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Here's A Secret: Sometimes an Average Return Is Excellent
05/12/2017 2:50 am EST
Steve Pomeranz compares the average returns of an S&P 500 index fund against a generic asset-allocated portfolio over a 44-year period. You may be surprised by the results.
As a financial advisor, I am constantly regaled by stories of the big stock winners of the day. The so-called ten-baggers, a term coined by the legendary Fidelity Fund manager, Peter Lynch, who would talk about those stocks that went up 10-fold. But today I want to make the case against reaching for the stars and just make the case to you to reach for mediocrity in your investments.
No one ever talks about the merits of reaching for mediocrity, but I am going to, so please stay with me on this.
I plan to use some data in my commentary today that came from Craig Israelsen who wrote an article titled “Are Average Returns Enough for Clients?” for FinancialPlanning.com.
In his article, Craig compares annual returns from the S&P 500 Index versus a portfolio of seven other different types of assets. We call these assets “asset classes” and they consist of large-cap US stocks, small-cap US stocks, international stocks, commodities, real estate, US bonds, and cash. To further my reaching for mediocrity, I’ll call this the “Average Portfolio.” The author looked at what may have happened if one invested an equal amount in each class over a 44-year period from 1970 to 2013 and compared it to the S&P 500 index, which, as you probably know, is comprised of 500 large US companies. Remember that the S&P 500 is a cap-weighted, unmanaged index made up of stocks only.
The data Craig presented in the article showed that annual returns from the S&P 500 were better than the Average Portfolio 55% of the time, doing better in 24 of the 44 years. And sometimes the S&P 500 was way ahead of the Average Portfolio. Like in 1998, for example, it beat the Average Portfolio by about 27.5%. And furthermore, over the 24 years that the S&P was ahead, it beat the Average Portfolio by an average of 8.3% per year—a pretty massive margin.
But here’s the key. Despite those 24 years of solid outperformance, the two portfolios delivered about the same average annual returns over the 44-year period, with the S&P up 10.4% annually and the Average Portfolio up 10.3%.
So what gives? How’s this possible?
Turns out, the S&P had nine losing years while the Average Portfolio had five losing years—not much there to explain the strange performance. Looking a little deeper, we find the answer not in the frequency of the declines, but in the magnitude of the declines. You see, the losing years for the S&P 500 were dramatically worse. The S&P 500 average decline was 15.2% versus only 8.7% for the Average Portfolio—that 6.5% average disparity is what makes all the difference.
Most of us would likely jump to the conclusion that 24 up years with an average outperformance of 8.3% would easily beat 9 down years of 6.5% annual underperformance, but compounding works a little differently because negative returns damage a portfolio way more disproportionately than positive returns. And here’s a simple example:
If you start with $100 and lose 50%, you’re down to $50. But to get back to $100, you need a gain of $50. Earning $50 on $50 requires a 100% gain to make up for a 50% loss, so negative gains are much harder to dig out of. Do you see what I mean?
Even though the S&P 500 frequently outperformed the Average Portfolio, those gains were largely undermined by the 4 extra down years and the extra depths of those down years.
Investors should also understand that an Average Portfolio will probably never outperform a single sector, in any given year—it’s one reason so many people have trouble sticking with an asset allocated portfolio. It’s much easier and more fun to chase popular stocks that are going up right now. It really feels like you are onto something when you start to make money this way. The problem is that when the bad times come—and they always do—your losses may wipe all your gains away and then some.
I hate to be a spoilsport, but the trophy goes to the tortoise, not the hare. Consider being comfortable with slow and steady gains over flashy returns washed out by horrible years.
And while it’s natural to want to chase top-performing sectors, doing so is really an exercise in folly, which most of us humans are susceptible to until we see the logic of a well-diversified portfolio.
I chose this topic today because I thought it was pretty timely. The year 2016 was good for equities, with the S&P 500 up around 12% versus about an 8.3% return for a generic asset-allocated portfolio. Once again, some would view that difference to be disappointing, but I’d urge you to fight that temptation and consider sticking with a well-diversified portfolio for the long run. Pick the plodding but victorious tortoise over the running, skipping, and jumping hare.
In addition to what I’ve said here today, you may even be able to sleep better at night.
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