If that’s how you remember it, you’re not alone. But is that how it really was?

Truth in numbers
The chart below tracks two data elements. In green is the calendar year price change for the S&P 500 index from 1980-2011. In 24 of the 32 years, the index rose in value. During the happy days of 80’s and 90’s it climbed 20 percent or more in nine years and fell only three times. No wonder we remember those years as a one way street going up.

S&P 500 returns 1980-2011 and intra-year declines.  Data source: Yahoo Finance.

But there’s more to the story. The red dots show the largest intra-year decline for each year. For the three-decade period, the average intra-year decline has been more than 14 percent. These declines, even in up years, have often been steep enough to shake investor confidence.

For instance, in 1980 the index gained 26 percent. But at some point during the year the index fell by 17 percent. To make the big annual gain, investors needed to sit tight during a dramatic and troubling slide.

Jaggedly we go
Consider 1998, charted below, as another example. The index rose a handsome 27 percent for the year, but took a very jagged path to get there. After a nice climb of approximately 20 percent by mid-July, prices slammed into reverse and all of the gain was gone by late August. The index climbed again in September, fell again in October, and then finished the year with a big rally.

S&P 500 price change 1998.  Data source: Yahoo Finance.

As a while 1998 was a great year for S&P investors, but the late summer decline of 19 percent, easily forgotten by year-end, surely felt like a dangerous freefall at the time.

Package deal
It’s natural to remember the big market trends (up in the 80’s, up in the 90’s, and down/sideways in the 00’s) and forget the short-term moves along the way, especially those that go against the trends. But even when the trend is up, the declines do matter; they’re part of the package one buys with every stock or mutual fund share. The risk of significant and discouraging short-term losses is simply the price of admission for the opportunity to reap potential long-term gains.

The S&P 500 index started 1980 at 108. In early 2012 it is now over 1300 (before adding the significant benefit of reinvested dividends). Investors who have been able to stomach all the rollercoaster dives along the way – sometimes feeling like they were holding on for dear life – have earned a nice return.

The future moves of this or any other investment can’t be predicted, but there’s no reason to expect the future to be any less volatile. With the ups there will be downs.

All S&P 500 data from Yahoo Finance. Data does not include dividend yield and does not account for transaction costs. An investment cannot be made directly in an index. Past performance is no guarantee of future results. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2011 Bright Sky Group, LLC. All rights reserved.

That’s the conclusion of a new book that says people who invest in hedge funds would have been better off over the past nine years if they had stuck to a broadly diversified portfolio of vanilla stocks and bonds.

The book is The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to be True, by Simon Lack, an asset manager who formerly chose hedge funds for major US bank JPMorgan.

Lack argues that the 18% return on hedge funds in the nine years to November 2011 was easily beaten by the total 29% gain from the S&P 500 index. The gap was even starker for investment grade corporate bonds, which in the same period gained 77%, as measured by the Dow Jones Corporate bond index.

Of course, the underperformance of hedge funds over this period is even greater once the customary 2% management fee and 20% performance fees charged by hedge fund managers are taken into account.

If individual hedge fund managers are generating the desired “alpha,” or additional returns above the market, then the benefits of that skill tend to go to the managers themselves rather than to investors.

In fact, Lack estimates that from 1998 to 2010, the hedge fund industry captured at least 86% of the returns it earned for its customers. This might explain why yachts cruising the Caribbean tend to be skippered by hedge fund managers, not investors.

For anyone who has followed the hype surrounding hedge funds for many years, this is not really a surprise. A good proportion of the investing public—egged on by the financial media—genuinely wants to believe that consistent market-beating returns are achievable without taking on additional risk and paying excessive fees.

From a marketing perspective, at least, the appeal is fairly evident. After all, the more exclusive you make a club, the more likely people will pay a premium for joining it.

While the hedge fund industry no doubt would contest the findings of Lack’s book, one doesn’t have to agree with his numbers to still harbor reasonable doubts about risking one’s hard-earned savings by investing in hedge funds.

In a recent white paper¹, Dimensional senior associate in Research Ronnie Shah explains that, due to the lack of disclosure around returns, it is difficult to determine how much alpha, if any, hedge funds generate.

