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Joshua Tree

Adaptation Devaluation: Why A U2 Concert . . .

Re-posted from Forbes.com

Personal finance is more personal than it is finance.

Opinions expressed by Forbes Contributors are their own.

My favorite discovery in the field of behavioral economics confirms what we already knew deep down, even if it contradicts “common sense”–that experiences are more valuable than stuff. I recently put this finding to the test:

Concert of a Lifetime

“You’re crazy.”

Those were my wife’s words when I called her from the road, rushing to discuss what I termed “the concert of a lifetime.”

I’d just learned that living legends U2 were touring in support of the 30th anniversary of their most celebrated album, “The Joshua Tree.”

Joshua Tree

The greatest live band of a generation playing the soundtrack of my youth from start to finish.

Andrea was on board with going to the show–she’s a big fan, too. But what invited her claim of insanity was my insistence that we take the whole family to Seattle to see the show. We live in Charleston. South Carolina.

But the Seattle show promised to be superior to almost all others along the route. In the Emerald City, the Emerald Isle’s most melodic export would be supported by Mumford and Sons as the opening act, playing only the first three West Coast stops.

The two best live bands performing in one of the world’s greatest cities in a single concert.

(In case you’re wondering, music is not subjective, but objective. These are all facts.)

I insisted that we had a moral obligation to go as a family–assuring my wife that it would result in a lifelong memory soon to be deemed priceless.

Reality Check

Now, we’re a family of four (and a half) with two boys–13 and 11–in youth sports (and an adorable puppy). One could argue that every piece of furniture in our home is a candidate for replacement.

If you are in–or remember–or tried to forget–this phase of life, you know that, regardless of your income, every dollar seems to be pledged even before it is earned. Even when you’re occasionally surprised by a surplus inflow, it feels like the money has already been spent (if it hasn’t) on the necessity du jour.

Experiences > Stuff

But a mathematical fact remains: There are only two ways to dispose of our money–on experiences or stuff. Even if we save, invest or give, we’re just deferring when and where the money will be spent on experiences or stuff.

Our eyes tell us that stuff is worth more because we can see it.

But our hearts know what has now been proven in numerous studies–that we derive more joy from [insert experience] than by purchasing a [product of comparable price].

For our family, going to see Mumford and U2 in Seattle was simply more valuable than something like … replacing the battered couch, maybe the bedroom furniture.

WHY?

But why?  It’s not necessarily because it’s obvious from the start. Initially, the experience worth $X gives about the same amount of joy as the stuff worth $X. But as we adapt to the stuff, as it literally depreciates in value, our joy in its utilization also decreases. Or as Cornell psychologist Dr. Thomas Gilovich puts it, “One of the enemies of happiness is adaptation.”

But while stuff devalues, the recently elapsed experience can actually increase in value.  “Even if it was negative in the moment,” writes James Hamblin in the The Atlantic, “it becomes positive after the fact. That’s a lot harder to do with material purchases because they’re right there in front of you.”

Furthermore, those material purchases aren’t only in front of you. They’re in front of lots of people who have the same thing–or better. My black four-door Jeep was awesome until my buddy pulled up–right behind me–in his black four-door Moab-edition Jeep (with the top down and the doors off).

The intangible nature of experience means that no one has the exact same one. Meanwhile, having shared experiences compounds their value further, as diverse recollections tend to open our eyes to elements we didn’t catch the first time around.

Sadly, despite the conviction in our collective gut and the studies that prove it’s right, “ People do not accurately forecast the economic benefits of experiential purchases.

Where the Streets Have No Name

By now, you know what happened, right? Yes, my loving wife succumbed to my outlandish pledge that “this will be the best memory we’ve ever had as a family!” We scraped together all the respective rewards points and discretionary dollars we could muster, ordered the tickets, booked the flights and reserved the room.

We fought through jet lag to enjoy hiking in a blizzard on Mt. Ranier, having coffee at the first-ever Starbucks, enjoying breakfast overlooking a bustling Pike Place Market, going up the Space Needle and down the Great Wheel, taking in a comedy show at a vintage theater near University of Washington, running to catch the ferry to Bainbridge Island for lunch and–the best part–watching my boys’ eyes light up as the prelude to “Where the Streets Have No Name” rumbled through our bellies.

On the plane ride home–gloriously exhausted–my wife turned to me and said, “You were right. It was worth it. But you’re still crazy.”

