Swedroe: Lessons From 2016, Part One

Every year, the market provides us with some important lessons on prudent investment strategy. Many times, the market will offer investors remedial courses, covering lessons that it has already delivered in previous years. That’s why one of my favorite sayings is that there’s nothing new in investing—there’s only investment history you don’t yet know.

Last year gave us nine lessons. As you may note, many of them have appeared before. Unfortunately, many investors fail to learn from them. Rather, they keep repeating the same errors, which is what Albert Einstein called the definition of insanity. We’ll begin with my personal favorite, a lesson the market, if measured properly, teaches each and every year.

Lesson 1: Active Management Is a Loser’s Game

Despite an overwhelming amount of research that demonstrates passive investing is far more likely to allow you to achieve your financial goals, the vast majority of individual investor assets are still invested in active funds. And, unfortunately, investors in active funds continue to pay for their “triumph of hope over wisdom and experience.”

2016 was another year where the large majority of active funds underperformed, despite the great opportunity for active managers to generate alpha in the very large dispersion of returns between the best and worst performers.

For example, while the S&P 500 returned 12.0% for the year, there were 25 stocks in the index that returned at least 45.5%. Oneck Inc. (OKE) returned 132.8%, while Nvidia Corp. (NVDA) returned 223.9%. All an active manager had to do to outperform was to overweight these superperformers.

On the other side of the coin, there were 25 stocks in the index that lost at least 22.9%. Endo International (ENDP) lost 73.1% and First Solar (FSLR) lost 51.4%. To outperform, all an active manager had to do was to underweight, let alone avoid, these “dogs.”

It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform. The table below shows the percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard, for both 2016 and the 15-year period ending December 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Note that Morningstar’s data contains survivorship bias, as it only considers funds that have survived the full period. And the bias is significant, as about 7% of actively managed funds disappear every year and their returns are buried in the mutual fund graveyard. Thus, the longer the period, the worse the survivorship bias, and at 15 years, it’s quite large.

The results make clear that active management is a strategy we could call fraught with opportunity. Year after year, active managers come up with an excuse to explain why they failed that year and then assert that next year will be different. Of course, it never is.

The good news is that investors are waking up to the reality. In October, The Wall Street Journal reported that, according to Morningstar, “although 66% of mutual-fund and exchange-traded-fund assets are still actively invested … those numbers are down from 84% 10 years ago and are shrinking fast.”

Lesson 2: So Much of Returns Come in Very Short and Unpredictable Bursts

The road to investment “hell” is paved with market-timing efforts, because so much of the long-term returns provided by the market come in short, and totally unpredictable, bursts. Last year provided the following example. From January through October, the DFA Small Value Fund (DFSVX) returned 8.0%. From November through December, it returned 18.8%. For the full year, it returned 28.3%. Two-thirds of the full year’s return happened in the last two months.

These types of results are not at all unusual, For instance, the study “Black Swans and Market Timing: How Not To Generate Alpha,” which covered the 107-year period ending in 2006, found that the best 100 days (out of more than 29,000) accounted for virtually all (99.7%) of returns.

Here’s another example. There are 1,020 months in the 85-year period from 1926 through 2010. The best 85 months, an average of just one month a year (or just 8.3% of the months), provided an average return of 10.7%. The remaining 935 months (or 91.7% of the months) produced virtually no return (just 0.05%).

Peter Lynch offered the following example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.

If that investor missed just the best 10 months (2%), his return dropped 27%, to 8.3%. If the investor missed the best 20 months (4%), the return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (8%), the return dropped 76%, all the way to 2.7%.

Do you really believe there is anyone who can pick the best 40 months in a 40-year period? Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Despite this evidence, investors persist in market-timing efforts. Charles Ellis described the winning strategy in the following way: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”

Lesson 3: Events Occur That No One Predicted

Those who have spent their careers forecasting learn to be very humble about their predictions. The reason is that almost every year, major surprises occur. And by definition, surprises are unpredictable.

That is why, when I’m asked for a forecast, my response is that my crystal ball is always cloudy. That is also why my recommendation is to stop spending time listening to forecasts, which have no value and can cause you to stray from your well-thought-out plan. Instead, spend your time managing risk.

2016 saw at least two major unpredicted events that could have had major negative impacts on financial markets. Yet they did not. The first came in June when Great Britain voted for exiting the European Union—the so-called Brexit, which passed 52% to 48% with a referendum turnout of 72% and votes from more than 30 million people.

The other, of course, was the primary win by Donald Trump and then his election to the presidency. With both Brexit’s and Trump’s victories, the market’s immediate reaction was a dramatic self-off. And then a rapid recovery.

Later this week, we’ll discuss lessons four through six, which cover what the market taught us last year about the value of forecasts, the difficulty of predicting stock prices and performance-chasing (or persistence in performance).

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