Industry groups that report hedge fund returns rely on voluntary disclosures by the funds themselves on the returns they generate. Shah notes this creates potential for biases in the data, such as the omission of poor returns or the dropping out of the returns of failed or discontinued funds.

This is in addition to other drawbacks of hedge funds, such as illiquidity, relative lack of oversight, the additional costs of leverage and derivatives and, of course, the substantial fees charged by the managers themselves.

Shah’s paper concludes that the highly uncertain payoff from hedge funds, the high expense ratios, and the lack of disclosure around them mean investors should exercise caution before investing in them.

Starting one up is another matter altogether.

1. Ronnie R. Shah, “Demystifying Hedge Funds: A Review,” (white paper, Dimensional Fund Advisors, December 2011).

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

Lesson 1: Ignore All Forecasts — All Crystal Balls Are Cloudy

Financial analyst Meredith Whitney made a forecast that caused quite a stir in December 2010, when she predicted “50 to 100 sizable defaults” in the municipal bond sector in 2011, totaling “hundreds of billions of dollars’ worth of defaults.” By May 2011, investors had withdrawn money from municipal bond funds for 24 consecutive weeks. Whitney’s prediction might join BusinessWeek’s August 1979 forecast of “The Death of Equities” among the worst of all time.

The massive scale of problems that Whitney had anticipated did not occur because governments have taken actions by cutting spending and raising revenues. Unlike the federal government, all states except one are required to balance their budgets. As a result, budget gaps have been closed by greatly reduced services, renegotiation of contracts with union members regarding wages and benefits, layoffs of public employees, and increased taxes and fees. These actions have gotten results. And intermediate-term municipal bonds were among the best-performing asset classes in 2011.

The following is another example of why all market forecasts should be ignored, no matter how revered the source. In February 2011, Bill Gross (dubbed the “bond king”) announced that the world’s biggest bond fund had reduced its U.S. government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years.

By April, PIMCO had announced it had eliminated government-related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve System ended its quantitative easing program.

In August, Gross admitted he had made a mistake. Interest rates continued to fall, defying the forecasts of the vast majority of professional investors, including those of the 16 primary dealers who make markets in government debt. A corollary lesson is that timing the market is just as much a loser’s game in bond markets as it is in equity markets.

Lesson 2: Make Sure Your Investment Plan Incorporates the Virtual Certainty That Crises Will Occur, and Will Do So With Great Frequency

We cannot know what form crises will take, when they will occur, how deep they will be or how long they will last. However, we do know they will occur. Therefore, you must be sure to avoid taking more risk than you have the ability, willingness and need to take. If you do not, you are likely to allow emotions such as fear and panic and the noise of the markets to cause your plan to end up in the trash heap. Once you sell, there is never a green light that will let you know that it is once again safe to invest.

While bear markets are painful, there is no good alternative to buy and hold except avoiding risk and accepting Treasury bill returns. Few investors can reach their goals by investing solely in Treasury bills. Timing the market is a mug’s game.

Lesson 3: Last Year’s Winners Are Just as Likely To Be This Year’s Dogs as They Are to Repeat

The historical evidence demonstrates 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 is consistent with findings that investors actually underperform the very mutual funds they invest in by significant margins.

Using Dimensional Fund Advisors’ passive asset class funds (as well as PIMCO’s Commodity Real Return Fund), the following table compares the returns of various asset classes in 2010 and 2011. Sometimes, the winners of 2010 repeated, but other times, they became losers.

For example, emerging markets small-cap stocks, the third-best performer among asset classes in 2010, was the second-worst performer in 2011. Of the 14 asset classes shown, U.S. large-cap stocks finished 12th in 2010 and ranked second in 2011.

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 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 buying, holding and rebalancing — the process of restoring your portfolio’s asset allocation to the plan’s targeted levels.

Lesson 4: Yesterday’s Masters of the Universe Are Tomorrow’s Cosmic Dust

Not that long ago, hedge fund manager John Paulson was hailed as a master of the universe. He was in a class by himself, generating returns of up to 600 percent in 2007 by betting against subprime mortgages.