She’s right. About all of it.

I’m a speaker, author of “Simple Money” and director of personal finance for Buckingham and the BAM Alliance. Connect with me on Twitter, Google+, and click HERE to receive my weekly email.

Dimensional

LETTER FROM THE CHAIRMAN, 2017

After more than 35 years in the financial services industry,
I have found that having an investment philosophy—one that
is robust and that you can stick with—cannot be overstated.

Just like a personal philosophy can act as a moral compass, an investment philosophy can guide your decisions on how to invest. While this may sound simple, the implications can be significant. People who
put their savings to work in capital markets do so with the expectation of earning a return on their investment, and there is ample evidence to support that long-term investors have been rewarded with such returns. But we also know that investors will encounter times when the results are disappointing. It is in these times that your philosophy will be tested, and being able to stay the course requires trust.
The alternative approach likely consists of moving between different strategies based on past results, which is unlikely to lead to a good outcome.  At Dimensional, our investment philosophy is based on the power of market prices and guided by theoretical and empirical research.

What does that mean?

Markets do an incredible job of incorporating information and aggregate expectations into security prices, so it does not make sense to form an investment strategy that attempts to outguess the market. Our approach focuses on using information contained in prices to identify differences in expected returns. We conduct research to help us organize our thinking, improve our understanding of what drives returns, and gain insights on how to build sensible portfolios. One such insight is looking beyond average returns. By considering the entire distribution of outcomes, we can better understand what investors should be aware of to help them stay invested when results aren’t what they expect.  As an example, the S&P 500 Index has returned about 10% annualized since 1926. But over that time period, there the S&P’s return was within two percentage points of 10%.1 If investors were to adopt a strategy that tracks the S&P 500 Index expecting 10% each year, they need to understand that returns over any given period can look different.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.  In this regard, an index-like approach is useful because of how transparent it is.

It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.

In this regard, an index-like approach is useful because of how transparent it is.  It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

At Dimensional, we’ve sought to improve upon indexing, taking the best of what it offers and adding the ability to make judgments. Our experience has been that by incorporating a little bit of judgment, you can add a lot of value.

Dimensional began back in 1981 with a new idea: small cap investing. The premise was that many investors didn’t invest in small cap stocks, and that small caps behaved differently than large cap stocks and could offer diversification benefits to investors concentrating in large caps. We found clients who agreed the idea was sensible. Over the next nine years, the performance of small cap stocks was disappointing relative to large caps (at one point the S&P 500 outpaced our portfolio by about 10% annually), so on the surface it may have appeared that both we and our clients had a reason to be nervous. But clients were willing to stick with us because we were clear about our objective—providing a diversified portfolio of small cap stocks—and we delivered on it.2 Having compelling ideas is important, but the implementation of those ideas is what really counts. From the beginning, we focused on developing protocols about how to design and manage portfolios, and 35 years later we have amassed a track record of results that we believe stands out in the industry.

————————————————————————————————————————

1. Past performance is not a guarantee of future results. Indices are not available for direct
investment; therefore, their performance does not reflect the expenses associated with the
management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services
Group.
2. Diversification does not eliminate the risk of market loss. Investing risks include loss of
principal and fluctuating value. Small cap securities are subject to greater volatility than those
in other asset categories. There is no guarantee an investing strategy will be successful.
Consider the investment objectives, risks, and charges and expenses of the Dimensional funds
carefully before investing. For this and other information about the Dimensional funds, please read
the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund
Advisors collect at
(512) 306-7400 or at us.dimensional.com. Dimensional funds are distributed by DFA Securities LLC.

Relative Performance of Equity Funds with More than 15 years of History

While our long-term results show an ability to add value over benchmarks, we still place tremendous value on helping our clients understand why we do what we do. Just like those first years, we have lived through other times when the results have looked disappointing. This is one reason our approach combines our ability to make judgments with the transparency we believe is necessary for clients to understand what they can expect from us. The solutions we provide are meant to help clients achieve their financial goals. We know that a big part of enjoying the expected benefit of long-term returns relies on the ability to stay invested. By clearly articulating what we promise to provide, and delivering on those promises with robust portfolios, our hope is that we can help increase clients’ confidence in their decision to invest with us and provide them with a more successful investment experience.
On behalf of all of us at Dimensional, we want to thank our clients for the trust you have placed in us. We will continue working hard to reinforce the decision you have made. For those of you who may not yet work with us, we look forward to the prospect of serving you in the future.

