Every year the markets provide us with lessons on the prudent investment strategy. Many times markets provide remedial courses covering lessons it had provided in prior years. That's why one of my favorite statements is that there's nothing new in investing, only the investment history you don't know.
2013 provided us with a dozen lessons the market taught investors. As you may note, some of them are repeat lessons. Unfortunately, most investors fail to learn - they keep repeating the same errors, which is what Einstein called the definition of insanity. To make them less daunting, I've divided the lessons into four, three lesson installments. Let's begin with the first three.
Lesson 1: The World Isn't Flat, Diversification of Risky Assets is as Important as Ever
The financial crisis of 2008 caused the correlations of all risky assets to rise towards one. This led many in the financial media to report on the "death of diversification" - because the world is now flat (interconnected), diversification no longer works. This theme has been heard repeatedly since 2008. The table below provides the evidence, demonstrating that this is clearly false. I used the funds of Dimensional Fund Advisors to show the returns of various asset classes for 2013. (Full disclosure: My firm Buckingham recommends Dimensional funds in constructing client portfolios.) As you can see, there is a large dispersion of returns between the best and worst performing asset classes - the difference between the return of the best and worst performing asset class was 46.2 percent. If the world was flat, this would not be the case.
Large (MUTF:DFUSX) 32.3
Large (MUTF:DFALX) 20.7
Large Value (MUTF:DFLVX) 40.3
Large Value (MUTF:DFIVX) 23.1
Small (MUTF:DFSTX) 42.2
Small (MUTF:DFISX) 27.4
Small Value (MUTF:DFSVX) 42.4
Small Value (MUTF:DISVX) 32.4
Real Estate (MUTF:DFREX) 1.4
Real Estate (MUTF:DFITX) 2.3
Emerging Markets (MUTF:DFEMX) -3.1
Emerging Markets Small (MUTF:DEMSX) -1.4
Emerging Markets Value (MUTF:DFEVX) -3.8
The table above provides another important lesson: diversification is always working - it's just that sometimes you won't like the results. We're all 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 like the S&P 500, you must accept the fact that 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.
Lesson 2: "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 until November. While it is true that stocks have provided greater returns from November through April than they have from May through October, since 1926 there has still been an equity risk premium from May through October. From May through October 2013 the large cap S&P 500 returned +11.5 percent and the small cap Russell 2000 returned +16.9 percent. Keep in mind that holding assets in safe, liquid investments from May through October would have produced almost no return. In case you're wondering, 2011 was the only year in the last five when the "Sell in May" strategy would have worked. And over the very long term it hasn't worked either. From 1927 through 2012, the "Sell in May and Go Away" portfolio produced an annualized return of 8.3 percent. However, compare this to the return of the S&P 500 Index, which produced an annualized return of 9.8 percent. And that's even before considering any transactions costs, let alone the impact of taxes (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).
The most basic tenet of finance is that there is 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 that stocks are less risky during those months - a nonsensical argument.
Lesson 3: Rising Rates Aren't Necessarily Bad For Stocks
Among the conventional ideas that are wrong about investing is that rising interest rates are bad for stock returns. Let's see why this is the case. First, it's important to understand that if you know something about the market (such as interest rates are likely to rise), you can be sure the sophisticated institutional investors that dominate trading, and therefore set prices, are also aware of that information. Thus, even if rising rates were bad for stocks, unless they rose more than was already expected, we shouldn't expect a negative impact on stock prices.
Second, it matters a great deal why rates are rising. If rates are rising because the economy is gaining strength, that not only should lead to greater corporate earnings but it could also lead to a reduction in the risk premium demanded for investing in stocks. That would lead to rising price/earnings ratios. The Federal Reserve made clear that it would unwind its policy only if the economy is strengthening sufficiently to continue to lower unemployment.
Third, the historical evidence simply doesn't support the conventional wisdom. A study found:
- The median return for all 10-month windows when interest rates rose the most was 7.9 percent, comparing to the median of all possible 10-month-long windows of 8.9 percent.
- Eighty percent of 10-month windows of greatest interest rate increase delivered positive stock market returns. In contrast, only 72 percent of all possible 10-month windows generated positive S&P returns.
As you can see it's hard to conclude that rising rates are bad for stocks. And that certainly was the case in 2013.
Yield on January 1, 2013
Yield on December 31, 2013
The 5-year Treasury note yield rose from 0.72 percent to 1.74 percent. The yield on the 10-year Treasury note rose from 1.78 percent to 3.03 percent. And the yield on the 30-year Treasury bond rose from 2.95 percent to 3.97 percent. Defying the interest rate gods, the S&P 500, returning 32.4 percent, turned in its best performance since 1997.
These lessons were just the beginning. I'll continue to delve into 2013 with my upcoming posts.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.