Market Lessons From 2007

Every year the market provides investors with lessons on the prudent investment strategy. The following is my annual review of some of the important lessons the capital markets provided us with in 2007.

Lesson 1: Globalization and Diversification

One of the more common investment themes we all have been reading about revolves around globalization. With increased globalization the thought is that the correlation of returns of stocks around the globe is rising, reducing the benefits of international diversification. Thus, one need no longer take the risks of investing internationally. Instead, just invest in U.S. multinational companies, like those that dominate the S&P 500 Index. While the world may be getting smaller, the benefits of global diversification should still be obvious to anyone paying attention to stock returns. As one good example, we can only wonder what Japanese investors have felt since 1990 when the Nikkei peaked at about 40,000 (it closed 2007 at 15,308) about the advice that they did not need to diversify internationally.

Using the passive asset class funds of Dimensional Fund Advisors [DFA], the following table presents the 2007 returns of the four major U.S. equity asset classes and their international counterparts. The returns for the various emerging market asset classes are included. The benefits of global diversification are obvious.

The important lesson is that broad global diversification is always the prudent strategy for those investors who do not have clear crystal balls.

Lesson 2: Last Year’s Winners are Just as Likely to be this Year’s Dogs as they are to Repeat

The historical evidence demonstrates the individual investors are performance chasers—they watch yesterday’s winners and then buy (after their great performance) and watch yesterday’s losers and then sell (after the loss has already been incurred). This causes investors to buy high and sell low—not exactly a recipe for investment success. This behavior explains the findings from studies that demonstrate that investors actually underperform the very mutual funds they invest in by significant margins.

Unfortunately, while there are streaks in asset class returns, they occur randomly relative to expectations. The streaks have no more meaning than streaks at the craps table—a good (poor) return in one year does not 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 investors 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 letter until it reaches its destination. Similarly, investors should adhere to their investment plan (asset allocation). Adhering to one’s plan does not mean just buying and holding. It means buy, hold and rebalance—the process of restoring your portfolio’s asset allocation to the plan’s targeted levels.

Using DFA’s passive asset class funds (as well as PIMCO’s Commodity Real Return Fund) the following table compares the returns of various asset classes in 2006 and 2007. As you can see, sometimes the winners of 2006 repeated, but other times they became losers.

It is also worth taking a little longer perspective. From 2003 through 2006 DFA’s Real Estate, U.S. Small Value and Emerging Markets Funds returned 28.7, 27.2 and 36.7 percent per annum, respectively. In 2007, the Real Estate and U.S. Small Value funds lost 18.7 percent and 10.8 percent, respectively. However, the Emerging Markets Fund once again produced spectacular returns. Streaks are purely random. Also note that the fund with the worst return in 2006, the PIMCO Commodity fund, outperformed all but the emerging markets funds.

The lessons are that investors need to ignore the emotions that bull (greed and envy) and bear markets (fear and panic) create and that disciplined rebalancing is the winning strategy.

Lesson 3: Yesterday’s Master’s of the Universe are Tomorrow’s Cosmic Dust

For believers in active management the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many “believers” had been Bill Miller, legendary manager of the Legg Mason Value Trust [LMVTX]. 2005 marked the fifteenth straight year his fund had beaten the S&P 500 Index—the longest streak on record. To the “faithful,” surely fifteen years had to be the result of skill and not random luck. That belief led to huge inflows of assets over the years. On the other hand, perhaps the streak was purely a lucky one. In 2006, the fund returned 5.9 percent, underperforming the S&P 500 Index by 9.9 percent. Perhaps that was just one bad year. Perhaps the market just did not see what Miller saw as real value. Unfortunately, the fund managed to repeat that dubious feat in 2007. The fund lost 6.7 percent, underperforming the S&P 500 Index by 12.2 percent. The last two years left the fund with a cumulative five-year record of underperforming the S&P 500 by 2 percent per annum.

Was Miller really skillful—and he had just lost his touch? Or, was he lucky and “Lady Luck” had abandoned him? And how is an investor to know which is the correct answer? And what should an investor in the fund do now? If you stay with the fund, how long do you wait before you give up? And if you sell, what if he turns the performance around—how would you know if it was skill or random luck showing up again?

The really bad news is that most of Miller’s great returns came when the fund was much smaller. The great returns attracted huge cash flows, and the longer the streak went on the greater the flows. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by investors in the Legg Mason Value Trust are actually well below the returns reported by the fund. Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected (at least among winners—losers tend to repeat because of high expenses). And, as history suggests it would, the fund experienced large outflows in 2007. Investors withdraw almost $10 billion of assets in the fourth quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors won’t be there to benefit.