Letter from the Chairman 2017 Signature

DAVID BOOTH
Founder and Executive Chairman
DIMENSIONAL FUND ADVISORS

LETTER FROM THE CHAIRMAN, 2017

Appendix Letter from the Chairman

105.-Tracking-error-how-it-affects-FTSE-All-Share-trackers

Tracking Error Regret Is the Enemy of Investors

by Larry Swedroe, Director of Research

There are several keys to having a successful investment experience. The first is to create a well-thought-out financial plan. This plan should begin with identifying your ability, willingness and need to take risk, as well as what it is that you want your money to do for you. Having identified all the appropriate risks and objectives, an overall financial plan can then be developed (one that integrates the investment plan into an estate, tax and risk management plan). The next step is to decide on the investment strategy most likely to allow you to achieve your goals within the risk parameters acceptable to you.

Two tools that advisors, trustees and investors can use to help identify the prudent investment strategy are the 1992 Restatement of Trust (Third), also referred to as the Prudent Investor Rule, and the 1994 Uniform Prudent Investor Act. Both of these incorporated Modern Portfolio Theory (MPT) into their writing. Among the fundamental tenets of MPT is that, done properly, diversification reduces the risk of underperformance as well as the volatility and dispersion of returns, without reducing expected returns.

Thus, a diversified portfolio is considered more efficient (and thus more prudent). The Uniform Prudent Investor Act states that “because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing.”

Clearly, the benefits of diversification are well known. In fact, it’s been called the only free lunch in investing. It’s why I recommend that investors diversify not only across domestic equity asset classes (small- and large-cap stocks, value and growth stocks, and real estate) but also that they include a significant allocation to international equity asset classes (including emerging markets stocks).

However, investors who adopt the strategy of broad diversification must understand that they are taking on another type of risk, a psychological one known as tracking error regret. Think of tracking error as the risk that a diversified portfolio underperforms a popular benchmark, such as the S&P 500. Regret over tracking error can lead investors to make the mistake that I call confusing
ex-ante strategy with ex-post outcome.

 Confusing Strategy With Outcome

“Fooled by Randomness” author Nassim Nicholas Taleb had the following to say on confusing strategy and outcome: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Unfortunately, in investing there are no clear crystal balls. Thus, a strategy should be judged in terms of its quality and prudence before its outcome is known, not after.

 2008-2015 Provides a Test

Since 2008, investors have been faced with a major test of their ability to ignore tracking error regret. From 2008 through 2015, major U.S. asset classes provided fairly similar returns. While the S&P 500 Index returned 6.5 percent per year, the MSCI Prime (Large) Value Index returned
5.1 percent, the MSCI U.S. Small Cap 1750 Index returned 7.7 percent and the MSCI U.S. Small Cap Value Index returned 7.7 percent. The total returns of the four indices were 66 percent,
49 percent, 82 percent and 70 percent, respectively.

International stocks, however, have underperformed by wide margins. Over the same period, the MSCI EAFE Index returned 0 percent per year and the MSCI Emerging Markets Index returned
-3 percent per year (with a total return of -21 percent).

Clearly, investors who diversified globally have been disappointed. Unfortunately, that disappointment has led many to consider abandoning their strategy of global diversification. But, should we judge the strategy to have been a poor one based on the outcome? Not when we look at the question through the lens provided by Taleb.

To see the wisdom of taking the correct viewpoint (Taleb’s), let’s consider an investor at the beginning of this period (one who doesn’t have the benefit of a clear crystal ball). How did the world look to that investor? To answer that question, we’ll look at the returns for the prior five-year period.

The Good Side of Tracking Error

An investor contemplating their investment strategy looking backward at the start of 2008 would have been reviewing the following returns. For the five-year period from 2003 through 2007, the S&P 500 Index provided a total return of 83 percent. That was less than half the 171 percent total return provided by the MSCI EAFE Index and not much more than 20 percent of the 391 percent return of the MSCI Emerging Markets Index. Yes, the S&P 500 Index underperformed the MSCI Emerging Markets Index by 308 percentage points over just a five-year period.

