After I became an independent financial advisor back in 2013, I was offered the opportunity to go visit several different money managers for what are called, due diligence meetings. Basically, the money managers invite advisors to come to their home office or one of their events, give presentations and tell the advisors why their systems and ideas work really well for the advisor’s clients.
I went out to Los Angeles and visited The American Funds Group. I went to Seattle to visit Russell Investments. I went to Omaha to meet with a group called CLS Investments and finally flew to Puerto Rico to attend a meeting with Symmetry Partners. When I was getting ready to fly to Puerto Rico my wife, who is trained as an art therapist and has spent the past 24 years as a full-time mother tells me, “You know all this shit works!”
I’m like, what are you talking about? She tells me, you know all these money managers’ stuff works, you just like to get wined and dined and treated like a big shot. I told her, well hon, I have to do my due diligence!
Here’s a chart from the J.P. Morgan Guide to the Markets. This chart shows the 20-year annualized rates of returns for various asset classes. It includes the return on homes, a 60/40 stock to bond portfolio, inflation, and the returns of the average investor. I have often said, a lot of investors underperform their own investments. This chart clearly illustrates that point.
As you can see, the average investor has outperformed inflation, commodities and cash by a couple of percent but has underperformed the asset classes that you would think they invest in like stocks, real estate and bonds. The underperformance ranges from 7.2% per year for real estate, 5.9% versus the S&P 500 to .6% difference versus the return on homes. Even a balanced portfolio of 60% stocks and 40% bonds has outperformed by 2.8% per year.
What does that mean in real numbers? If someone had put $100,000 into an investment that averaged 9.5% for twenty years, at the end of that period their $100,000 would be worth $614,612.21. If they had put the same $100,000 into the 60/40 portfolio, they would have had $345,806.03. At the average investor’s 3.6% rate of return their $100,000 would be worth $202,859.38 at the end of the same 20-year period. These numbers do not include taxes, expenses, fees, or anything like that. They are just being used to illustrate a point.
Why Does This Happen?
I don’t think people are naturally hard wired to be great investors. We have the fight or flight instincts. When there is trouble, perceived or real, our natural instinct is to either fight or run. It's very difficult when the TV is screaming at you and news of inflation, wars and recession dominate the headlines. Maybe you have experienced downturns in the past and don’t want to go through that again. Now you’re seeing advertisements about “safe” investments and don’t “lose” money. You just got your 2nd quarter 401k statement, and your balance is lower even after you have been making contributions. What should you do?
What is the money for? I always ask this question and get the funniest looks from people. They often ask, what do you mean? I want it to grow. Then I ask again, what is this pot of money for? Is it old man money? Is it going to be used to pay for your daughter’s college tuition next year? Is it the down payment for your house? What’s it for???
If you have short term needs, then you probably should have that pot of money in something that isn’t going to fluctuate in value very much. Here’s some more numbers. Let’s say you have $50,000 and need this money in one year. If you put it in a savings account, it might pay .25%. This means at the end of the year you will have $50,001.25. Yay you!
On the other hand, if you were to put that same $50,000 into the S&P 500 and you received the average return (which you won’t, of course) of 9.5%, at the end of the year you would have, $54,750. Here’s the problem with this. What if you had invested that money in the S&P 500 at the beginning of 2022 and YTD the return on the S&P 500 has been -20%? Instead of having $50,001.25 or $54,750, you now have $40,000. Ouch!!
For short term needs like paying for next year’s college tuition or making your down payment, volatility is bad. The down is worse than the up is good. However, for the long term, the volatility is not the problem. The problem is the lower returns you generally get from “safe” investments. Let’s go back and look at our chart.
What is Risk?
For most people, when they think of risk they think of volatility. You received your 2nd quarter 401k statement, and your balance is $50,000 lower than it was at the end of last year. That’s risky! Or is it? The definition of risk is the possibility of loss or injury. If your 401k balance is lower than it was at the end of the previous year, but you haven’t sold any of your shares, have you lost any money? I say the answer to that question is No!
While you have not lost any money, you still have experienced volatility. So, when we look at our chart, the asset classes with the highest returns like real estate, the S&P 500, small cap, and high yield bonds will experience more ups and downs than the safer asset classes like bonds and cash. This is called the risk premium. A risk premium is the return in excess of the risk-free rate of return that a risk-free asset is expected to earn. To earn more return, you have to put up with more volatility. That’s the reason the S&P 500 has returned 9.5% per year and cash has had an annual average rate of return of 1.2%. More math: $100,000, 9.5% return, 30 years equals $1,522,031.27. The same $100,000 invested at 1.2% for 30 years returns $143,026.12. Which one is riskier?
Don’t Be Average
I think this comes down to behavior. Before you invest, you need to really think about how much your investment would have to go down before you freaked out and ran. Everybody is different. There are some people who can do all of this stuff by themselves. I believe a lot of people are better off working with an advisor. I’m biased. I admit it. Advisors don’t work for free.
But when you look at charts like these and see people barely doing better than inflation, would it make sense to pay for the guidance, encouragement, and knowledge that a professional can bring? When I work with people, the first thing we figure out is what job this money needs to do? Then we figure out what rate of return this money needs to make in order to do that job. Then we work with our money managers to build the portfolio. After that we monitor it and encourage good behavior. A lot of time that means doing nothing. When the market is hot, we don’t go chasing returns. When the market is down, we don’t freak out and sell into a panic.
Morgan Housel says the most important question is not, “What are the highest returns I can earn?” The most important question is, “What are the best returns I can sustain for the longest period of time?” And the way to answer that question is to figure out, what do I need this money to do, and go from there.
If you want help with this stuff, reach out to me HERE. As always, thanks for reading. KB