Fair Returns, Volatility & Benchmarks
As Mike walked through the door, the seventy-year-old clutched his latest investment statement.
Mike is a smart and often blunt man. Never one to pull any punches he rarely stops by just to chat. As such, it was pretty easy to know he had something on his mind.
Mike sat down and slid some handwritten notes across the table. He calculated his portfolios performance to three decimal points. I told him he must be losing his touch since he had not carried the decimal to the fourth place. Mike smirked and quickly got down to business.
He said, “The S&P 500 is up 14.06% this year—why am I lagging the market?”
It is a fair conversation we have had many times before. However, to answer this properly any investor must look at their own goals and asset allocation.
Mike is a retired accountant and is pretty conservative. Understanding this, when he set up his account he required 10% or a full $100,000 be kept in cash. I reminded Mike of this and pointed out that given where interest rates are—this money will essentially earn nothing. Furthermore, after adjusting for inflation, his cash cushion would produce negative returns. He listened and internalized the figures.
We shifted the conversation to Mike’s “tolerance for volatility.” I told Mike that although I enjoy the discipline of the stock market, it produces certain extreme, if not erratic, volatility characteristics. Ben leaned back in his chair and asked what I meant.
Most people know the stock market averages about 10% per year. However, it is a very bumpy ride.
We always tell our clients that if they are going to be stock market investors they need to focus on the long term—meaning where they want to be in ten or more years. This allows enough time to absorb the volatility and still produce a good outcome. Investors need to be prepared for the stock portion of their portfolio to decline by 40% in any one year and 60% over any two-year period.
When I reminded Mike of this, he vaguely recalled the conversation. He quickly replied that at his age he did not want that kind of volatility for his whole portfolio.
Given this, we reviewed what Mike did own. About half of his assets were in stocks. Despite being retired, these would give him the best opportunity to outpace taxes and inflation. However, the rest of it was diversified in assets that would give a seventy year old some stability. In doing so, we pointed out that the more you want in stable assets, generally the lower your overall returns will be.
In simple terms, Mike owned 45% in stocks, 10% in cash, 35% in short term fixed income and the remainder in real estate. We then showed Mike how to identify appropriate indices for each component of his portfolio so he could develop a fair composite benchmark.
Once he ran the math again on his composite benchmark, a smile appeared as he said, “Well, I guess that’s nothing to complain about.” I asked if I could get that in writing from him and he dryly said he’d drop it in the mail.
It was also worth mentioning that Mike was collecting Social Security each month. This functions as a quasi-fixed income asset that requires no management. Although Mike had paid in for decades, he never considered it to be part of his investment mix.
Human nature is such that we always want the returns of the stock market when it is up—but don’t want the volatility that comes with it. As such, we have to know why we own investments. In doing so, every intelligent investor must recognize that different time frames allow better opportunities for success with each asset class.
If you might need quick cash—then money market or CD’s are just fine. However, if you’re trying to maintain your purchasing power over decades, then the stock market offers the best opportunities. With this opportunity, you must stomach the volatility. For most people, a combination of assets offers the best compromise and opportunities for investing success.
Dave Sather is a Certified Financial Planner and the president of the Sather Financial Group, a fee-only and fiduciary investment management and strategic planning firm.