Butler: Weighing the rewards, and living with the risks
A lineup of the five-year returns of the major investment categories illustrates some truisms of investment theory.
We can start with one of the most basic fundamentals of modern portfolio theory, which holds that it isn’t stock picking that determines success, but rather success is predicated on asset categories that happen to be in the right place at the right time. Or in the case of some hapless laggards such as precious metals, success is based on avoiding being in the wrong place at the wrong time.
The AAII Journal prepared an index of returns, based on the Dec. 31 Morningstar compilations, that ranked the five-year results of various sectors. The winner, with an annualized 18.9 percent return, was health care. The loser was precious metals, at minus-14.5 percent per year. This average five-year loss was despite the fact that precious metals gained 50 percent in 2016 alone and has gained an additional10 percent in the first quarter of this year.
And health care? For 2016 alone, it was the only category that had lost money, and that one-year loss was 9 percent. In the first quarter of 2017, it has gained back 10 percent, so it is essentially even with where it was at the start of 2016.
A $1,000 investment in health care, compounding at 19 percent per year, would have grown to $2,386 in five years. The same $1,000 invested in precious metals would have dropped to $470 in the same five-year period — a loss of almost half the money. The case of precious metals illustrates another truism: a loss of 50 percent requires a 100 percent gain just to get back to where you started.
Two other winners were the financial and technology sectors, each generating 16 percent average annual five-year returns. Not far behind, however, were boring large-cap stocks spread over all industries, at 13.4 percent. Balanced funds with a mix of stocks and bonds (typically one-third bonds/two-thirds stocks) came in at 7.6 percent, which is a very consistent long-term average.
It can be tempting to get excited about sector funds — a term that describes funds focused on a single industry category, with no pretense of diversification. Any reduction in diversification increases risk.
Given enough time, the “invisible hand” of economic forces rewards investors who can stomach more risk. The increased return over more conservative investments is called the “risk premium.” If that condition didn’t exist, nobody would have an incentive to take risk.
But how much risk do we have to stomach to earn outsized rewards? The same technology sector enjoying the aforementioned recent run-up lost roughly 80 percent of its value from 1999 to 2002. The financial sector lost 75 percent in 2007 and 2008. So if you are putting all of your eggs in one basket, you have to watch that basket very carefully.
Most investors — both professionals and amateurs — become catatonic when the basket gets upset. They are trapped in the “status quo bias” driven by the expectation that what happened in the past will extend into the future. Plus, selling out and taking a loss is a definitive act. We are programmed to be more disappointed and upset by a loss triggered by something we actually do as opposed to an equivalent loss (on paper) as a result of doing nothing.
The worst case, of course, is the investor who finally throws in the towel somewhere toward the bottom and, as the saying goes, “sells down to the sleeping point.” This means that by bailing out entirely, they finally are able to get some sleep.
For those who find this subject matter anxiety-provoking, it may be instructive to consider the 10-year numbers — a period that included the worst market crash in more than 70 years. In this longer time frame, almost all of the categories generated about the same average annual return per year — about 7 percent.
The balanced fund (about 50-50 stocks and bonds) actually outperformed the large-cap stock fund and all of the industry-specific sector funds (except health care.) The lesson here is that if you’re satisfied with a reasonably consistent 7.5 percent average rate of return in normal fluctuating markets, you only have to live with the prospect of a 15 percent one-time loss over a 20-year period, statistically.
That conservative approach may be what you should adopt as a way to capture and retain what you’ve accomplished in the years since the market bottomed out back in 2009.