If you think that’s bad (or impressive, depending on which side of the coin you happen to be looking at), during that same period, the DFA Emerging Markets Small Cap Fund (DEMSX) provided a total return of 430 percent, outperforming the S&P 500 Index by 347 percentage points, and the DFA Emerging Markets Value Fund (DFEVX) provided a total return of 546 percent, outperforming the S&P 500 Index by 463 percentage points. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Looking at the domestic asset classes, the S&P 500 Index also underperformed the MSCI U.S. Small Cap 1750 Index by a total of 40 percentage points, the MSCI U.S. Small Cap Value Index by a total of 28 percentage points and the MSCI Prime (Large) Value Index by a total of 14 percentage points.

As you can see, tracking error works both ways. You have to take the positive tracking error with the negative. Importantly, I doubt that any investors looking back at the returns in the period from 2003 through 2007 would have been questioning the benefits of building a globally diversified portfolio. Regrettably, the twin problems of “relativism” (how the performance of your portfolio compares to that of your friends and to popular benchmarks) and “recency” conspire to lead investors to abandon even well-thought-out plans.

Relativism

Unfortunately, too many investors have entered what Vanguard founder John Bogle calls the “Age of Investment Relativism.” Investor satisfaction or unhappiness (and, by extension, the discipline required to stick with a strategy) seems determined to a great degree by the relative performance of their portfolio to some index (an index that shouldn’t even be relevant to an investor who accepts the wisdom of diversification).

Relativism, sadly, can best be described as the triumph of emotion over wisdom and experience. The history of financial markets has demonstrated that today’s trends are merely “noise” in the context of the long term. Bogle once quoted an anonymous portfolio manager, who warned: “Relativity worked well for Einstein, but it has no place in investing.”

 Recency

The recency effect — in which the most recent observations have the largest impact on an individual’s memory and, consequently, on their perception — is a well-documented cognitive bias. This bias could affect investment behavior if investors focus on the most recent returns and project them into the future. This is a very common mistake, leading investors to buy what has done well recently (at high prices, when expected returns are now lower) and sell what has done poorly recently (at low prices, when expected returns are now higher). Buying high and selling low is not exactly a prescription for investment success. Yet, the research shows that is exactly what many investors do, partly due to recency bias. And that behavior leads investors to earn lower returns than the very funds in which they invest. A superior strategy is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently and buy what has performed relatively poorly.

We can observe the buy-high-and-sell-low strategy at work by examining current valuations. What we should expect to see is that the dramatic outperformance of the S&P 500 has made U.S. stocks more expensive (have higher valuations) relative to international equities. Valuations are the best predictor we have of future returns. As of year-end 2015, the Shiller Cyclically Adjusted Price-to-Earnings (P/E) Ratio, referred to as the CAPE 10 ratio, was at 24.4. To estimate future expected returns using the CAPE 10 metric, you first calculate the earnings yield (E/P) — the inverse of the CAPE 10 — and get 4.1 percent. However, because the CAPE 10 is based on lagged 10-year earnings, you need to make an adjustment, since real earnings grow over the long term. I suggest using 2 percent as a real earnings growth estimate. Make that adjustment by multiplying the
4.1 percent earnings yield by 1.1 (1 + [0.02 x 5]), producing an estimated real return to stocks of about 4.5 percent. (We multiply by five because a 10-year average figure lags current earnings by five years.)

By comparison, the CAPE 10 for both the international developed and emerging markets were at much lower levels. The CAPE 10 for the MSCI EAFE Index was at 16.4. That results in an earnings yield of 6.1 percent. In making the appropriate adjustments, you get an expected real return for the MSCI EAFE Index of 6.7 percent, or 2.2 percentage points greater than that of the S&P 500 Index. The CAPE 10 for the MSCI Emerging Markets Index stood at 12.3. That results in an earnings yield of 8.1 percent. In making the appropriate adjustments, you get an expected real return for the MSCI Emerging Markets Index of 8.9 percent, almost double that of the 4.5 percent expected real return of the S&P 500 Index.

We can also measure the relative valuations of domestic versus international markets by examining the more current valuations from three of Vanguard’s index funds. The data below is from Morningstar and is as of the end of February 2016:

  • S. Total Stock Market Index Fund (VTSMX): P/E of 17.0
  • Developed Markets Index Fund (VTMGX): P/E of 14.3
  • Emerging Markets Index Fund (VEIEX): P/E of 11.5

Investors who abandon the strategy of broad global diversification due to recency would now be selling international and emerging market equities when their valuations are much lower, and their expected returns are much higher. They likely would already have suffered the pains of the lower returns and would at this point be selling low to buy high.

We have one last problem to discuss.

