Lessons from 2013

Posted by on January 27, 2014 @ 4:15 pm in Investing

Many people spend the final days of each December reminiscing about the year gone by. At this time, it’s not uncommon for individuals to draw “lessons learned” from both the good and bad moments, and to make resolutions for the upcoming year.

I recently was part of an online, interactive panel with The Wall Street Journal on investing lessons from 2013. As I thought back on the economy and markets in 2013, there’s no question that individual investors were confronted with some events and news that sparked questions about how to invest moving forward. Here are my big takeaways from the year.

1.       The key to success is still sticking with a long-term strategy.

In 2013, we witnessed a number of reasons not to invest in equities—the debt ceiling, gridlock in Washington, the conflict in Syria, slow U.S. economic growth, and many more. But despite all of these perceived headwinds, the U.S. stock market posted its biggest percentage gain in 16 years. For this reason, we must keep in mind that economic growth does not correlate with equity market returns. Rather, valuations provide a better guide for expected returns over the long term, and even then, varying factors will impact predictive power.

As investors, we want to make an effort to stay up-to-date with current events surrounding U.S. and international economies. But, we should avoid tracking the progression or regression of economic growth alone to determine asset allocations and instead focus on aspects that have served investors well in the past, such as developing a thoughtful, long-term asset allocation without regard to the hysteria that may surround us—and then having the discipline to stick with it.

2.       Know what you’re getting into with alternatives.

The media had a heyday with discussing alternatives, including commodities and hedge fund–like strategies, in 2013, and the hype surrounding this as an asset class worries me a bit. There’s a wide dispersion of returns from these types of investments—some with quite good performance, but many, if not most, with mediocre to disappointing performance. It’s incredibly hard for individual investors to determine what’s going to perform well going forward.

First, information about alternative investments, such as the management’s capability, their strategy, and their performance, is limited, so these investments require a considerable amount of research, which includes locating the right information and having the time to devote to it. Second, and perhaps even more important, is cost. David Swensen, chief investment officer at Yale University and a very successful user of alternative investments, says that when analyzing alternative investments, high cost is a deal breaker. And I agree with him, as fees can quickly diminish returns. And third, investors just do not have the access to the best-performing alternatives that institutional investors, with significant assets and bargaining power, do.

3.       Keep your bond allocation intact.

Low current bond yields are a pretty good predictor that bond returns over the next decade will be modest—perhaps an annualized return of 2.5%–3.5%.  Nevertheless, bonds should continue to play an important role in your portfolio.

We’ve observed modest outflows from bond mutual funds (relative to bond fund assets in aggregate), so it does appear that some investors soured on the asset class in 2013 because of the low yields and rising rates that depressed bond returns. But we must remember that bonds aren’t part of an asset allocation to provide higher returns. They play the role of providing stability in our portfolios and of tempering equity volatility.

Perhaps surprisingly, even with lower expected bond returns, the math behind modern portfolio theory would prescribe that an investor whose personal asset allocation of say 60% stocks and 40% bonds should only modestly reduce their bond allocation, and only if they believe equities will provide returns in line with their 10% historical returns.

On the other hand, if bond returns are expected to be less than historical returns, then it’s logical that equity returns will be also. And the math for these expectations says to keep your allocation unchanged. In other words, the risk-return trade-off and the stabilizing characteristics of bonds in a diversified portfolio will remain intact even with different levels of optimism and outlooks for the bond market. Fixed income investors should stay the course because we don’t know what bumps are in the road ahead and, in the long run, that allocation to fixed income will help mitigate stock market volatility in a portfolio.

I can’t profess to tell you what will unfold in 2014, but in this new year, I plan to try to employ these lessons, ignore the noise, and dig my heels in by keeping my focus on the long term. I hope you can do the same.

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