In December 2011, Bloomberg reported that Paulson was “mired in the worst slump of his career.” In 2011, the Paulson Advantage Fund lost 36 percent. His gold fund lost 10.5 percent in 2011 even as gold marked its 11th-straight annual gain.

Bill Miller and the Legg Mason Capital Management Value Trust (LMVTX) provide the basis for the next example. After beating the S&P 500 Index for 15 straight years, the fund underperformed the

S&P 500 from 2006–2008 by 9.9 percent, 12.2 percent and 18.1 percent, respectively.

However, after turning in a stellar performance in 2009, returning 40.7 percent, some in the media were reporting that Miller’s “still got game.” In 2010, LMVTX underperformed the S&P 500 by

8.4 percent. 2011 was not much better. The fund lost 4.0 percent.

The third example is legendary investor Bruce Berkowitz, manager of the Fairholme Fund (FAIRX). Miller was named domestic stock fund manager of the year in 1998, while Berkowitz earned Morningstar’s title of domestic stock fund manager of the decade in 2010. Berkowitz has said, “Beat the pack by breaking from it.” Of course, that is the only way to beat the pack — and it is also the road to underperformance. In 2011, FAIRX lost 32.4 percent, underperforming its benchmark by 31.7 percent.

The question for investors is this: Was 2011 just a bad year for Berkowitz (even Warren Buffett has bad years), or is he the next Bill Miller? Unfortunately, there is no way to know the answer to that question today. And because the evidence from research on the persistence of performance of active managers has demonstrated that even long streaks do not have predictive value (as Miller’s case demonstrates), prudent investors have learned not to bet on the answer either.

Lesson 5: Conventional Wisdom Is Often Wrong

One bit of conventional wisdom is that the third year of the presidential cycle is great for stocks. In fact, there was not a single negative return for the S&P 500 during a third year since the 1930s. Since 1945, the S&P 500 has advanced in the third year of a president’s term by an average of 15.9 percent. The year 2011 bucked that trend as the S&P 500 returned just 2.1 percent, well below the historical average.

Other U.S. equity asset classes produced not-so-great results in 2011. For example, a December 24 Wall Street Journal article reported that, according to a December 2011 Bank of America-Merrill Lynch report, only 23 percent of U.S. stock-fund managers outperformed the large-cap benchmark for the year.

Lesson 6: Tactical Asset Allocation Is a Loser’s Game

In September, Vanguard closed its second-worstNEW YORK-performing active balanced fund, Vanguard Asset Allocation Fund (VAAPX), and it fired VAAPX fund advisor Mellon Capital Management. Vanguard’s plan: to transfer the remaining $8.6 billion in assets to Vanguard’s Balanced Index Fund (VBINX), which follows a passive investment strategy.

VAAPX underperformed its moderate risk target by almost 2.9 percent a year over its last 10 years. The failure of the fund to achieve its objective highlights just how difficult it is for active managers to generate alpha after the expenses of the effort. Vanguard is one of the largest money managers in the world. The cautionary tale for investors: Even with tremendous resources at its disposal, Vanguard failed to find a manager that would generate future alpha.

Lesson 7: Hedge Funds Are Compensation Schemes, Not Investment Vehicles

2011 was another year that demonstrated that calling hedge funds absolute return vehicles is an absurdity. For the year, the HRFX Global Hedge Fund Index returned –8.9 percent. It underperformed all the major domestic equity and bond asset classes, as well as international REITS, although it did outperform other international equity asset classes.

By comparison, an all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned –7.0 percent. And a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned  –4.0 percent using one-year Treasuries, –0.4 percent using five-year Treasuries and 7.1 percent using long-term Treasuries.

Hedge funds often tout the freedom to move across asset classes as their big advantage, so one would expect that “advantage” to show up. The problem is that the efficiency of the market, as well as the costs of the efforts, changes that supposed advantage into a handicap.

Conclusion

2011 was a year in which the financial markets were seriously challenged by problems in the Eurozone and concerns over state and municipal finances. Like most years, 2011 provided many real-life examples that illustrate why one of the main principles of a prudent investment strategy is to build a globally diversified portfolio that reflects an investor’s unique ability, willingness and need to take risk.