It is also worth noting that the domestic fund that had the current longest streak of outperforming the S&P 500 Index—eight years—Cambiar Opportunity [CAMOX], also saw that streak end. The fund lost 1.9 percent in 2007 and underperformed the S&P 500 Index by 7.4 percent. The fund’s cumulative three-year performance now trailed the S&P 500 Index by 1.6 percent per annum.

The lesson is that while active management gives you the hope of outperformance, the far greater likelihood is that you will underperform well-designed passively managed funds—even if you rely on managers with long-term records of success. Ignoring the SEC’s warning about relying on past performance of an actively managed fund is the financial equivalent of ignoring the surgeon general’s warning about the dangers of smoking.

Lesson 4: The Importance of Portfolio Insurance

As individuals we know the important role insurance plays in managing the threats to our financial security and our ability to achieve our financial goals. We insure against the risks to our homes, cars and personal priority. We insure against personal liabilities (via the purchase of products such as umbrella insurance). And we insure against premature death (life insurance), medical expenses (health insurance and long-term health care insurance), disability and even longevity (lifetime payout annuities).

The same principles of prudent risk management apply to investment portfolios. There are two asset classes that provide a form of portfolio insurance because their returns are negatively correlated with the returns of both stocks and nominal return bonds (bonds whose returns are not indexed to inflation). When two assets are negatively correlated, when one produces higher than average returns the other tends to produce below average returns. Thus, the addition of negatively correlating assets to a portfolio dampens the volatility of the overall portfolio and reduces volatility’s negative impact on compound returns.

The two asset classes with this valuable characteristic are TIPS (Treasury Inflation-Protected Securities) and CCF (Collateralized Commodity Futures). Both TIPS and CCF provide hedges against inflation risks and CCF also provides a hedge against some event risks (such as an interruption of oil supplies). Both the academic research and the historical evidence suggest that adding these assets to portfolios is likely to produce more efficient portfolios (portfolios with higher risk-adjusted returns). And the portfolios will experience less volatility. In 2007, both TIPS and CCF produced above average returns. The Vanguard TIPS fund returned 11.6 percent and the PIMCO Commodities Real Return Fund returned 23.8 percent.

Lesson 5: Even with a Clear Crystal Ball

Like many years, 2007 was filled with news that if investors had a perfectly clear crystal ball allowing them to see (ahead of time) the events (but not how they would impact stock prices) they would likely have been sellers of stocks. Let’s review some of the bad news the markets had to deal with.

• The price of a barrel of oil more than doubled to end the year at about $96.
• The price of many other commodities, including gold and silver, also rose dramatically. This raised the threat of inflation, a negative for both the stock and bond markets.
• The U.S. capital markets experienced one of the most significant financial crises in history. And with globalization, the holdings of subprime debt had spread around the world. The losses from the subprime mortgage meltdown are already in the hundreds of billions. This led to a general flight to quality, a drying up of liquidity in lending markets (not just mortgage related lending), and a resulting widening of credit spreads. The central banks of the world had to orchestrate massive efforts to provide liquidity and keep the markets functioning.
• The U.S. housing market experienced its worst recession since the Great Depression. This created the threat of an overall recession.
• The dollar collapsed against most major currencies including the Euro and the Canadian dollar. The headlines were filled with predictions about global investors abandoning the dollar.
• The showdown with Iran over their nuclear weapons program continued to dominate the headlines.
• Several of the largest hedge funds in the world experienced huge losses due to the volatility of the markets.
• And the year ended with a political crisis in Pakistan, a nuclear power already threatened by terrorism in the region.

One can only wonder how many investors abandoned their investment plans in the face of all this bad news. Despite all the bad news, the markets overall provided relatively good returns. Despite rising commodity prices and the threat a falling dollar posed, Treasury bond yields fell across the board. Thus, with the exception of junk bonds (and other risky credits) fixed income investments produced good returns. Both the S&P 500 Index and Vanguard’s Total Stock Market Fund managed to produce returns of about 5.5 percent. And with the exception of the asset classes of U.S. small, large and small value and real estate most equities around the globe provided good returns.

The lesson is that not only should you ignore all economic forecasts (as research has demonstrated that the accuracy of the forecasts are no better than the proverbial monkeys throwing darts), but also that even if you could forecast events accurately it still might lead you to make poor investment decisions. Thus, the prudent strategy is to make sure you have the right investment plan in the first place—one that does not take more risk than you have the ability, willingness and/or need to take. Having such a plan gives you a much better chance of ignoring the emotions (fear and panic) caused by the inevitable bad news investors face over time.

