Swedroe: Lessons From 2016, Part Three

January 27, 2017

So far this week, we have covered six important lessons that the markets taught investors in 2016 about prudent investment strategy.

These lessons, some of which repeat year after year, have taken on active management as a loser’s game, the fact that so much of returns tend to come in very short and unpredictable bursts, the propensity for events to occur that no one ever predicted, the value of forecasts, the difficulty of predicting the direction of stock prices and the dangers of chasing performance. Today we’ll conclude our series with three additional lessons, giving us a final total of nine.

Lesson 7: “Sell in May and Go Away” Is the Financial Equivalent of Astrology

One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to buy back into the market until November.

While it’s true that stocks have provided greater returns from November through April than they have from May through October, since 1926, an equity risk premium has still existed in those May-through-October months. From 1927 through 2015, the “Sell in May” strategy returned 8.3% per year, underperforming the S&P 500 by 1.7 percentage points per year. And that’s even before considering any transaction costs, let alone the impact of taxes (with the “Sell in May” strategy, you’d be converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income).

How did the “Sell in May and Go Away” strategy work in 2016? The S&P 500 Index’s total return for the period from May through October was 4.1%. Alternatively, during this same period safe, liquid investments would have produced virtually no return. In case you’re wondering, 2011 was the only year in the last eight when the “Sell in May” strategy would have worked.

A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, as with many myths, this one seems hard to kill off. And you can bet that, next May, the financial media will be resurrecting it once again.

Lesson 8: Hedge Funds Are Not Investment Vehicles, They Are Compensation Schemes

This lesson has appeared about as regularly as our first lesson, which is that active management is a loser’s game. Hedge funds entered 2016 coming off their seventh-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins.

Unfortunately, the streak has continued into an eighth year, as the HFRX Global Hedge Fund Index returned just 2.5% in 2016, and underperformed the S&P 500 Index by 9.5 percentage points. The table below shows the returns for various equity and fixed income indexes.


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