Last year was historic for the stock market, with the S&P 500 Index soaring 28.9% in one of its best performances ever. The surge higher reinforced the notion that investors need to be in stocks over the long haul. Indeed, the evidence shows that equities have historically been the top asset class – by a lot. Research from JPMorgan Chase & Co. finds that the S&P 500 returned about 5.6% a year from 1999 through 2018.
But there’s a dirty little secret to all this: most investors come nowhere close to realizing those returns. In fact, they only earned 1.9%, the research shows, which is not a lot better than parking cash in a bank account. And if the average investor made 1.9% in a period of 5.6% returns, then it stands to reason that a below average investor, such as one in the 30th percentile, actually lost money in a period of strongly positive returns.
This is important, because it suggests there are people who will find a way to lose money in any environment, with or without a financial adviser or behavioral coaching. It doesn’t matter whether they are allergic to risk or have an unlimited appetite for risk. Both tend to do poorly in stocks, and would be better off in an FDIC-insured bank account.
The culprit here is suboptimal investor behavior. Retail investors don’t faithfully dollar-cost average nor do they faithfully buy and hold. They market-time in both subtle and unsubtle ways. Market-timing can take the form of putting a little more money in mutual funds when stocks are going up and investors are excited, and a little less when they are going down and investors are frightened.
It is difficult to make a portfolio of stocks resistant to emotions, which is why retail investors never do as well as the broader market. So how do you make a portfolio emotion-proof? The answer is trade-offs. A portfolio of 100% stocks—which many investors seem to have these days—have the highest expected return. It also has the highest expected risk.
Not a lot of thought is going into what makes the ideal portfolio these days, as many financial advisers throw the traditional model of 60% stocks and 40% bonds out the window and implicitly – or even explicitly — encourage their clients to take on more risk with interest rates at historic lows. But it doesn’t feel like risk if the market doesn’t go down and volatility is muted. When volatility starts working the other direction, emotions will again kick in and portfolios will be liquidated at the worst possible time.
The American Association of Individual Investors regularly polls its members on asset allocation. The most recent reading, in December, showed that its members had almost a 66% allocation to stocks, with an 18% allocation to bonds, and a 16% allocation to cash. Based on my interactions with investors and conversations with financial advisers, that allocation to stocks seems low, but it is still very high by historical standards. At the bottom of the financial crisis, the AAII survey showed that investors only had 41% allocated to stocks, suggesting that investors are unsuccessful in market-timing.
There is a lot of risk to being out of equities and missing a big move higher. Those who inadvertently missed out on the top 10 daily moves in the stock market over the last 10 years achieved only about half the gains. And those who missed the top 25 moves in the stock market hardly had any gains.
That’s why it’s important to create a diversified portfolio from the start, with plenty of bonds to go along with stocks. I have written about the benefits of a 35/65 portfolio even though sentiment toward bonds is pretty negative. It is tough to get people excited about a bond portfolio that yields 2% to 3%, and most financial advisers don’t try. What they don’t have a grasp of is the diversification benefits of bonds, and how the addition of bonds to any portfolio of stocks automatically improves the risk-adjusted returns of the portfolio.
It doesn’t matter what you add to a portfolio of stocks, as long as you add something. Over the last 20 years, an 80/20 portfolio of stocks and bonds returned 6.16% annually, with a standard deviation of 11.5% and a maximum peak-to-trough loss of 46%. A portfolio with just 5% gold (and 5% less stocks) actually returned more, but with less risk, a smaller max loss, and a higher Sharpe ratio.
Not many people talk about the diversification benefits of commodities or real estate, which tend to be uncorrelated with stocks. If you don’t like bonds, the goal is to add something else that will reduce overall risk.
The thing about bear markets and crashes tend to come when they are least expected, which is usually when exposure to and enthusiasm for stocks are at their highest. That’s not unlike now, with people seemingly pretty happy even though the S&P 500 is trading at almost 22 times earnings. It pays to have some insurance even if it means lower returns because, after all, making nothing is better than losing money.
