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Investing Lessons from 2018

In the first installment of his annual look at what markets taught investors over the previous year about prudent investment strategy, Larry Swedroe unpacks lessons one through three from 2018.

Every year, the markets provide us with lessons on the prudent investment strategy. Many times, markets offer investors remedial courses, covering lessons it taught in previous years. That’s why one of my favorite sayings is that “there’s nothing new in investing, only investment history you don’t yet know.”

2018 supplied 11 important lessons. As you may note, many of them are repeats from prior years. Unfortunately, too many investors fail to learn them—they keep making the same errors. We’ll begin with my personal favorite, one that the market, if measured properly, teaches each and every year.

Lesson 1: Active management is a loser’s game.

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

Last year was another in which the large majority of active funds underperformed despite the fact that the industry claims active managers outperform in bear markets. In addition to their advantage of being able to go to cash, active managers had a great opportunity to generate alpha through the large dispersion in returns between 2018’s best- and worst-performing stocks.

For example, while the S&P 500 Index lost 4.4% for the year, including dividends, in terms of price-only returns, the stocks of 10 companies in it were up at least 42.6%. The following table, with data from S&P Dow Jones Indices, shows the 10 best returners.

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To outperform, all an active manager had to do was to overweight those big winners, each of which outperformed the index by at least 47%. On the other hand, 10 stocks lost at least 49%, with the worst performer losing 67% on a price-only basis.

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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 following table shows the Morningstar percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors and Vanguard, in 2018 and over the 15-year period ending December 2018. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

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

For example, performing the same analysis at the end of 2016, I found that, while the average Vanguard fund had a 15-year Morningstar ranking of 36 and the average Dimensional fund had a ranking of 16, once I accounted for the survivorship bias, Vanguard’s ranking improved to 21 and Dimensional’s to 10. For taxable investors, the data is even more compelling, because taxes are typically the highest cost of active management. Thus, the survivorship-bias-free, after-tax rankings for Vanguard’s and Dimensional’s funds would be significantly better.

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

Lesson 2: 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 the fact that, almost certainly, you will be faced with periods, even long ones, when a popular benchmark index, reported by the media on a daily basis, outperforms your portfolio. The noise of the media will then test your ability to adhere to your strategy.

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

As the table below demonstrates, 2018 was just such a year. To show the returns of various equity asset classes, I used Dimensional’s asset class funds. Returns data is from Dimensional. (Again, in the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

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In some ways, 2018 was similar to 1998 in that U.S. stocks outperformed international stocks, and large and growth stocks outperformed small and value stocks. What’s important to understand is that we should want to see a wide dispersion of returns. If we didn’t, when one asset class performed poorly, we could expect them all to perform poorly, and to similar degrees.

Wide dispersions of returns also provide us with opportunities to rebalance the portfolio, buying the underperformers at relatively lower prices, at a time when their expected returns are now higher, and selling the outperformers at relatively higher prices, at a time when their expected returns are now lower. Of course, that requires discipline, which is a skill that most investors don’t possess. The table below demonstrates the importance of adhering to your plan.

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Lesson 3: Don’t make the mistake of recency. Last year’s winners are just as likely to be this year’s dogs.

The historical evidence demonstrates that individual investors are performance chasers—they buy yesterday’s winners (after the great performance) and sell yesterday’s losers (after the loss has already been incurred). This causes investors to buy high and sell low—not exactly a recipe for investment success. As I wrote in my book “The Quest for Alpha,” this behavior explains the findings from studies that show investors can actually underperform the very mutual funds in which they invest.

For example, in a July 2005 study published in “Morningstar FundInvestor,” Morningstar found that in all 17 fund categories it examined, the returns earned by investors were below the returns of the funds themselves. Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns.

Thus, the prudent strategy for an investor 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 envelope 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—the process of restoring your portfolio’s asset allocation to your plan’s targeted levels.

Using Dimensional’s structured mutual funds, the following table compares the returns of various asset classes in 2017 and 2018. As you can see, sometimes the winners and losers repeated, but other times they changed places.

For example, the best performer in 2017, emerging markets, fell to 6th place in 2018; and the worst performer in 2017, U.S. real estate securities rose to first place in 2018. Returns data is from Dimensional. (Once more, in full disclosure, my firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

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Later this week, we’ll resume with lessons four through seven.

This commentary originally appeared January 21 on ETF.com

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