Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the second installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.
Click here for Part 1
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Lesson 2: Globalization and Diversification
One of the more common recent investment themes revolves around globalization. The thought is that the correlation of returns of stocks around the globe is rising with increased globalization, reducing the benefits of international diversification. This train of thought suggests that no one needs to invest internationally. Instead, just invest in U.S. multinational companies, such as those that dominate the S&P 500.
Using the passive 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.
|
Fund |
Change From 12/31/06 to 12/31/07 |
|
Domestic |
|
|
DFA US Large |
+5.4% |
|
DFA US Large Value |
-2.8% |
|
DFA US Small |
-3.1% |
|
DFA US Small Value |
-10.8% |
|
International |
|
|
DFA International Large |
+12.5% |
|
DFA International Large Value |
+10.2% |
|
DFA International Small |
+5.7% |
|
DFA International Small Value |
+3.0% |
|
DFA Emerging Markets |
+36.0% |
|
DFA Emerging Markets Small |
+38.0% |
|
DFA Emerging Markets Value |
+45.6% |
Source: Dimensional Fund Advisors
The benefits of global diversification should be obvious. The important lesson is that broad global diversification is part of a prudent strategy.
Lesson 3: Last Year's Winners Just as Likely To Be This Year's Dogs as They Are to Repeat
The historical evidence demonstrates that many individual investors are performance chasers - they buy yesterday's winners (after their 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.
Unfortunately, streaks in asset class returns occur randomly relative to expectations. Such 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, above average 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, which does only one thing, but does it exceedingly well: It adheres to its letter until it reaches its destination.
Similarly, investors should adhere to their investment plan. Adhering to one's plan does not mean just buying and holding. It means buying, holding and rebalancing - the process of restoring the portfolio's asset allocation to the plan's targeted levels.
Using DFA's passive funds (as well as PIMCO's CommodityRealReturn Fund), the following table compares the returns of various asset classes in 2006 and 2007. As you can see, some 2006 winners repeated, but some became losers.
|
Fund |
2006 (Rank) |
2007 |
|
DFA Emerging Markets Value |
37.9% (1) |
45.6% (1) |
|
DFA Emerging Markets Small |
37.3% (2) |
38.0% (2) |
|
DFA Real Estate |
35.3% (3) |
-18.7% (13) |
|
DFA International Value |
34.2% (4) |
10.2% (6) |
|
DFA Emerging Markets |
29.2% (5) |
36.0% (3) |
|
DFA International Small Value |
28.4% (6) |
3.0% (9) |
|
DFA International Large |
24.9% (7 tied) |
12.5% (5) |
|
DFA International Small |
24.9% (7 tied) |
5.7% (7) |
|
DFA U.S. Small Value |
21.6% (9) |
-10.8% (12) |
|
DFA U.S. Large Value |
20.2% (10) |
-2.8% (10) |
|
DFA U.S. Small |
16.6% (11) |
-3.1% (11) |
|
DFA U.S. Large (S&P 500) |
15.7% (12) |
5.4% (8) |
|
PIMCO CommodityRealReturn Fund (Institutional) |
-3.5% (13) |
23.2% (4) |
Source: Dimensional Fund Advisors
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, DFA's Real Estate and U.S. Small Value funds lost 18.7 percent and 10.8 percent, respectively. However, the DFA Emerging Markets Fund once again produced favorable returns, with a return of 36.0 percent.
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.
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