period from 2010 through 2014, despite China’s economy growing at a much faster rate, VOO returned 15.3 percent and outperformed FXI’s return of 2.1 percent by 13.1 percentage points a year.

 

 

 

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