One key to achieving that objective is to ignore economic and market forecasters, the noise of the market and the emotions that noise can cause. Doing so should allow for more time to be spent on the important things in life, like family, friends and community.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2011, Green Wealth Management, LLC, used with permission.

One human tendency is to judge the effectiveness of our retirement savings strategies by looking at performances on one-, two-, or three-year horizons. We do this because we are wired to be more sensitive to short-term losses than to long-term gains.

This is why much of the financial services industry and media encourage a short-term focus for an audience with a long-term horizon. This is akin to looking through the wrong end of a telescope. The thing you should be focusing on looks even farther away.

The result of this short-term mindset is that investors end up following the herd and seeking safety when opportunities are plentiful and seeking risk when opportunities are few. The less dumb thing is to maintain a level of discipline amid the noise.

Another human tendency—and one allied to our built-in loss aversion—is to be suckers for the supposedly “free” or discounted offer. Like Homer Simpson, a zero price tag makes us fall for pitches selling us stuff that is neither necessary nor good for us.

In the world of investment, it’s this tendency that makes people gravitate to strategies that headline high returns without mentioning the risk, or that conveniently bury fees, commissions, and other costs. Regret lies on the other side of those decisions.

A less dumb thing is to focus on return and risk. They’re related. Focusing exclusively on return can lead to rude awakenings when risk shows up. Focusing exclusively on risk can lead to disappointment when returns are delivered.

A third tendency among humans is to succumb to what behavioural scientists call “hindsight bias.” Essentially, this is our habit of viewing events as more predictable than they really were. Call it the “I saw it coming” syndrome.

There is a fair bit of this around at the moment, with plenty of “experts” saying the sovereign risk crisis was completely predictable. This is strange, because as we saw in my previous column “Things Change,” the overwhelming consensus among institutional investors a year ago was that fixed income would underperform in 2011. The crisis may have been predictable, but the market reaction wasn’t.

The consequence of hindsight bias for investors is they tend to be forever rewriting history and forever seeking to interpret performance based on what they know now rather than what they knew a year or more before.

A less dumb thing is to accept there will always be a level of uncertainty. The future is unknowable. And all we can do as investors is to ensure the risks we take are related to an expected return, that we diversify around those risks as much as possible, and that we exercise a level of discipline amid the noise.

It’s a way of embracing your imperfection, and it’s a New Year’s resolution you have a chance of sticking to.

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

Take the late 2010 Barclays Capital Global Macro Survey of more than two thousand institutional investors. The pick for the best performing asset class in 2011 was equities (with 40% support), followed by commodities (34%) and bonds (less than 10%).[1] The consensus prediction was a 15% gain in the S&P 500 for the year to around 1,420.

As we now know, the truth turned out to be rather different. To the beginning of December and using broad indices, diversified fixed income was the best performing asset class of the year, followed by government bonds. Returns from commodities and equities were negative. The year-to-date return for the S&P 500 was close to zero. (And remember, these are the forecasts of big institutional investors.)

Barron’s, meanwhile, was telling readers this time last year that smart stock pickers were “looking eastward” in 2011. The year was to be dominated by fast growth and rising inflation, and the smart thing was to reweight toward China and other tigers.[2]

That didn’t really turn out to be such a good idea, as China had another bad year. The Hong Kong Hang Seng index was down nearly 17% to early December. The Shanghai Composite was down by a similar amount.

Conversely, the gloom around fixed income in late 2010 was all pervasive. Barron’s surveyed 10 strategists and investment managers and found nearly all expected stocks to outperform bonds in 2011. “You’ve got to believe in outright deflation to put new money into bonds right now,” said one investment banker.[3]

The logic might have been impeccable, but the strategy wasn’t so. As of early December, US debt securities, as measured by a Bank of America Merrill Lynch index, had risen by 8.7% in 2011, their best performance since 2008.[4]

In other words, bond yields might have been seen as unusually low a year ago. But they have fallen even further since, and those who tried to profit by market timing or making concentrated bets elsewhere have paid a heavy price.

