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.

 

 

Lesson 3: Diversification Is Always Working; Sometimes You Like The Results And Sometimes You Don’t

Everyone is familiar with the benefits of diversification. It’s been called the only free lunch in investing because, done properly, diversification reduces risk without reducing expected returns.

However, once you diversify beyond a popular index, such as the S&P 500, you must accept that you will almost certainly be faced with periods, maybe even long ones, when a popular benchmark index outperforms your portfolio.

Popular benchmark indexes are covered by the financial media on a daily basis. The noise created by the media will test your ability to adhere to your strategy.

Of course, no one ever complains when their diversified portfolio experiences positive tracking error, meaning it outperforms the popular benchmark. The only time you hear complaints is when the diversified portfolio underperforms, and results in negative tracking error.

As Figure 2 indicates, 2014 was just such a year. To demonstrate returns of various equity asset classes, I used the asset class funds of Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)

 

Figure 2: DFA 2014 Fund Returns

U.S.
Fund 2014 Return (%)
Large (DFUSX) 13.5
Large Value (DFLVX) 10.5
Small (DFSTX) 4.4
Small Value (DFSVX) 3.5
Real Estate (DFREX) 31.1
International
Fund 2014 Return (%)
Large (DFALX) -5.2
Large Value (DFIVX) -6.9
Small (DFISX) -6.3
Small Value (DISVX) -5
Real Estate (DFITX) 11.1
Emerging Markets (DFEMX) -1.7
Emerging Markets Small (DEMSX) 3
Emerging Markets Value (DFEVX) -4.4

 

In some ways, 2014 was similar to 1998. During both years, U.S. stocks outperformed international stocks, and large and growth stocks outperformed small and value stocks. What’s important to understand, however, is that we should want to see a wide dispersion of returns. If we didn’t, then when one asset class performed poorly, we could expect them all to perform poorly, and to similar degrees.

A wide dispersion of returns also provides investors with opportunities to rebalance their portfolios, buying underperformers at relatively lower prices (and at a time when their expected returns are now higher) and selling outperformers at relatively higher prices (and at a time when their expected returns are now lower). Of course, that requires discipline, which is a skill many investors don’t possess.

Figure 3 presents evidence from 1998 and 2001 indicating the importance of both diversification and discipline.

 

Figure 3: Returns For Key Market Indexes, 1998 & 2001

Year Return (%) S&P 500 Index Russell 2000
(U.S. Small Stocks)
Russell 2000 Value
(U.S. Small Value Stocks)
1998 28.6 -2.6 -6.4
2001 -11.9 2.5 14

 

We’ll cover lessons four through six—which include some instructive information on the accuracy of economic and financial forecasts—in our next post.


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

 

 

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