In this piece, we distill the broad subject of investing into the one (overly) simple choice that investors have when deciding what type of experience they’d like to pursue. Both approaches are valid, both have their merits and drawbacks. Which is right for you?
Option 1:
“Stock markets go up in the long run. I am not concerned with volatility or losses along the way, because I’m invested for the long term, markets are efficient, and I want to capture that return.”
This approach is based on long-term market history, typically as measured by the S&P500, that shows stock market returns average around 10%/year, observed over about 100 years. There is a great deal of evidence supporting this argument, all of which is easily sourced. Here’s one.
If this is the approach you wish to take with your investments, it is easily accessed. However, if this is your choice, and unless you can time the market consistently (you can’t), be prepared to stick with it, even when your assets drop precipitously. Take a look at this chart (40 yr. S&P) [Google Finance] showing the S&P500 over the last 40 years—the growth is there, but twice in the last 20 years the value has been cut almost in half. That can be hard to stomach.
Option 2:
The second possibility is some variation of the following:
“I don’t particularly care what the market does because my life is not the market. I am interested in preserving and growing the value of my assets as they relate to my life and objectives. I prefer consistency over big swings.”
This approach prescribes some measure of risk management and hedging. Whether through the use of cash, bonds, alternative investments or a combination thereof, it involves holding positions that behave differently at different times for different reasons (i.e. non-correlated). Building a portfolio of this type attempts to capture returns from different sources while minimizing the impact of market drops and providing for consistent compound growth.
Three Thoughts to Ponder:
1. An investor’s perceived tolerance for risk tends to vary with market performance. During and after positive market periods, investors often state that they want more risk and are increasingly likely to side with Option 1. During and after periods of stress and market decline, investors often want to reduce their risk and exposure. We’ve even heard of clients (not ours, of course) stating after 2008 that they wanted nothing to do with equity markets while wondering after last year why they are not keeping up with equity markets. Invariably, this leads to one doing the wrong thing at the wrong time In 2010, the S&P500 had fallen from 1400 to 1100 over the previous 10 years [Thompson Reuters]—known as “the lost decade of investment returns” [ Wall Street Journal]; virtually no one was touting the importance of “just buying the index” then. Following a number of strong years now, it seems desire to “be like the market” is all the rage. Your portfolio should be appropriate for you, accounting for the reality of good and bad times, neither of which can be predicted.
2. An index is only one component of a prudent portfolio. There are countless indices, approaches to their construction, assets and options. The bigger questions include, “which index”, “how much to each” and “when to adjust”. Most importantly ,the theory of Goals-based investing mandates that one measure performance based on their objectives, by taking the following steps:
- Establish Personal Goals
- Implement a Strategy to Achieve Them
- Monitor Your Progress Towards Them
3. The problem with “average annual returns” is that they aren’t necessarily reflective of your actual investment experience. Here’s why: An investment that goes up 100% in year one (from $100 to $200) and then loses 50% (from $200 down to $100) in year 2, is “averaging” 25%. But you have not gained anything and only have the amount you started with. So “average” returns can be deceiving. And this is the way indices report performance—so their track records are not reflective of an investor’s.
Consider which approach is right for you. We invite your questions and comments, and we are here to help.