So if the experts can’t get the broad asset class movements right, what chance on earth have they of correctly and consistently predicting individual stock or commodity performances? But year after year, that doesn’t stop them from trying.

One prominent investment bank team was quoted by The Australian Financial Review last January as saying that platinum was the metal to back in 2011. As of early December, the spot platinum price was down nearly 14% for the year. On the Australian stock exchange, platinum stocks Platinum Australia and Aquarius Platinum—both recommended by the bank—had delivered total returns to the end of November of –83% and –53%, respectively.[5] Ouch!

Stock picks often go wrong because forecasters base their calls on what turn out to be incorrect assumptions on macro-economic variables like base lending rates and inflation. Take the AFR Smart Investor magazine “expert panel,” which in late 2010 suggested to readers moving out of international fixed income and into cash given expectations of rising cash rates in Australia.[6] As it turned out, Aussie rates did not move until November, and when they did the direction was down, not up.

Currencies are another variable that defy even the most assiduous forecasters. In its 2011 outlook, published in the London Daily Telegraph in December 2010, a major British bank forecast sterling would be the best performing currency of the year.[7] The banks also predicted stock markets would outperform bonds, with the FTSE 100 rising about 18%. A year later, sterling ranked only a distant fourth behind the Japanese yen, Norwegian krone, and Swiss franc, and the FTSE was nearly 6% lower.

It’s a tough business, isn’t it? And remember these are major financial institutions with armies of expert analysts, mountains of data, and sophisticated forecasting tools. So what is an ordinary investor supposed to do?

The first lesson might be that forecasting is hard, particularly about the future! You can do all the analysis you want, but events have a way of messing with your assumptions.

The second lesson is you don’t really need forecasts to succeed as an investor. Yes, equity markets were rocky again this past year. But a properly diversified fixed income portfolio provided excellent returns. Staying diversified both across and within asset classes helps lessen the effects in down times and ensures you are still positioned to reap returns when riskier assets come back into demand.

The third lesson is that the past has gone. The news may be gloomy, but that information is in the price. When risk appetites are low, the price of safety is higher than at other times. But the expected reward for risk is higher. Conversely, when risk appetites are high, the expected rewards are lower.

It’s human to feel anxious about bad news because we fear loss more than we like gains. But in this case, the loss isn’t real unless you realize it, so it makes sense to stay with the asset allocation your advisor has tailored for you.

The final lesson is that nothing lasts forever. In fact, of all the forecasts ever made, the only one really worth counting on is that things change. What’s more, they often change in ways we least expect.

1. “For 2011, It’ll Be All About Equities,” Pensions & Investments, December 27, 2010.
2. “Asian Trader: Stockpickers, Look Eastward,” Barron’s, December 20, 2010.
3. “Outlook 2011,” Barron’s, December 20, 2010.
4. “Treasuries Rise on Concern Europe Struggling to Resolve Crisis,” Bloomberg, December 7, 2011.
5. “Platinum to Become the Price of Metals in 2011,” Australian Financial Review, January 7, 2011.
6. “How to Rebalance Your Portfolio in 2011,” AFR Smart Investor, December 17, 2010.
7. “Sterling Best Major Currency Next Year, says Barclays,” The Daily Telegraph, December 10, 2010.

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

As the year comes to an end, consider these gifts that can provide peace of mind and security for your family for years to come:

Review – Situations change. Make sure your investment portfolio, insurance coverages, and estate plan stay in synch with your family, values and goals. An annual discussion with your financial and legal advisors helps to keep your portfolio and important documents up to date.

Simplify – We’re all on the move today, so it’s easy to accumulate investment assets in multiple retirement plans, at a variety of financial institutions, or with more than one investment advisor. This fragmentation can lead to skewed asset allocations, extra work at tax time, and uncertainty about what you really own. Consolidating disparate accounts will simplify things for you, and for your family when you get older.

Prepare for the unexpected – Emergencies can strike at any time. Make sure you and your family are prepared. That means not just a pantry full of food, water and batteries, but also having legal and insurance documents up to date and in a safe place.

