Despite a bumpy ride throughout 2014, the US economy gained pace while the US equity and fixed income markets outperformed most markets around the world. This performance came with higher market volatility in the US, a rallying dollar, slowing economies in Europe and Asia, and rising geopolitical tensions, including conflicts in Ukraine and the Middle East.

The Dow Jones Industrial Average rose for the sixth straight year, posting a 7.52% gain (price-only return). The S&P 500 Index (large US companies) rose 13.69% (including reinvested dividends), marking the third straight year in which the benchmark has returned more than 10%. The Dow closed at a record high on 38 calendar days, while the S&P 500 had 53 record closes. 

The non-US markets followed a much different track:  All major stock indices logged negative performance for the year (in USD). The MSCI EAFE (Developed Markets) Index had a -4.90% return and the MSCI Emerging Markets Index a -2.19% return (net dividends, in USD). The dollar's strong performance relative to major regional currencies contributed significantly to the lower returns for US investors.

Returns of major bond indices were positive due to falling yields and rising prices. One-year US Treasury notes returned 0.18%, US government bonds 4.92%, world government bonds (1-5 years USD hedged) 1.90%, and US TIPS 3.64%.

Real estate securities had a banner year: The Dow Jones US Select REIT Index returned 32.00%, and the S&P Global ex US REIT Index returned 10.94%. Commodities were negative for the fourth year in a row, with the Bloomberg Commodity Total Return Index returning -17.01%.

What about small and value?

While US stock returns were high relative to those of other regional markets, returns within various US market segments diverged. Based on the respective Russell 1000 and 2000 indices, US large cap stocks significantly outperformed small cap stocks, and within the relative price dimension, large value slightly outperformed large growth. Among small cap stocks, growth outperformed value.

In the non-US developed markets (based on the MSCI indices in USD), all segments had negative performance. Negative returns among large and small caps stocks were similar, while large growth slightly outperformed large value. In the emerging markets, small cap, which had a slightly positive return, outperformed large cap, and growth outperformed value, although both returns were negative.

The mixed results of the small and value tilts in our portfolios in 2014 were not unusual from a historical standpoint. Although small cap and value stocks have offered higher expected returns relative to their large cap and growth counterparts, these return premiums do not appear each year. For example, since 1979, US small caps have outperformed large caps in 19 of the 36 calendar years-or 52% of the time. Results are similar for the relative price dimension: Since 1979, value has outperformed growth in 20 calendar years-or 55% of the time. Small cap value has outperformed large cap growth in 58% of the calendar years. 

History also has produced multiyear periods in which small caps and value did not outperform large caps and growth. Noteworthy periods include 1984 to 1987 and 1994 to 1998, when small caps underperformed large caps, often by a wide margin each year. Since 1979, the value premium has also experienced extended periods of underperformance-and, in some cases, the differential exceeded 15% margin. The same is true of small value vs. large growth stocks. In the three-year period from 2009 to 2011, both value and small caps underperformed. Yet, despite even extended negative-premium periods, small caps and value have outperformed over time, and when the premiums reversed, they often did so strongly and in multiple years.

In summary ...

Normally when the U.S. investment markets have posted six consecutive years of gains, five of them in double-digit territory, you would expect to see a kind of euphoria sweep through the ranks of investors.  But for most of 2014, investors in aggregate seemed to vacillate between caution and fear, hanging on every economic and jobs report, paying close attention to the Federal Reserve Board's pronouncements, seemingly trying to find the bad news in the long, steady economic recovery.

One of the most interesting aspects of 2014-and, indeed, the entire U.S. bull market period since 2009-is that so many people think portfolio diversification was a bad thing for their wealth.  When global stocks are down compared with the U.S. markets, U.S. investors tend to look at their statements and wonder why they're lagging the S&P index that they see on the nightly news.  This year, commodity-related investments were also down significantly, producing even more drag during what was otherwise a good investment year.

But that's the point of diversification: when the year began, none of us knew whether the U.S., Europe, both or neither would finish the year in positive territory.  Holding some of each is a prudent strategy, yet the eye inevitably turns to the declining investment which, in hindsight, pulled the overall returns down a bit.  

At the end of the day, we need to focus on what we can control: diversification, keeping investing costs low, managing taxes, and staying disciplined in applying documented academic research to our investment portfolios.  We don't need to predict which asset class will end each year on top to have a successful investment experience over the long term, meet our financial goals, and enjoy our lives.  Which is the reason we do all this, right?

You already know that our financial habits determine our financial fate.  If we avoid credit card debt, spend less than we earn and create a financial buffer against the unexpected, we tend to thrive financially.  If we carry a lot of debt or live constantly on the edge, with little savings, then our financial future is much cloudier.

Recently, a paper published by the Federal Reserve Bank of St. Louis proved these truisms in the real world.  For eight individual years between 1992 and 2013, the Fed's Survey of Consumer Finances has posted a series of financial questions to thousands of people in all walks of life, at all income levels and ages.  

Among them:

1) Did you save any money last year?

2) Did you miss any loan or mortgage payments in the last year?

3) Did you have a balance on your credit card after the last payment was due?

4) Do liquid assets make up at least 10% of the value of your total assets?

5) Is your total debt service-the cash you devote each month to paying principal and interest-less than 40% of your income?

The paper scored the answers, giving every positive answer (yes for 1, 4 and 5, no for 2 and 3) one point, assigning zero points to the "wrong"answers. Then they added up the scores for each household and looked at a financial health score taken from the same survey, and compared the two.  They found what you would probably expect: that good financial habits are highly correlated with the accumulation of wealth.  A small chart at the back of the study, which divided people according to age and ethnic profile, found that individuals who averaged a score of 2.63 had a median net worth of $25,199, while those who averaged a 3.79 score enjoyed a median net worth in excess of $800,000.  The average score: 3.01, associated with a net worth somewhere in the $70,000 to $75,000 range, which happens to fall neatly in between the median for people age 35-44 ($51,575) and those age 45-54 ($98,350).   

So while I'm not a fan of New Year's resolutions, it's always a good time to consider how your day-to-day habits may be helping (or hurting) your financial health.

 Material adapted with permission of financial columnist Bob Veres.

While Congress took the extension of many popular tax provisions down to the wire, the Tax Increase Prevention Act of 2014 passed before the end of December.  All of the following provisions were among those retroactively extended, and are now effective through the end of 2014.  

It's time to reconsider whether making after-tax contributions to a 401k is a good financial planning strategy.

Prior to this ruling, we generally did not recommend making after-tax contributions to a 401k.  Even though the original contribution wasn't taxed again at distribution, all the earnings were taxed as regular income.  The regular income tax treatment made it unattractive compared to the alternative of putting the money into a taxable investment account and having your capital gains and qualified dividends taxed at the lower capital gain rates.

With this change, you should still make your full contribution as regular (pre-tax) or Roth contributions up to the federal maximums ($18,000 for 2015 plus a $6,000 catch-up if you're 50 or older before 12/31/2015).  But if your employer allows you to make additional after-tax contributions, the opportunity to roll those into a Roth when you leave the company creates an appealing opportunity to get more money into the Roth bucket.  Depending on your situation and other opportunities available to you, it may be a really good option to consider after you've maxed out other sources of tax-advantaged savings.

For examples from the IRS applying this new ruling, please visit our website: www.KeenerFinancial.com.