Taking "Stock" in the Market -- and Staying There
During the market downturn of late 2007 through early 2009, most of us wished we had less money in the stock market. And in May and June of this year, the market again made many investors worry about how much money they should have there. In fact, when you consider what we've been through in the 21st Century, many investors are asking: "Is it even worth being in the stock market?"
Volatility is the Name of the Game
The stock market has always been risky and prone to bubbles and dramatic drops. A globally diversified, 100% equity investor should expect to experience an assortment of returns like these in any given 10 to 16-year period:
- At least one, maybe two, bad markets (negative returns)
- Several sub-par markets (returns from zero to 7%)
- Several good markets (returns from 8% to 17%)
- And several great markets (from 17% to 30% or more)
Those are annual expectations. Day by day, and month by month, an investor will experience even more volatility! And volatility has increased in the last decade.
Looking at Three Time Periods**
Let's explore three different time periods since 1973 and three different equity allocations for a globally diversified portfolio as well as the S&P 500 as a benchmark:
- Traditional Portfolio: 60% in equities/40% Fixed Income.
- Aggressive Portfolio: 80% in equities/20% Fixed Income.
- 100% Equities Portfolio.
- S&P 500 Benchmark.
Each market period lasts 16 years.
1973 through 1988: The average annualized return was as follows:
- Traditional Portfolio: 60% in equities/40% Fixed Income: 14.5%
- Aggressive Portfolio: 80% in equities/20% Fixed Income: 16.0%
- 100% Equities Portfolio: 17.3%
- S&P 500: 10.3%
The S&P 500 resulted in an average annualized return of 10.3%. Notice that each of the diversified portfolios beat the S&P 500 significantly - even the ones with allocations to fixed income. During the early years of this period, the market performed poorly, and all of the portfolios were declining in value. But, by 1977, the three diversified portfolios had approximately the same value. From 1977 forward, the higher the allocation was to equities, the better the performance and the better the ending value. The S&P trailed significantly.
1983 through 1998: The average annualized return was as follows:
- Traditional Portfolio: 60% in equities/40% Fixed Income: 14.3%
- Aggressive Portfolio: 80% in equities/20% Fixed Income: 16.1%
- 100% Equities Portfolio: 17.9%
- S&P 500: 18.2%
The S&P 500 had a strong average annualized return of 18.2%. The 100% diversified portfolio did virtually the same as the S&P 500. The diversified 60% and 80% portfolios underperformed the S&P, but only because they had allocations to fixed income. During all of this 16-year period, the stronger the allocation was to equity, the better the return and the better the ending value.
1994 through 2009: The average annualized return was as follows:
- Traditional Portfolio: 60% in equities/40% Fixed Income: 8.2%
- Aggressive Portfolio: 80% in equities/20% Fixed Income: 8.8%
- 100% Equities Portfolio: 9.1%
- S&P 500: 7.6%
The S&P 500 had an average annualized return of 7.6%. Once again, all three diversified portfolios beat the S&P 500!
Risk and Reward Observations
Each of the diversified portfolios beat long-term and short-term government and corporate bonds for each of the three periods and did so in a meaningful way. So even though there is more risk in owning equities, it paid off in a significant way in each of these three time periods. Yes, historically there have been short term periods when fixed income has generated returns in excess of a diversified portfolio of all equities, but the timing of these periods is unpredictable. If you expect to be in the market more than a short time period, a portfolio that includes diversified equities has a strong likelihood of outperforming any type of fixed income.
Even with an allocation to fixed income, a globally diversified portfolio does not protect an investor from volatility, crashes or from bear markets. Fixed income helps to dampen the downside - it also dampens the upside, of course. With an allocation to fixed income, an investor can temper the risk but still benefit from some of the reward. The stock market offers investors a way to harness capitalism.
Looking only at these three periods does not constitute a complete exercise in market analysis. Some might accuse us of data mining and it is true that the past is no guarantee of the future. However, we find it educational and interesting to observe the facts - without bias - and hope the result creates perspective at a time when emotion can get the best of us and cause us to undermine well-conceived long-term plans.
Market Timing
Why be in the market when it is flat or down? Why not shift to fixed income? Why not take advantage of the market segment that is doing well? The short answer is: these cycles cannot be accurately timed; the future is unknown, and even though it may look a lot like the present, we can't discern the important details in advance. Without specifics, we can't make an intelligent transition to a safe or profitable option. Who knew that BP would create the worst oil spill in American history? Who knew that gold would quadruple in value after three decades of not even keeping up with inflation? It is said that the devil is in the details. Speculating about the details can ruin a long-term investment plan. Fortunately, an investor can make good use of the market without being able to predict the future.
We'll continue to work with each of our clients to ensure that their asset allocation is consistent with their long term goals. We remain confident that the market will continue to deliver a fair reward for the long term investor.
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**For Illustrative purposes only. The balanced strategies are not recommendations for an actual allocation. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.