WHEN ARE YOUR RETURNS?

Diversifying your portfolio is important but understanding when your portfolio is likely to pay off, and when it’s not, is an important part of a long-term investment plan.  What good are returns if they tend to show up when you don’t need them?  The chart above, and the ones that follow explain this concept in greater detail.

If you were to make your investment decisions off the long-term evidence of asset class returns, found in the graph above and the table below, you’d come to three main conclusions:

• holding more stocks than bonds (S&P 500 versus t-bills) is a good idea,
• holding small-cap value stocks within your stock allocation (DFA US Small Value Index versus S&P 500) is a good idea,
• and within your bond portfolio holding the longest-term bonds (20-yr government bonds versus 1-month t-bills) is a good idea.

But the long run conceals some important facts about meaningful short-term stretches.  From 1982-2018, inflation was only 2.7% per year, which means the things you are or will eventually spend your portfolio on didn’t increase that much.  That has not always been the case.  

From 1965-1981, inflation was more than twice as high, averaging 6.4% per year!  During a stretch of rapidly rising prices, you need your investment portfolio to grow even faster to keep pace with your ever-increasing cost of living.  If your returns fail to exceed inflation you’ll have to save more or save longer to reach your retirement goals, and in retirement, you will have to spend down your principal to produce the necessary income, while running the risk of eventually depleting your assets.

How did the various stock and bond asset classes perform during this period?  Let’s find out.

Surprising to many, the three core investment decisions break down.  

(1) Stocks (S&P 500) barely outpaced inflation and t-bills (+6.9% versus +6.4% and +6.3%).  

(2) Within the bond market, extending your maturities beyond just one year resulted in lower returns!  The highest returns from bonds during this stretch of high inflation came from the 1-Year Treasury Note Index at +7.0% per year, or 0.5% per year more than inflation.  Long-term bonds returned just 2.5% per year, 4.5% per year less than the 1-Year Treasury Note Index and almost 4% per year less than inflation.  If you think you can achieve your goals holding a meaningful allocation to an asset class that underperforms inflation by 4% per year for most of your time horizon, you’re not thinking very hard.

(3) It was only the performance of small-cap value stocks that would have salvaged investment portfolios.  A diversified mix of large cap, large value, small cap, and small value stocks (33/33/17/17, as represented by the DFA Domestic Balanced Strategy Index) returned +11.3% per year, beating inflation by 5% per year.  We have additional evidence since 1970 (through 1981) that international stocks, especially small cap and value companies, helped as well.

I present this data, not as a forecast that we will return to the high inflation 1970s, but instead to explain that understanding when your portfolio will perform relatively well and relatively poorly is an important part of planning and just as important as what your return has been or will be.  

Assuming two portfolios with the same long-term expected returns, the one that is expected to perform better during periods where it is increasingly challenging to accomplish your goals (during a stretch of higher inflation, let’s say) is a much better option for you.

This is the type of consideration that I put into each client’s investment plan only after spending the necessary time to learn what their long-term goals are and what the possible risks to achieving those goals could be.  As I like to say, I just consider that a smarter approach for serious wealth.

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Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and should not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.