Lesson 6: It’s Called a Risk Premium for Good Reasons

From 1927 through 2006 value stocks provided an annual return about 5 percent above that of growth stocks. However, 2007 was a very different story. The subprime mortgage crisis led to a flight to quality across all financial assets. In a flight to quality, Treasury bonds outperformed investment grade bonds, investment grade bonds outperformed junk bonds, large-cap stocks outperformed small-cap stocks and growth stocks outperformed value stocks. This type performance is not unusual. In fact, it is very typical of what happens whenever there is a financial crisis of some kind. Two relatively recent examples are from 1998 and 1990. In 1998, we experienced what became known as the Asian Contagion. A crisis in several of the emerging market countries spilled across borders and the events eventually led to the spectacular failure of the then largest hedge fund in the world, Long Term Capital Management. In that year, while the S&P 500 Index turned in a very good year (up almost 29 percent), small-cap stocks fell 2.3 percent and small value stocks fell 10 percent. In 1990, we experienced the S&L crisis. In that year while the S&P fell just 3.1 percent, small stocks fell by more than 20 percent and small value stocks fell 26 percent.

Academic research has found that value stocks are the stocks of companies with common characteristics that are easily identified with risky investments. For example, they tend to have high volatility of both earnings and dividends. They also tend to be more highly leveraged than growth stocks. In addition, they have fewer sources of capital and tend to be the first to be cut off from those sources during crises (like those of 1990, 1998 and 2007). While there are some academics who believe that the value premium is a behavioral story (investors persistently overpay for growth stocks and overestimate the risks of value companies), it is seems hard to argue against the risk-based story when each time there is a financial crisis of some sort value stocks underperform.

There are a few lessons here. First, value stocks have a risk premium for a good reason. These are stocks of risky companies and the risks will, unexpectedly, show up from time to time. Which brings us to the second lesson. The evidence from academic studies suggests that there is no way to time the value premium. In other words, a streak of several years in a row when value outperforms tells you little to nothing about what the value premium will be in the next year. Sometimes value outperforms for just a year or two and sometimes it goes on a long winning streak. In fact, the seven-year streak of value outperforming growth from 2000 through 2006 was not that unusual. We have had other fairly long streaks. There was a five-year streak from 1961 through 1965, a six-year streak from 1972 through 1977 and a nine-year streak from 1940 through 1948. On the other hand, the longest streak of growth outperforming value has been just three years. We experienced three of those: 1937–39, 1978–80 and 1989–91. Investors seeking to capture the value risk premium must be prepared to accept that risk and stay the course.

Lesson 7: How Not to Make or Keep Wealth

Morningstar dedicates a large amount of resources to identifying the great money managers. It rates about 5,000 mutual funds, giving just 500 its coveted five-star rating. But why settle for the top 500? Why not invest in just the very best in each asset class? In November 2001, Morningstar created its Aggressive Wealth Maker and Wealth Maker portfolios. In May 2002, it added the Wealth Keeper Portfolio. Each portfolio contains less than ten funds. It’s Morningstar’s effort to identify the best of the best. This provides us a living laboratory to test the ability to identify future outperformers. How has Morningstar done? All three of the portfolios trail their benchmark portfolios that consist of simple broad market index funds. The Aggressive Wealth Maker trails its benchmark by 1.41 percent per annum, the Wealth Maker by 1.28 percent per annum and the Wealth Keeper by 1.76 percent per annum. And we should note that the hurdle is actually too low as Morningstar includes small and value oriented funds in their portfolios while their benchmark contains only total market index funds. Since small and value stocks have outperformed broader market indices, Morningstar’s portfolios had a tail wind at their backs aiding their performance. Unfortunately, it was not enough.

The lesson is that there is a reason the SEC requires that mutual fund advertisements contain the disclaimer about past performance. While investing in actively managed funds does give you the hope of outperformance, the far greater likelihood is that it will lead to underperformance.

Summary

Like most years, 2007 provided us with many reminders of the principles of the prudent investment strategy—build a globally diversified portfolio of passively managed funds that reflects your unique ability, willingness and need to take risk. You should then formalize that plan by creating an investment policy statement including a rebalancing table, and then adhere to that plan. One key to achieving that objective is to ignore all economic and market forecasts, the noise of the market and the emotions that noise can cause. Doing so will also allow you to spend more time on the really important things in life, like your family, friends and community.

_{Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).}

_{His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.}

Comments

[Steve E]

Hi Larry,

Can you please tell me where you found updated information on the Morningstar Wealth Portfolios? I could not find any info on their site and I am a Premium member.

Thanks,

Steve

[Steve E]

Hi Larry,

Can you please tell me where you found information on Morningstar's Wealth Portfolios? I am a Premium member and I cannot find any information on the site.

Thanks,

Steve

[larryswedroe]

mfi.morningstar.com/fs...