 Impatience

I have learned that when contemplating investment returns, the typical investor considers three to five years as a long time, and 10 years as an eternity. When it comes to the returns of risky asset classes, however, periods as short as three or five years should be considered nothing more than noise. And even 10 years is a relatively brief period. No more proof is required than the negative
1 percent per year return to the S&P 500 Index over the first decade of this century. Investors in stocks shouldn’t have lost faith in their belief that stocks should outperform safe Treasury bills due to the experience of that decade.

Here’s a much more striking example. Over the 40-year period ending in 2008, U.S. large-cap and small-cap growth stocks both underperformed long-term U.S. Treasury bonds. I would hope that investors didn’t abandon the idea that these risky assets should be expected to outperform in the future just because they had experienced a long period of underperformance. Yet, when it comes to international investing, perhaps because of home country bias, investors are far too willing to abandon well-thought-out strategies involving global diversification of international equities when they experience inevitable periods of underperformance.

As I have discussed previously, investors need to understand that when they invest in risky assets (such as stocks, and more specifically small and value stocks), they should expect they will experience some very long periods in which those risky assets underperform. If that wasn’t the case, there would not be any risk.

 Summary

Diversification means accepting the fact that parts of your portfolio may behave entirely differently than the portfolio itself. Knowing your level of tolerance for tracking error risk, and investing accordingly, will help keep you disciplined. The less tracking error you are willing to accept, the more the equity portion of your portfolio should look like the S&P 500 Index. On the other hand, if you choose a market-like portfolio, it will be one that’s not very diversified by asset class and will have no international diversification. At least between these two choices (avoiding or accepting tracking error), there is no free lunch.

It is almost as important to get this balance right as it is to determine the appropriate equity/fixed-income allocation. If you have the discipline to stick with a globally diversified, passive asset class strategy, you are likely to be rewarded for your discipline.

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Glasses on newspaper

INDEXING VS. EVIDENCE-BASED INVESTING

Overview: Many investors may believe that evidence-based investing means simply buying index funds.

However, there are some key differences between index investing and evidence-based investing. The following article discusses some of those differences.

Many investors realize that an evidence-based investment approach offers many benefits when compared with an active investment approach. Evidence-based investing involves buying and holding market components, whereas an active investor or fund manager tries to pick the next winning stock or time where the market is headed next.

An evidence-based approach offers these major benefits:

  • By holding entire market components, the investor maximizes the benefits of diversification.
  • By “tilting” the portfolio to riskier or less risky components, the investor can expect to capture the highest market return given his or her risk tolerance.
  • The investor maintains control over his or her portfolio’s components (by avoiding active funds’ tendency to style drift without the investor’s knowledge).
  • Expenses can be minimized.
  • Tax efficiency can be maximized.

To implement an evidence-based investment approach, investors can choose from:

  • Index mutual funds
  • Exchange-traded funds (ETFs)
  • Evidence-based funds

Investors may wonder, “Why shouldn’t I just buy index funds instead of evidence-based funds? What is the benefit of evidence-based management versus ‘index’ investing?”

The historical evidence has shown that index investing and evidence-based investing are superior strategies to investing in individual stocks or actively managed mutual funds. But building a portfolio of evidence-based funds expands upon the benefits of index investing while minimizing some of its potential negatives.

Evidence-based equity funds invest in a group of stocks with similar risk and return characteristics. These characteristics can be as broad as “U.S. stocks” or “international stocks,” or they can be as specific as “U.S. large-cap momentum stocks” or “international small-cap value stocks.” An evidence-based fund manager creates a set of objective rules that guide which stocks are selected as part of the strategy as well as the target weight of each stock in the portfolio. The funds are managed in a rules-based manner and are not reliant on an individual person or management team’s beliefs about the overall market or individual stocks.

Evidence-based funds retain the benefits of indexing. They are relatively low cost, low turnover and tax efficient. However, they improve on the index model through additional strategies. Let’s look at some of the ways an evidence-based asset class fund can improve returns.

Creating Buy-and-Hold Ranges

Index funds must sell a stock when it leaves the index. For example, if a small-cap stock increases in market capitalization so that it is no longer part of the small-cap index, the fund tracking that index must sell it. This creates turnover and tax inefficiency.

