I’ve said it before and I’ll say it again. The US stock market isn’t going to go to zero. If you buy some horrible stock then that company might go out of business and the investment may go to zero. But, if you buy quality, diversified investments then all you need is time. There are several ways that investments should be evaluated, but the one evaluation novices don’t consider is suitability. That is, does this investment suit me and my needs?
You aren’t going to win the lottery in the stock market. That’s just not going to happen. Yes, you’ve heard stories of some guy that took $12k and turned it into $1 billion. But, those are anomalies. That’s why it’s a story. Realistic expectations of the market are important. Every advisor has a story about somebody coming to his or her office, wearing fancy clothes, driving an expensive car, with a ton of debt, $10,000 in hand, who sits down and tells the advisor to turn the cash into enough to pay off the debt and retire. I have to say, I consider myself pretty good at this job. If I could do that I wouldn’t be sitting here typing this. But, I’ll let you know if I figure it out.
Here’s how it really works: There are tradeoffs, just like with anything else in life. Patience and savvy are key. Maybe you don’t have the savvy. That’s where I come in. Maybe you also don’t have patience. I can coach you through it, unless you’re just very tough to coach. But, if you’re ready to be patient and let me talk you through the markets, then maybe you’re ready to start investing. The tradeoffs are risk tolerance (how much decline you can stomach), time horizon (how long you have to invest) and liquidity needs (when you need income or have to take out money for any reason).
If you come to me and you expect to double your money in 10 years then I’ll assume you have a fairly aggressive risk tolerance. I’ll ask you some questions or have you complete the risk tolerance profile questionnaire. If your responses indicate that you actually lean in a more conservative direction, then I will explain to you that you may have to wait longer to double your money or learn to think about risks differently. That’s your choice. That’s the tradeoff in this example.
Let’s start the next scenario the same way: You, in my office, double the money in 10 years, aggressive risk tolerance. I administer the questions and you are indeed an aggressive investor type. Then I start asking you about your outside holdings and find out that your budgeting style is “fly by the seat of your pants,” you have a lot of debt, and you don’t have any cash in savings. This amount you want to invest is all of it. I’m going to explain to you that you can’t invest all of it. So, maybe instead of investing $30,000 we decide together that I can only invest $10,000. Having $20,000 in 10 years instead of $60,000 in 10 years isn’t what you had in mind, but you need to maintain liquidity and pay off debt. Those are a higher priority than investing. That’s one liquidity tradeoff.
The other liquidity tradeoff relates to taking income. If you’re taking over a certain amount of income off of the investments then the higher risk that comes with a higher reward will cause your account value to shrink faster. So, I will ask you to accept a lower risk and therefor lower return investment model.
Let’s talk about this idea of doubling money. This rule is not iron-clad, but it’s pretty close and can give you an idea of what to expect from different investment types. It’s the Rule of 72. Advisors use it as a quick rule of thumb to help people understand what to expect with different rates of return. It goes like this: Take the number of years in which you’d like to double your investment. Let’s say 10. 72/10=7.2 % annual return is required. Let’s say you’d like to double in 20 years. 72/20=3.6%. Easy enough? Here’s a graphic I made just for you to illustrate this point. Note that the vertical axis is years to double and the average annual rate of return is at the bottom. The percentages used for returns for gold, stocks, bonds and the average investor are real values based on the 20 years between 1997 and 2016. I added the current 1 year CD rate in there for fun. Average investor rates are terrible because the average investor is bad at investing. Here it is:
You can see that it would take the average investor 31 years to double his money at a rate of 2.3% per year. Every super-conservative investors favorite, 1 year CDs, are paying about 1.2%-1.3% which would double your money in 55 years (let’s hope those rates go up someday). Stocks at those averages would double in about 9 years and bonds would double in about 14 years. Gold would double in 12. All of these use the rule of 72. Now, let’s test it out.
