Fintech executive, writer, math geek, and investment systems developer. Founder and CEO of Altruist and Founder of FormulaFolios.

Why Smart Investors are Having a Bad Year, and They Should Embrace it

As an advocate of balanced, conservative investing - 2013 has been a bad year. Not bad in the losing money sense, most balanced investors are up. It's just that with the S&P 500 and Dow Jones Industrial Average up 15%+ and near all time highs, the balanced/conservative investor is wondering why they too aren't up big this year. Most are up just small single digits, and the real conservative investors might even be down a touch.

I'll explain, and show why you shouldn't be concerned if you're in the balanced/conservative camp...

One of the tenets of Modern Portfolio Theory is the value of proper diversification. I'm sure most people have heard the saying, "don't put all your eggs in one basket," that's what this means. The idea is that not all investment types are highly correlated to one another, so by having a diverse mix of investment types you can weather the market ups and downs better by having a smart asset allocation. It's not a perfect science, but it is the single investment management philosophy shared by almost all of academia.

It's the "smart" way to invest.

The problem is, in years like 2013 investors get sucked into believing the hype of financial media. Whether it's CNBC, The Wall Street Journal, Money Magazine, etc - they all are trumpeting the big gains of the US Stock Market. However, a properly diversified portfolio has a lot more in it that just US Stocks. And almost everything except US Stocks is having a below average to downright terrible year.

For example, the chart below comes from Google Finance. It shows how US Large Cap Stocks, US Small Cap Stocks, Developed International Stocks, Emerging Markets Stocks, Real Estate, Commodities, and Bonds are doing this year:

Screen Shot 2013-08-13 at 9.22.46 AMYes, US stocks are up nicely, developed international pretty good too. Real estate is up a couple percent. Everything else is negative. Some substantially.

As a result, a typical 50/50 (growth/income) investor that is properly diversified should only be up about 2.7% this year.

Not too great, huh?

So What Gives? Why Shouldn't I be Upset About This? I Want the Big Returns! :)

While US Stocks are doing well this year, we know that eventually they will do poorly. Investors that flock to the best asset class almost always end up getting burned. Remember the tech bubble? How about the real estate bubble? How about gold up until last year?

Every asset class has it's day in the sun - at the moment it looks to be US Stocks.

The best way to illustrate this is to show how a balanced investor performed over the past 15+ years, compared to someone who relied too heavily on just this years "top" asset class (US Stocks).  Check out this chart below:

Asset Allocation WinsThe orange is the S&P 500, the blue is a simple, diversified benchmark. The allocation is as follows:

  • US Large Cap Stocks - 17.5%
  • US Small Cap Stocks - 7.5%
  • International Stocks - 10.0%
  • Real Estate - 7.5%
  • Commodities - 7.5%
  • Bonds - 50.0%

Nothing fancy, no curve fitting, just a simple allocation I made up on the fly in about 15 minutes.  The return for this portfolio in 2013: 2.7%.

However, it has trounced the S&P 500 by a wide margin over time and done so with much less volatility.

To be fair, I'm picking on the US Stock Market only because it's having such a great year. Truth is, had I singled out just about any asset class and compared it to the boring, diversified portfolio; the diversified portfolio wins almost every time. It always wins in creating the most steady, consistent returns over long time periods.

Eventually US Stocks will be the worst place to invest. Hopefully investors won't have been suckered into buying just this past year, only to have their hearts broken when it happens. Proper asset allocation is never the most popular approach, but it does work, and it reminds me of a great saying from arguably the worlds greatest investor...

You should be buying when they're crying, and selling when they're yelling

- Warren Buffet

Some More Stats, and Free Access to the Spreadsheet I Built for this Study

I'm a math geek, so I like statistics. If you are the same way, feel free to download the spreadsheet I used to create the charts above by clicking here (may need to right click and save). It's nothing pretty, just the facts. It allows for a user to change the asset allocation for each asset class and see how the returns change (and chart too).

For those that don't want to play around on their computer, but do like the stats that validate this years terrible investment philosophy (although it always works over time), consider the following:

  • The balanced approach to investing would have produced a total return 35% greater than just the S&P 500 with 60% less volatility from 1997 to 8/2013
  • Measured by calendar years the S&P 500 would have outperformed the balanced portfolio 8 out of 17 times, so this year is hardly an anomaly
  • The biggest outperformance of the S&P 500 compared to the balanced portfolio was in 1999, when it beat the balanced portfolio by 17.4%
  • 2013 is the second biggest outperformance of the S&P 500 compared to the balanced portfolio, up YTD by 15.8%
  • After the last (and only 15%+ outperformance by the S&P 500) the balanced portfolio went on to outperform in 7 of the next 10 years

I could go on and on, but hopefully everyone gets the point. Being a balanced investor won't win every year. In fact, it will only win about 50% of the time. But winning one year at a time is no way to grow a portfolio - it's about getting more consistent results over time with less volatility. The key is simply having a solid long term investment philosophy and sticking with it, some of the oldest advice in the books...and advice many investors hate to hear.

Best,

Jason Wenk

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