Share your knowledge – If you are the family member in charge of financial decisions and transactions, make sure someone else in the family is up to speed in the event of you becoming ill or some other emergency. At minimum, make a list of key service providers and contacts to make things easier if you are incapacitated.

Give now – If your intention is to pass significant assets to your children or other loved ones upon your death, consider getting started now. There may be tax advantages to making smaller annual gifts during your lifetime. And your children, depending on their age and career status, may need the funds more today than in the future.

Focus on college – The average 2011 college graduate in 2011 left school with more than $27,000 in student debt (not including parent loans or the cost of graduate education). Helping your children, grandkids, or others pay for college can make a huge impact on their lives, career prospects, and financial futures. Discuss 529 educational savings plans and other options with your financial advisor.

Review spending and savings – Year-end is an ideal time to review how much you made during the year and where it went. An annual look at your spending, saving and philanthropic habits may reveal areas where you can make changes that benefit you and your family.

Tend to your health – Perhaps more precious than any other gift you can give your family is to take a proactive approach to health and wellness. As the year comes to an end, schedule your next physical, make exercise a priority, and watch what you eat.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2011 Bright Sky Group, LLC. All rights reserved

It’s a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.

As the year winds down (if that’s the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.

While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it’s worth reflecting critically on our often second-hand memories of the “good old days.”

A Brief History of the 20th Century

Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.

Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world’s population was infected over a two-year period.

A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.

In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.

In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.

This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.

In economic terms, the war’s impact was profound. Most of Europe’s infrastructure was destroyed, millions of people were left homeless, much of the UK’s urban areas were devastated, labor shortages were rife, and rationing was prevalent.

While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.

The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.

In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.

While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.

In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.

Another Perspective

So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn’t overlook the good either.

Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women’s suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news and long for the “good old days.”

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

S&P data provided by Standard & Poor’s Index Services Group.

Morningstar data provided by Morningstar Inc.

Russell data copyright 2011, Russell Investment Group 1995-2011, all rights reserved.

Weston Wellington

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.

These pub philosophers tend either to be permanent bulls or permanent bears about the market. They have their standard story, and they adapt the facts to fit. Some of them even end up writing newspaper columns and hosting television shows. 

By contrast, some of the world’s most respected and seasoned investors strike a humbler tone, having learned from personal experience about the unpredictability of markets and deciding to focus instead on those things within their control. 

Take, for instance, the frequently heard line that smart investors should seek to time their entry points to markets and wait for the volatility to clear. We are hearing a lot of that right now as the European crisis dominates market attention. 

Writing about this in 1979 before one of the biggest bull markets in history, Warren Buffett said: “Before reaching for that crutch (market timing), face up to two unpleasant facts: The future is never clear [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”1 

Another line from the pub philosophers is that the job of an investment expert is to spot the best market-beating returns and harvest them before someone else finds out. 

Asked about this in 2007, two years before his death, legendary investment consultant and historian Peter Bernstein said it was better to focus on risk than return. “The central role of risk, if anything, has grown rather than diminished,” he said. “We really can’t manage returns because we don’t know what they’re going to be. The only way we can play the game is to decide what kinds of risk we’re going to take.”2 

A third perennial pub conversation is the role of stock picking in investment success. The line here is that the key to wealth building lies in painstakingly analyzing individual stocks and buying them based on a forecast or even a hunch about their prospects. 

Prompted by a newspaper reporter for his opinion on that piece of conventional wisdom, Charley Ellis, long-time Wall Street observer and the founder of Greenwich Associates, said the truth was actually quite the opposite.3 

“The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy,” Ellis said. 

“Sure, these approaches all have their current heroes and war stores, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it.” 

While that’s probably not the kind of message you are likely to hear from the instant experts who prop up your local bar, it may be a more durable and a more useful one. 

2. Jonathan Burton, “Alpha and Bets,” MarketWatch, April 30, 2007. 

3. Barrie Dunstan, “Global Money Masters,” Australian Financial Review, November 2006. 

Jim Parker

Copyright 2011 Dimensional Fund Advisors. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.