If you’d invested in the S&P 500 at the top of the stock market in 2007, you’d have finally doubled your money last month. Let’s call it 10 years even. 72/10 years = 7.2% rate of return, right? Yes. Here’s what that straight line looks like over a 10-year period:
Here’s the actual S&P 500 over the same time period:
Okay. They look different. That’s because the market doesn’t do what we expect it to do. In fact, that line plots annual returns. The first year the money would have been invested it would have lost about 37%. It would have actually dipped below $50,000 before coming back. But, we’re not going to get into all of the things that happened in the middle of each year. We’re just going to talk about annualized returns and that’s what’s plotted. Everyone knows the market doesn’t move in a straight line. But, how much did it actually differ from the 7.2% of the Rule of 72? Here are the two lines together:
It checks out. Starting with a $100,000 investment 10 years ago, both the straight line and the annualized returns line crossed the $200,000 mark in the same year. Remember, the straight line was arrived at using the Rule of 72.
What about bonds? Let’s look at the 10 Year US Treasury annualized returns. To have doubled your initial investment as of 2017, you’d have started 16 years ago. Your average annualized would have been about 4.6% over that time period. 72/16=4.5 so that sounds about right. Here’s the combined straight line and actual annualized return line chart for the 10 year Treasury Bond, showing the time you would have had to have it invested to have doubled your money this year:
So, we’ve established that it takes longer to double an initial investment when using something that has a lower rate of return. But, what does that return look like over the same years? What if I have different goals with different liquidity needs (remember: likelihood you’ll need to take money out for income or otherwise)?
Let’s look at the two straight lines for the average annual returns over the same ten year time period first so we can get an idea of how they compare.
Notice that if you’d invested $100,000 in bonds at the beginning of the same period, 10 years ago, you’d have a little over $150,000 as of this year, versus doubling to $200,000 in stocks.
Now let’s look at the actual annualized returns for these two investments. I’m also going to overlay the average annual returns using a dotted line. Notice the straight dotted lines that represent the data that was in the previous chart and notice how far the annualized returns deviate from the straight line. Notice that the stocks (S&P 500) double, but that the annualized returns deviate from the straight line more than the 10 year Treasury Bonds. The bonds deviate less from the straight line, but don’t return as much over the investment period. This is what “risk-reward tradeoff” means, and I’ll discuss it a bit more in a moment.
So, the way to think about the risk-reward logic is this: The greater the return you anticipate over a specified period, the more deviation you must accept from the straight line, and the more flexible you must with your time horizon in case the specified time frame is not met due to a sudden decline. No, you can’t all together avoid all declines. However, Respire’s Tactical Asset Allocation Strategies do seek to mitigate them. That’s the key: asset allocation.
Asset allocation is the tool you use when you need to meet multiple goals or to change the risk profile of an investment. Let’s look at the annualized returns of stocks vs. bonds vs. a very basic moderate risk profile mix (60% S&P 500 and 40% 10 yr Treasuries) to see how blending them changes the returns:
First, look at the way the yellow line, treasuries, tend to perform well when the orange line, stocks, are performing poorly, and vice versa. This relationship is called correlation, and these two are said to have low correlation. So, by blending the two asset classes I’m taking advantage of low correlation (the fact that they don’t move in the same direction most of the time) and I’m also mitigating my downside risk. This comes at a cost, and that’s upside. So, for example, stocks lost approximately 37% in 2008, but the 60/40 mix lost about 14%. That’s not nearly as bad. However, in 2013 stocks gained over 32%, but the 60/40 mix gained 16%. That’s not nearly as good when considering the numbers relative to only each other. However, 16% is not a bad return to get in any year and might be perfectly acceptable to someone with a moderate risk tolerance profile. And, look at the green line that represents the blend. While stocks have doubled and more, the 60/40 has also doubled, and for many of those years the 60/40 even outperformed stocks. So, depending on different factors, sometimes an index fund isn’t what you need. Sometimes you need asset allocation. When an asset allocation strategy (a mix of different investments like stocks and bonds) is tactical, it takes things a step further. The strategy uses rules to sell holdings that become less favorable and replaces them with other holdings that might still be performing well to not only reduce losses, but also to take advantage of whatever investment(s) might be going up at the time in hopes of experiencing a greater return. Blending asset classes can also help investors to work toward multiple goals on different time horizons or with different liquidity needs. For example, someone who’s recently retired might have an investment model that’s positioned to mitigate volatility for the portion they need to take income from now, and another investment model that’s more aggressive for the portion of their funds that they need to accumulate for later in retirement.
Taking this a step further, investors add in additional asset classes. So, they’ll use stocks and bonds, like in the example. And they’ll also add gold, commodities, real estate and more. This can help with both the correlation picture and with diversification. Even within one asset class, such as stocks or bonds, there are multiple segments. So, an investor who wants to optimize for accumulation over a longer time period, who has low or no liquidity need and an aggressive risk tolerance, might consider adding more emerging markets and international stocks or more small US companies that have a higher risk-reward tradeoff. Someone who’s taking advantage of stock growth who has a more moderate risk profile, a shorter time horizon, and who needs more liquidity such as for income, might consider large dividend paying US stocks. If the investor wants more income than he or she can get from the 10 year Treasury bond, then investment grade corporate bonds or investment grade emerging market bonds might be added to the mix. Adding these other types of bonds would move the investor slightly up the risk profile scale from conservative toward moderate. So you can see that it all pivots on this sort of risk-reward, goals-based seesaw.
If you remember the chart that showed the actual annualized returns versus the straight line return, we learned that some investments deviate more from that straight line than others. This data could be arranged in a bell curve that represents the likelihood of data to deviate from that line. Remember taking statistics and having to look at the standard deviation bell curve? Whether you do or not, let’s simplify it and say that we can assume by looking at my actual annualized vs straight line chart that the more an investment deviates from its line, the greater the standard deviation would be. This is one of the measures of risk used, among several others, that helps investment managers to marry asset classes together and optimize a portfolio for a risk tolerance. An investment manager might determine the acceptable standard deviation, or risk, that is suitable for a specific risk tolerance. Then, a mix of investments would be put together in percentages that optimize the reward received per unit of risk taken. Let’s look at the risk-reward tradeoffs of several asset classes we’ve already discussed in terms of standard deviation and annualized return. I have to give the caveat that I was a little lazy in hunting down this data. So the standard deviations I’ve used here are general expected standard deviations based on the full histories of the asset classes. Whereas, the returns I’ve used are specific to the period of the markets for the asset classes from 1997 to the end of 2016, 20 years. So, the standard deviations during that time may have been slightly different, in fact, I’d wager that the standard deviation of stocks as represented by the S&P 500 would have been higher during that 20 year period than for the history of the S&P 500 in whole because it was a tumultuous 20 year period compared to the rest of the index’s history. Let’s look.
This is pretty self-explanatory. The horizontal axis shows risk as measured by standard deviation. As you look to the left of the chart risk is less and as you look to the right of the chart risk is more. The vertical axis represents reward as measured by average annual returns from 1997 to 2016. Cash doesn’t even show up on this scale because it has such a low standard deviation and return and I’ve started the risk measure units at 8, less than half of the “risk” or standard deviation of the S&P 500; and, I’ve started the reward scale at 4% annual return and we know cash doesn’t pay 4%. But, you can see that bonds, which have a lower standard deviation also have the lowest return. Gold has the next highest standard deviation and the next highest return. Stocks have the highest standard deviation but also the highest return over the period.
You and I could continue this discussion and we could break this information down into numbers that represent the “reward per unit of risk taken” but I think that would get too deep in the weeds. My goal was to illustrate what can be expected from returns and to give you some rules of thumb that you can use in assessing your own investment goals. I also wanted to help set expectations and create an understanding of why investors use mixed asset classes and why you’ll sometimes see returns that don’t match the S&P 500 numbers you’ll see on the TV. Your takeaway should be that, if you’re trying to figure out how long it would take to double your money, you could start by using the Rule of 72. Then, you can assume that the faster your money will be doubled, the greater the risk you are assuming that you’ll have some periods of loss and the greater the likelihood that you’ll have to be flexible with your time horizon. These rules are not ironclad as I’ve mentioned. For example, there was a period when we came out of the “lost decade.” That was ten years from 2000 to a point in 2010 where, if you had invested in the S&P 500 your returns would have been 0. There was a 16 year period that started at the end of the 1960s and stretched into the early 1980s where the same thing happened. This is why it’s a rule of thumb. The Rule of 72 works most of the time but there have certainly been exceptions. This is also why we consider investing a long-term play—we have a longer investment time horizon, hopefully. As we say, it’s a marathon and not a sprint.
Source of average returns versus average investor from 1997 to 2016 is Dalbar, Inc. via the JP Morgan Quarterly “Guide to the Markets,” August 2017.
