Be Prepared for Losses

Be Prepared for Losses

By Larry Swedroe The stock premium—the annual average return of stocks minus the annual average return of one-month Treasury bills—has been high, attracting investors to the stock market. For the period 1927–2017, it averaged 8.5%. There have also been size (return of small stocks minus return of large stocks) and value (return of value stocks minus return of growth stocks) premiums of 3.24% and 4.82%, respectively. However, the excess returns are generally referred to as risk premiums—they aren’t free lunches. We see evidence of that in the volatility of the premiums. The stock, size and value premiums have come with annual standard deviations of 20.41% (2.4 times the stock premium), 13.78% (4.3 times the size premium) and 14.20% (2.9 times the value premium), respectively. Let’s take a closer look at some of the data that illustrate the riskiness of the premiums. For the period: The stock premium was negative in 27 of the 91 years (30% of the years). There were 17 years (19% of the years) when the premium was worse than -10%, 12 years (13% of the years) when it was worse than -15% and seven years (8% of the years) when it was worse than -20%. As another indicator of the volatility of the stock premium, we see that the gap between the best and worst years was 102.2%, more than 12 times the size of the premium itself. The worst year was 1931, when the premium was -45.11%. Given a premium of 8.5% and a standard deviation of 20.41%, this was more than a 2.5 standard deviation event. The best year was 1933, when the premium was 57.05%, also more than two standard deviations from the mean. In fact, we had six such two-standard-deviation events. We would have had just four if the returns had been normally distributed....
Understanding The Financial Crisis

Understanding The Financial Crisis

By Larry Swedroe The 10th anniversary of the Great Financial Crisis is the subject of lots of articles and media coverage. As a result, I’ve been getting many questions about what caused that crisis and what, if any, lessons we can take away from it to help prepare for the almost inevitable next one. I’ll begin with a brief review of the main causes. (Entire books have been written on the subject.) Unfortunately, while the media often focuses on the failure of financial models, the real causes can be found elsewhere. Origin Story The origin of the crisis stemmed from the political objective of increasing home ownership, beginning with FDR and including Reagan, Clinton and George W. Bush. This goal was aided by the enactment of the Community Reinvestment Act (CRA) of 1977. The CRA’s intent was noble—to encourage depository institutions to help meet the credit needs of the communities in which they operate and to eliminate “redlining” (not lending to anyone in certain neighborhoods) and discrimination. Next up was the Housing and Community Development Act of 1992, which established an “affordable housing” loan purchase mandate for Fannie Mae and Freddie Mac. That mandate was to be regulated by HUD. Initially, the 1992 legislation required that 30% or more of Fannie’s and Freddie’s loan purchases be related to “affordable housing” (borrowers who were below normal lending standards). However, HUD was given the power to set future requirements, and HUD persistently increased the mandates, which encouraged “subprime” mortgages. By 2007, the goal had reached 55%. In other words, more than half the loans originated were “affordable housing” loans. Like many well-intentioned...
Mutual Fund Benchmark Discrepancies Can Fool Investors

Mutual Fund Benchmark Discrepancies Can Fool Investors

By Larry Swedroe Evaluating the performance of actively managed mutual funds generally involves comparing a product’s results with some passive benchmark (the SEC requires that funds select a benchmark for comparison purposes) that follows the same investment “style” as the fund’s portfolio (such as the S&P 500 for large-cap stocks, the S&P MidCap 400 for midcap stocks and the S&P SmallCap 600 for small-cap stocks). This practice can create problems, as funds can choose benchmarks with less exposure than they do to factors that historically have provided premiums (such as market beta, size, value, momentum, profitability and quality). Thus, the benchmarks have lower expected returns. This misleading practice is important because, as Berk Sensoy’s study, “Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry,” which appeared in the April 2009 issue of the Journal of Financial Economics, shows, “almost one-third of actively managed, diversified U.S. equity mutual funds specify a size and value/growth benchmark index in the fund prospectus that does not match the fund’s actual style.” Unfortunately, the same research also shows that when allocating capital, individual investors emphasize comparisons relative to the mutual fund’s self-selected benchmark, not its true, risk-adjusted benchmark. It’s clear that fund companies strategically choose a benchmark that will drive fund flows. Recent Research Martijn Cremers, Jon Fulkerson and Timothy Riley contribute to the literature on mutual fund performance relative to self-selected benchmarks with their May 2018 study, “Benchmark Discrepancies and Mutual Fund Performance Evaluation.” They used a holdings-based procedure to determine whether an actively managed fund has a “benchmark discrepancy”; that is, a benchmark other than the prospectus benchmark that better...
The Top 10 Places Your Next Dollar Should Go

