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Recently I have been hearing comments from clients, friends and family, that have me worried about people’s understanding of how markets work, risk and expectations for their portfolios.

It has been 10 years since the start of the bull market. I think people have forgotten that stocks, bonds and professionally developed portfolios don’t always go up. Unfortunately, there will be years that your investments go down.

Here are 3 key points I want to make:

Don’t expect your returns to be like those of the last 10 years:  An important lesson I remember from my driver education teacher was that of highway hypnosis. This is the effect that occurs when a driver leaves the highway and drives on a city street. The driver has been so conditioned to the speed of the highway that driving on the city street feels excruciatingly slow.  I am fearful that is what investors are experiencing now. The stock and bond market trend of the past 10 years has investors feeling that these returns are normal. Unfortunately, investors have been hypnotized into thinking that the last 10 years is what to expect the next 10 years.

The S&P Dow Jones Target Growth 60% stock benchmark is up 7.36% over the last 10 years and, if we remove 2008, it is up over 10% the last 9 years . The professional consensus is that investors should not expect this kind of return going forward. A hard and fast rule in finance is that when markets have been high expected returns should be low. We have been on an investing highway for 10 years, so expectations for the future should be tempered and not confused with the fast highway of returns we have been experiencing.

You should not compare your portfolio to the Dow Jones or S&P 500:  This year, clients have asked: why, if the US stock market is at record highs, is their portfolio barely breaking even. The answer is: most clients are invested in a diversified portfolio and only part of a diversified portfolio is in US Stocks. I am here to remind you that with those stock market record highs will come gut wrenching drawdowns. Diversification is designed to help cushion those bad times. If you are invested in a 60% stock portfolio you should compare it to a benchmark such as the S&P Dow Jones Target Growth benchmark: https://us.spindices.com/indices/multi-asset/sp-target-risk-growth-index  which is up 1.92% for the year through September.

A review of the chart below, sometimes known as the periodic chart of returns, shows various asset class returns for the years 2003 through 2012. There are more updated charts but not one that shows the returns of a 60%s stock/40% bond portfolio in the mix.

Note: An asset class is a specific categorization of investment such as bonds, small company stocks, large company stocks (S&P 500), international stocks, real estate (REIT), cash.

The lesson that an investor should learn from the chart is the importance of diversification. Notice how returns of asset classes are randomly distributed. In fact, there are years that an asset class could be the highest earning class then the next year the lowest earning, such as real estate (REIT) from 2006 to 2007. No genius or computer has ever figured out how to pick the asset class that will top the chart year after year. Or, which class will earn the longest 10 year return. In fact, if you were told in 2003 that emerging markets (MSCI EME) would give you the best probable 10 year return, would you have stayed invested when that class was down 53.2% in 2008?

Diversification smooths out the ups and downs which helps people stay invested. The 60% stock/40% bond diversified portfolio labelled “Asset Alloc” earned 8.1% over the 10 year period, actually beating the S&P 500 by 1% with less ups and downs.

If an investor wants the long term returns of the S&P 500 or Emerging Markets or small company stocks (Russell 2000) then they need to stay the course when the drawdowns are gut wrenching. We know from human behavior, this is not what happens. That is why one diversifies.

Asset Class Returns

 

One last note on diversification. If you are at, or nearing retirement, your portfolio is structured to be defensive, a retiree client may have more in cash or short term bonds than a younger clients growth portfolio.

Retiree’s and those approaching retirement need to keep in mind that they are playing a defensive game at this point in life. It is more important to preserve capital not put capital at risk. That is a young investors game. Think ROI (reliability of income) not ROI (return on investment). That is why your return on your diversified and maybe cash heavy portfolio is not the same as the S&P 500.

Just because your portfolio is professionally allocated doesn’t mean it always goes up: I will direct your attention again to the chart above which shows there are years that even a professionally designed mix  (Asset Alloc) resulted in losses (2008, 2011).  Investing hypnosis has investors forgetting this fact. What the professional portfolio provides is good diversification that should give the highest probability of return for a given level of risk.

Risk is the key variable here. Risk is defined as the probability of loss. Every asset class, and professionally designed portfolio, has risk which means a chance of a loss in a year or over many years. If there was no chance of loss there would be no risk. It is the down periods (risk), when there are losses, and holding during those periods,  that should reward the investor with a higher return.

A professional adviser should remind their clients of the above facts and to manage their behavior and prevent them from moving to the S&P 500 when it looks so much better than the boring 60/40 mix they own.

Bottom line: There is no algorithm or genius that has all the answers. If so, we would all be following it or him or her.

What we can do is follow what has worked for decades:

  1. Diversify intelligently based on individual circumstance.
  2. Stay the course, don’t dance in and out after the plan is made.
  3. Limit investing expenses: mutual fund, trading, and dare I say, adviser fees.
  4. Rebalance regularly.
  5. Limit taxes due to excessive buying and selling or non-strategic withdrawals from IRA accounts.