The Importance of Discipline When Investing
The most important decision many investors face is the choice of long-term stock and bond allocation. There is no proven way to time the stock or bond market, and the cost of missing only a few days of the best market returns can be devastating to long-term returns.
The most prudent strategy for most investors is to pick an allocation that they can stay invested in through the worst of downturns.
Why Do We Need to Consider Both Risk and Return?
Investors must always evaluate risk in the context of the return. In isolation, an investor would always choose the worst drawdown of 25% instead of the worst drawdown of 30% if the returns were equal. In a similar way, an investor may not choose an 8% expected return portfolio if the risk is double that of a 7% expected return portfolio.
One measure of risk is volatility, which is a measure of the amount that investment goes up and down over time. A portfolio with higher volatility will experience higher highs and lower lows than another portfolio that has the same average return but lower volatility.
The following chart shows why volatility matters. It shows that two generic portfolios with the same average return produce different wealth because Portfolio A has higher volatility and Portfolio B.
The most prudent strategy for most investors is to build a diversified portfolio that reduces the volatility associated with individual stocks or industries.
Understanding the Trade-Off Between Downside Risk and Long-Term Upside
This chart is an educational illustration of the potential downside risk an investor must endure in order to target incrementally higher expected returns from allocating more to stocks.
Another important part of this trade-off is the time frame over which the investor plans to invest. An investor’s chance of losing principal becomes less the longer the period of time over which they will invest.
This performance shown uses hypothetical historical returns of Indexed Portfolios adjusted by fund expenses and a 1.2% advisory fee for Worst Downside Loss percentages and the Expected Average Return and Growth figures use a simple 6.25% equity premium plus current 10-year Treasury Bond yields.
Investors can use this chart to help evaluate what Worst Historical 1 Year return they think they could endure in exchange for the long-term growth of that allocation. Investors in risk-based assets like stocks and bonds accept the risk of short-term losses in exchange for long-term expected returns. While there could always be a worse period in the future that is worse than the worst period in the past, our best way of getting a sense of what risk an allocation entails is by looking at the past.
Understanding How Stock and Bond Portfolios Have Performed in the Past
Similar to the prior chart, this series of tables use the hypothetical historical annual returns of Index Portfolios. These are most helpful to set expectations about how hard it was to remain invested during some of the worst downside periods in recent history. The remaining invested was necessary to capture the returns of the subsequent upside periods. Attempting to get out of the market after a loss to avoid further downside (one form of market timing), more often than not results in the investor missing out on positive future returns.
Ask yourself, could you have remained invested during back-to-back losses in 1973 and 1974, or during the financial crisis in 2008? Especially considering much of the news and opinions at the time expected things could get worse before they got better.
Data as of June 30, 2022
For Educational Use Only.
The illustrations and data above are presented for the Advisor and Client to discuss the relationship between risk and return in investing. These are historical numbers and are not representative of what the Client’s portfolio will return in the future.
Appendix Additional Disclosures and Definitions
The illustrations in this document represent the hypothetical historical annual returns of investment portfolios based on equity and fixed-income allocations. The illustrations are not intended to show actual investment performance or the actual investment performance of our firm’s portfolios, but rather, an example of how a similarly allocated portfolio performed in the past.
Source Disclosure for Data Used in Graphs
Allocation of Asset Classes of Equity Portfolio
The allocation of the stock portion of the portfolio is 49.5% Domestic Equity, 29% International Equity, 12% Emerging Markets Equity, and 9.5% Global Real Estate.
Domestic Equity Asset Classes Representative Indices: The US Core Equity asset class is represented for performance purposes by January 1970-present: Dimensional US Adjusted Market 2 Index.
International Equity Asset Classes Representative Indices: The International Core asset class is represented for performance purposes by January 1975-Present: Dimensional International Adjusted Market Index; January 1970-December 1974: MSCI EAFE Index.
Emerging Markets Equity Asset Classes Representative Indices: The Emerging Markets Core asset class is represented for performance purposes by January 1990-Present: Dimensional Emerging Markets Adjusted Market Index; January 1988-December 1990 MSCI Emerging Markets Index (gross div); January 1970-December 1987: Dimensional International Small Index.
Global Real Estate Asset Classes Representative Indices: The Global Real Estate asset class is represented for performance purposes by July 1989-Present: S&P Global REIT Index (gross div.); January 1970-June 1989: US REIT
Allocation of Asset Classes of Bond Portfolio
Bond Asset Classes Representative Indices: The Core Bonds asset class is represented for performance purposes by January 1976-Present Bloomberg Barclays U.S. Aggregate Bond Index; January 1970-December 1975 Long-Term Government Bonds Index.
The Long-Term Government asset class is represented for performance purposes by: January 1970-Present Long-Term Government Bonds Index.
Please contact our office today to discuss your specific situation. As always, planning ahead can help you maximize your family’s financial situation and position you for greater success.