The Top 10 Places Your Next Dollar Should Go

By Tim Maurer There is no shortage of receptacles clamoring for your money each day. No matter how much money you have or make, it could never keep up with all the seemingly urgent invitations to part with it. Separating true financial priorities from flash impulses is an increasing challenge, even when you’re trying to do the right thing with your moola — like saving for the future, insuring against catastrophic risks and otherwise improving your financial standing. And while every individual and household is in some way unique, the following list of financial priorities for your next available dollar is a reliable guide for most. Once you’ve spent the money necessary to cover your fixed and variable living expenses (and yes, I realize that’s no easy task for many) consider spending your additional dollars in this order: 1. Create (or update) your estate planning documents. Your estate planning, or lack thereof, is unlikely to make headlines like that of the rich and famous. But the frightening implications of not planning for your inevitable demise lands it in the top financial priority slot, especially for parents of minor children. With extremely rare exceptions, every independent adult should have the following three documents drafted, preferably, by an estate planning attorney: a will, durable powers of attorney and advance directives (health care power of attorney and a living will). 2. Ensure that insurance needs are met. Don’t become the next heart-wrenching 20/20 segment because your family was left destitute after you died or became disabled without adequate insurance for such catastrophic events. Please note, however, the difference between insurance needs and wants. Surprisingly, most insurance needs — especially regarding life insurance— are sufficiently covered...
Don’t Exclude Emerging Markets

Don’t Exclude Emerging Markets

By Larry Swedroe Thirty years ago, emerging markets made up only about 1% of world equity market capitalization, and just 18% of global GDP. As such, the ability to invest in emerging markets was limited—the few funds available were high-cost, actively managed funds. Today the world looks very different. Emerging markets represent about 13% of global equity capitalization, and more than half of global GDP. In addition, the cost of obtaining exposure to emerging markets has decreased considerably. The expense ratio of Vanguard’s Emerging Markets Stock Index Fund Admiral Shares (VEMAX), for example, is just 0.14%. Two Common Mistakes        Yet despite emerging market stocks representing about one-eighth of global equity market capitalization, the vast majority of investors has much smaller allocations to them, dramatically underweighting the asset class. This underweighting often is a result of two mistakes. The first, and most prominent, is the well-known home country bias, which causes investors all around the globe to confuse familiar investments with safe investments. Unfortunately, it cannot be that every developed country is safer than the others. Compounding the problem, investors tend to believe not only that their home country a safer place to invest, but also that it will produce higher returns, defying the basic financial concept that risk and expected return are related. The second mistake is that investors are subject to recency bias—allowing more recent returns to dominate their decision-making. From 2008 through 2017, the S&P 500 Index returned 8.5% per year, providing a total return of 126%. During the same period, the MSCI Emerging Markets Index returned just 2.0% a year, providing a total return of 22%....
Value May Be Down, But It’s Not Out

Value May Be Down, But It’s Not Out

By Larry Swedroe As the director of research for Buckingham Strategic Wealth and The BAM Alliance, I’ve been getting lots of questions about whether the value premium still exists. Today I’ll share my thoughts on that issue. I’ll begin by explaining why I have been receiving such inquiries. Recency bias—the tendency to give too much weight to recent experience and ignore long-term historical evidence—underlies many common investor mistakes. It’s particularly dangerous because it causes investors to buy after periods of strong performance (when valuations are high and expected returns low) and sell after periods of poor performance (when valuations are low and expected returns high). Value Premium Fading? A great example of the recency problem involves the performance of value stocks (another good example would be the performance of emerging market stocks). Using factor data from Dimensional Fund Advisors (DFA), for the 10 years from 2007 through 2017, the value premium (the annual average difference in returns between value stocks and growth stocks) was -2.3%. Value stocks’ cumulative underperformance for the period was 23%. Results of this sort often lead to selling. Investors who know their financial history understand that this type of what we might call “regime change” is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it’s been highly volatile. According to DFA data, the annual standard deviation of the premium, at 12.9%, is 2.6 times the size of the 4.8% annual premium itself (for the period 1927 through 2017). As further evidence, the value premium has been negative in 37% of years since 1926....
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