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weston_wellington

A Look Back at 2016 Weston Wellington

Reposted from dimensional.com

Every year brings its share of surprises. But how many of us could have imagined that 2016 would see the Chicago Cubs win the World Series, Bob Dylan receive the Nobel Prize in Literature, Donald Trump elected president, and the Dow Jones Industrial Average close out the year a whisker away from 20,000?

The answer is very few—a lesson that investors would be wise to remember.

At year-end 2015, financial optimists seemed in short supply. Not one of the nine investment strategists participating in the January 2016 Barron’s Roundtable expected an above-average year for stocks. Six expected US market returns to be flat or negative, while the remaining three predicted returns in single digits at best. Prospects for global markets appeared no better, according to this group, and two panelists were sufficiently gloomy to recommend shorting exchange-traded emerging markets index funds.1

Results in early January 2016 appeared to confirm the pessimists’ viewpoint as markets fell sharply around the world; the S&P 500 Index fell 8% over the first 10 trading sessions alone. The 8.25% loss for the Dow Jones Industrial Average over this period was the biggest such drop throughout the 120-year history of that index.2 For fans of the so-called January Indicator, the outlook was grim.

Then things seemingly got worse.

Oil prices fell sharply. Worries about an economic debacle in China re-entered the news cycle. Stock markets in France, Japan, and the UK registered losses of more than 20% from their previous peaks, one customary measure of a bear market.3 Plunging share prices for leading banks had many observers worried that another financial crisis was brewing. As US stock prices fell for a fifth consecutive day on February 11, shares of the five largest US banks slumped nearly 5%, down 23% for 2016.

The Wall Street Journal reported the following day that “bank stocks led an intensifying rout in financial markets.”4 A USA Today journalist observed that “The persistent pounding global stock markets are taking seems to be taking on a more sinister tone and more dangerous phase, with emotions and fear taking on a bigger role in the rout, investors questioning the ability of the world’s central bankers to calm the market’s frayed nerves, and a volatile environment in which selling begets more selling.”5

February 11 marked the low for the year for the US stock market. While prices eventually recovered, as late as June 28 the S&P 500 was still showing a loss for the year. Meanwhile, a number of well-regarded professional investors argued that the next downturn was fast approaching. One prominent activist in May predicted a “day of reckoning” for the US stock market, while another reportedly urged his fellow hedge fund managers at a conference to “get out of the stock market.” A third disclosed in August a doubling of his bearish bet on the S&P 500.6

Throughout the year, some observers fretted over the pace of the economic recovery. The New York Times reported in July that “Weighed down by anemic business spending, overstocked factories and warehouses, and a surprisingly weak housing sector, the American economy barely improved this spring after its usual winter doldrums.”7

Despite all of this noise, the S&P 500 returned 11.9% for the year and international stocks8 returned 4.4% for US dollar investors (6.9% in local currency9), helping to illustrate just how difficult it is to outguess market prices. Once again, a simple strategy of embracing sensible asset allocation and broad diversification was likely less frustrating than fretting over portfolio changes in response to news events.

Every year brings its share of surprises. But how many of us could have imagined that 2016 would see the Dow Jones Industrial Average close out the year a whisker away from 20,000?

1. Lauren Rublin, “Peering into the Future,” Barron’s, January, 25, 2016.
2. www.djaverages.com, accessed January 6, 2017.
3. Michael Mackenzie, Robin Wigglesworth, and Leo Lewis, “Stock Exchanges across the World Plunge into Bear Market Territory,”Financial Times, January 21, 2016.
4. Tommy Stubbington and Margot Patrick, “Banks Drop as Global Rout Deepens,” Wall Street Journal, February 12, 2016.
5. Adam Shell, “Market Tumult Charts New Waters,” USA Today, February 12, 2016.
6. Dan McCrum and Nicole Bullock, “Growling Bears Provide Soundtrack for Investors,” Financial Times, May 21, 2016.
7. Nelson D. Schwartz, “US Economy Stays Stuck in Low Gear,” New York Times, July 29, 2016.
8. Source: MSCI. International stocks represented by the MSCI All Country World ex US IMI (net div.).
9. Local currency return calculation represents the price appreciation or depreciation of index constituents and does not account for the performance of currencies relative to a base currency such as the US Dollar. Local currency return is theoretical and cannot be replicated in the real world.

Past performance is no guarantee of future investment results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

Diversification does not eliminate the risk of market loss. There is no guarantee an investment strategy will be successful.

Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

© 2017 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.
Dimensional

Market Timing – Prediction Season

December 2016

The close of each calendar year brings with it the holidays as well as a chance to look forward to the year ahead.

In the coming weeks, investors are likely to be bombarded with predictions about what the future, and specifically the next year, may hold for their portfolios. These outlooks are typically accompanied by recommended investment strategies and actions that are aimed at trying to avoid the next crisis or missing out on the next “great” opportunity. When faced with recommendations of this sort, it would be wise to remember that investors are better served by sticking with a long-term plan rather than changing course in reaction to predictions and short-term calls.

predictions and portfolios

One doesn’t typically see a forecast that says: “Capital markets are expected to continue to function normally,” or “It’s unclear how unknown future events will impact prices.” Predictions about future price movements come in all shapes and sizes, but most of them tempt the investor into playing a game of outguessing the market. Examples of predictions like this might include: “We don’t like energy stocks in 2017,” or “We expect the interest rate environment to remain challenging in the coming year.” Bold predictions may pique interest, but their usefulness in application to an investment plan is less clear. Steve Forbes, the publisher of Forbes Magazine, once remarked, “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”[1] Definitive recommendations attempting to identify value not currently reflected in market prices may provide investors with a sense of confidence about the future, but how accurate do these predictions have to be in order to be useful?

1. Excerpt from presentation at the Anderson School of Management, University of California, Los Angeles, April 15, 2003.

Consider a simple example where an investor hears a prediction that equities are currently priced “too high,” and now is a better time to hold cash. If we say that the prediction has a 50% chance of being accurate (equities underperform cash over some period of time), does that mean the investor has a 50% chance of being better off? What is crucial to remember is that any market-timing decision is actually two decisions. If the investor decides to change their allocation, selling equities in this case, they have decided to get out of the market, but they also must determine when to get back in. If we assign a 50% probability of the investor getting each decision right, that would give them a one-in-four chance of being better off overall. We can increase the chances of the investor being right to 70% for each decision, and the odds of them being better off are still shy of 50%. Still no better than a coin flip. You can apply this same logic to decisions within asset classes, such as whether to currently be invested in stocks only in your home market vs. those abroad. The lesson here is that the only guarantee for investors making market-timing decisions is that they will incur additional transactions costs due to frequent buying and selling.

The track record of professional money managers attempting to profit from mispricing also suggests that making frequent investment changes based on market calls may be more harmful than helpful. Exhibit 1, which shows S&P’s SPIVA Scorecard from midyear 2016, highlights how managers have fared against a comparative S&P benchmark. The results illustrate that the majority of managers have underperformed over both short and longer horizons.

Exhibit 1. Percentage of US Equity Funds That Underperformed a Benchmark  

Exhibit 1.  Percentage of US Equity Funds

Source: SPIVA US Scorecard, “Percentage of US Equity Funds Outperformed by Benchmarks.” Data as of June 30, 2016.
Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.

Rather than relying on forecasts that attempt to outguess market prices, investors can instead rely on the power of the market as an effective information processing machine to help structure their investment portfolios. Financial markets involve the interaction of millions of willing buyers and sellers. The prices they set provide positive expected returns every day. While realized returns may end up being different than expected returns, any such difference is unknown and unpredictable in advance.

Over a long-term horizon, the case for trusting in markets and for discipline in being able to stay invested is clear. Exhibit 2 shows the growth of a US dollar invested in the equity markets from 1970 through 2015 and highlights a sample of several bearish headlines over the same period. Had one reacted negatively to these headlines, they would have potentially missed out on substantial growth over the coming decades.

Exhibit 2.       Markets Have Rewarded Discipline
Growth of a dollar—MSCI World Index (net dividends), 1970–2015

 

Exhibit 2.  Markets Have Rewarded Discipline

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. MSCI data © MSCI 2016, all rights reserved.

CONCLUSION

As the end of the year approaches, it is natural to reflect on what has gone well this year and what one may want to improve upon next year. Within the context of an investment plan, it is important to remember that investors are likely better served by trusting the plan they have put in place and focusing on what they can control, such as diversifying broadly, minimizing taxes, and reducing costs and turnover. Those who make changes to a long-term investment strategy based on short-term noise and predictions may be disappointed by the outcome. In the end, the only certain prediction about markets is that the future will remain full of uncertainty. History has shown us, however, that through this uncertainty, markets have rewarded long-term investors who are able to stay the course.

Source: Dimensional Fund Advisors LP.
Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

 

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