Here's A Secret: Sometimes An Average Return Is Excellent
b'As a financial advisor, I am constantly regaled by stories of the big stock winners of the day. The so-called ten-baggers, which is a term coined by the legendary Fidelity Fund manager, Peter Lynch, who would talk about those stocks that went up 10 fold. But today\\u200b I want to make the case against reaching for the stars and just make the case to you to reach\\u200b for mediocrity in your investments.
No one ever talks about the merits of reaching for mediocrity, but I am going to, so please stay with me on this.
I plan to use some data in my commentary today that came from Craig Israelsen who wrote an article titled \\u201cAre Average Returns Enough for Clients?\\u201d for Financial-Planning.com.
In his article, Craig compares annual returns from the S&P 500 index versus a portfolio of seven other different types of assets. We call these assets \\u201casset classes\\u201d and they consist of large-cap U.S. stocks, small-cap U.S. stocks, international stocks, commodities, real estate, U.S. bonds, and cash. To further my reaching for mediocrity, I\\u2019ll call this the \\u201cAverage Portfolio.\\u201d The author looked at what may have happened if one invested an equal amount in each class over a 44-year period from 1970 to 2013 and compared it to the S&P 500 index, which, as you probably know, is comprised of 500 large U.S. companies. Remember that the S&P 500 is a cap-weighted, unmanaged index made up of stocks\\u200b only.
The data Craig presented in the article showed that annual returns from the S&P 500 were better than the Average Portfolio 55%\\u200b of the time,\\u200b doing better in 24 of the 44 years. And sometimes the S&P 500 was way ahead of the Average Portfolio, like in 1998, for example, it beat the Average Portfolio by about 27.5%. And furthermore, over the 24 years that the S&P was ahead, it beat the Average Portfolio by an average of 8.3% per year\\u2014a pretty massive margin.
But here\\u2019s the key. Despite those 24 years of solid outperformance, the two portfolios delivered about the same average annual returns over the 44-year period, with the S&P up 10.4% annually and the Average Portfolio up 10.3%.
So what gives? How\\u2019s this possible?
Turns out, the S&P had nine losing years while the Average Portfolio had five losing years\\u2014not much there to explain the strange performance. Looking a little deeper, we find the answer not in the frequency of the declines, but in the magnitude of the declines. You see, the losing years for the S&P 500 were dramatically worse. The S&P 500 average decline was 15.2% versus only 8.7% for the Average Portfolio\\u2014that 6.5% average disparity is what makes all the difference.
Most of us would likely jump to the conclusion that 24 up\\u200b\\u200byears with an average outperformance of 8.3% would easily beat 9 down \\u200b\\u200byears of 6.5% annual underperformance, but compounding works a little differently because negative returns damage a portfolio way more disproportionately than positive returns. And here\\u2019s a simple example:
If you start with a hundred dollars and lose 50%, you\\u2019re down to $50. But to get back to $100, you need a gain of $50.\\xa0 Earning $50 bucks on $50 bucks requires a 100% gain to make up for a 50% loss, so negative gains are much harder to dig out of. Do you see what I mean?
Even though the S&P 500 frequently outperformed the Average Portfolio, those gains were largely undermined by the four extra down years and the extra depths of those down years. Investors should also understand that an Average Portfolio will probably never outperform a single sector, in any given year\\u2014it\\u2019s one reason so many people have trouble sticking with an asset allocated portfolio. It\\u2019s much easier and more fun to chase popular stocks that are going up right now. It really feels like you are onto something when you start to make money this way....'