"Don't lower your expectations to meet your performance. Raise your level of performance to meet your expectations. Expect the best of yourself, and then do what is necessary to make it a reality." - Ralph Marston
Remember the rule of thumb: The stock market returns 10% per year? This simple assumption is why you’ll always find that one guy at the party arguing that it’s better to throw it all into an index fund. If there was an index that consistently pulled off 10%, then that would be smart! In reality, it’s quite the contrary. Take the S&P 500, very volatile, very inconsistent, and depending on the decade you pick, returns are widely divergent.
I’m not writing to say index funds are wrong. They aren’t. We use both active and passive strategies in our portfolios to create a better risk/reward profile over time. In some years passive is better, in other years active is better. There’s no clear winner.
Index only investing is inconsistent. Let’s take a look: the S&P 500 index took on its present form in 1957. Since then, it has returned right around 10% per year (if including dividends). This sounds compelling if you don’t look deeper. Annual returns by decade: 1960’s: +8% average, 1970s: +6% average, 1980s: +17% average, 1990s: +18% average, 2000s: -1% average. Historically the S&P 500 has been all over the board which is very hard to plan around. It would have been outstanding if you were an indexer in the 90s. Very unfortunate if you were an indexer in the 2000’s.
Volatility can be emotionally painful. This is where do-it-yourselfers often fail. Can you truly put aside emotions when things get really ugly? Case and point, take the last recession. The market fell by -57% from October 9, 2007 until March 9, 2009. What if you were retiring early 2009 and you had saved $2.5 million in an index fund by 2007 and it dropped to a mere $1.2 million by ‘09? It would be impossible to ignore the thought of losing everything. This gut instinct wrecked many retirements during the recession – not necessarily the market.
Volatility is expensive! Another reason not to index, the S&P 500 is very volatile. Take two investments of $100, both with an average return of 8% over 10 years. Investment 1 grows at +8% every year without fail. Investment 2 is volatile but still earns an 8% average. (Years 1-10 respectively: +20%, +20%, -20%, +20%, +20%, -20%, +20%, +20%, -20%, +20%)
Investment 1 without volatility has a total return of 116% growing from $100 to $216 over the decade. Investment 2 with volatility has a total return of 83%, growing from $100 to $183 over the same decade. This is due to that volatility. Both had an average return of 8% per year. The smooth investment made significantly more over the same time period due to the lack of volatility.
Volatility makes money work harder. Why did investment 2 above do so much worse? Deeper the losses require investments to advance much more than initial loss before breaking even. Here are the numbers. A loss of 20% needs a 25% gain to break even. A loss of 40% needs a 67% gain to break even. A loss of 50% needs a gain of 100% to break even. Even further, an 80% loss needs a gain of 500% just to break even. See the pattern?
Moral of the story: Win by not losing. Reducing volatility can increase our overall return on investment. We do this through diversification and asset allocation. Reducing the downside risk of a single stock, sector, index, or region can improve performance over a similarly returning, more volatile asset. Besides the shock of negative returns, the numbers alone suggest we shouldn’t just take on the riskiest asset and turn a blind eye in hopes of earning the highest performance. It’s not that easy and even less effective than a being a little more prudent.
*Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.