A report I receive each month helps to put last year’s market performance into perspective. S&P Dow Jones Indices’ “Market Attributes: Correlation & Dispersion” summarizes how close to being in lockstep stock prices are. It tracks dispersion, a measure of the degree to which components of a market index perform alike or differently. Low levels of dispersion indicate a tight distribution of individual stock returns. High levels of dispersion indicate a wide distribution of individual stock returns.

If you invest in individual stocks or follow a strategy designed to select individual stocks, you want high levels of dispersion. Fei Mei Chan and Craig Lazzara explained why in “Gauging Differential Returns” (S&P Dow Jones Indices, January 2014). They wrote “An active stock picker has more scope to display his skill than he does in a low dispersion environment. For a given (positive) skill level, higher dispersion should lead to higher levels of excess return. (And negative skill, regrettably, will produce larger losses.)”

For a good part of last year, dispersion among S&P 500 stocks was near the low end of its historical range. This meant it was harder to beat the market with active strategies. In early December, the Financial Times cited a Goldman Sachs analysis showing only 14% of large-cap core mutual funds beating the S&P 500 index in 2014. (We’ll have 2014 mutual fund return data in next month’s AAII Journal.)

Adding to the challenge of active management was this year’s domestic preference for size. Large-cap stocks beat mid-cap stocks and mid-cap stocks beat small-cap stocks. Any strategy not specifically tied to large-cap stocks likely incurred rougher waters than in years past. Outperformance by large-cap growth relative to large-cap value didn’t help matters either.

Our stock screens and our Model Shadow Stock Portfolio were unable to escape the challenges created by this backdrop. As Wayne Thorp explains in our annual AAII Stock Screens review here, just eight out of the 62 stock screens we track outperformed the S&P 500’s 11.9% year-to-date gain through November 28, 2014. The Model Shadow Stock Portfolio incurred its worst performance in six years, with a 9.6% year-to-date loss through November 28, 2014. You can read the update on the portfolio and new changes here.

When returns are disappointing for a particular year, it’s tempting to abandon an active strategy or an actively managed fund. Given the characteristics of 2014, I would resist the temptation. Market environments ebb and flow between being favorable for a given strategy to being lousy for it. One of the biggest red flags surrounding Bernie Madoff was the consistently good returns he reported. Even the great active money managers have a mix of good years, fantastic years, so-so years and lousy years. If we could predict what strategy will be in favor for a given future period of time and how long it will be in favor, investing in individual stocks would be much easier.

Since we humans lack such prognosticating skills, the best thing we can do is to look at long-term performance. If a strategy has a long track record of beating the market, a logical reason for doing so and follows a repeatable process, its odds of beating the market over the long term in the future are good. Over short periods of time, however, the results can give you both a headache and a reason to second-guess your desire to stick with the strategy. While abandoning a strategy with lousy recent performance may feel satisfying, the lousy long-term returns from constantly chasing the current “hot” strategy will not.

Keep in mind that you are never under any obligation to follow just one strategy. We have over 60 stock screens on AAII.com as well as our model portfolios to choose from. By combining approaches based on different methodologies, you may find it easier to stick with good active strategies over the long term.

Happy New Year,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII