Why Expected Returns Matter Most
The current emphasis on low volatility and non-correlated multi-asset portfolios, created by blending equities, bonds and alternatives, can lead to unnecessary over-diversification and result in significant underperformance for long-term investors. Lost in the myopic obsession with volatility and correlations is the overwhelming importance expected returns play in any growth-oriented strategy.
Looking at the average of all 20-year annualized asset class returns from 1951 through 2015, equities dominate. Large-cap U.S. stocks delivered an average annual compound nominal return of 10.8%, while long-term U.S. government bonds delivered 7.2%. After inflation, which averaged 3% during this same period, equities delivered real returns nearly two times higher than those of bonds. These differences are further magnified when compounded over time. To illustrate, a $1,000,000 investment in bonds versus equities over this period averaged a 20-year difference of $4.3 million.
HYPOTHETICAL GROWTH OF $1 MILLION OVER 20 YEARS (Average Annualized 20-year Returns 1951 – 2015)
Figures shown are based on the average annual return of all 20 year periods from January 1, 1951 - December 31, 2015 and include the reinvestment of dividends and interest. Source: Ibbotson (cash: 30-day Treasury bills; bonds: U.S. long-term government bonds; stocks: S&P 500 Index). Indices are unmanaged and, therefore, have no expenses.
Investors seek to minimize volatility, which is perceived as lowering risk, preferring to avoid the emotions associated with an unpredictable ride. But there is a sizable cost associated with substituting short-term comfort for a long-term perspective and potentially leaving millions of dollars on the table.
It is critical to understand that volatility is a normal characteristic of equity markets in the short-run. However, over the long-term volatility diminishes in importance while higher rates of compounded returns become the most important factor in determining ultimate wealth. The bumpy ride is the cost of admission for higher returns.
From the Behavioral Viewpoint
What is going on?
- Volatility triggers strong emotions of loss aversion, where we feel twice as bad about a loss as an equivalent gain. In response, claims of reducing volatility are embraced.
- It is natural that we seek short-term emotional comfort and once these “good feelings” take over, it can be easy to accept the tradeoff for reduced long horizon wealth. In what is known as present bias where we are unable to consider future needs seriously enough and focus more on the present.
- Diversification is considered an irrefutable investment management concept. Challenging it triggers emotions of social validation. Like our ancestors in their survival mode, we have a strong desire to conform with those around us, particularly those perceived to be experts.
- We make different decisions based on how things are framed. Bonds and T-bills are considered “safe investments”. This framing makes them seem less risky. Of course, when low-rate investments are held for long periods of time the real loss in purchasing power can be quite risky. Todays, low interest rate environment only magnifies this problem.
What can we do?
- Develop a needs-based financial plan and allocate assets to key financial needs of liquidity, income and growth. This approach builds confidence that real needs are being met and can help investors to avoid costly behaviors that sabotage long-term results.
- The highest expected return asset class should dominate any growth portfolio. Equities are the highest performing asset class and have delivered an average return of 10% with positive returns in 3 out of 4 years. A 100% stock portfolio will most likely generate the greatest wealth over time.
- Work with a financial advisor as a trusted resource and coach. Gain from their experience, process, perspective and insights. Building wealth is a long-term endeavor that requires both time and discipline.
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IMPORTANT INFORMATION AND DISCLOSURES
The information provided here is for general informational purposes only and should not be considered an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. It should not be assumed that recommendations of AthenaInvest made herein or in the future will be profitable or will equal the past performance records of any AthenaInvest investment strategy or product. There can be no assurance that future recommendations will achieve comparable results. The author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions. AthenaInvest disclaims any responsibility to update such views. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of AthenaInvest.
You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives financial circumstances. You should consult with a qualified financial adviser, legal or tax professional regarding your specific situation. Investments involve risk and unless otherwise stated, are not guaranteed. Past Performance is no guarantee of future results.