Here are two of the most common questions I have received recently: Are all the traditional investments like bonds, stocks, and real estate posed for a fall in value or at least very low returns? And what should investors do with their portfolios?
Good questions, and it does seem like everything is overpriced these days. Interest rates near zero mean that bond values are high and have little room to grow, and can potentially fall if interest rates increase. US stock prices are high relative to earnings and other measures of profitability, based on historical experience. Home and real estate prices are also high given the low mortgage rates that have made it easy to buy homes. So, what should investors do?
Discuss a Long term view about Investments with Desmo Wealth Advisors Austin TX
First, realize that going through highs and lows is part of investing for the long term. If you have set out a long term plan and have been invested so far, you have been rewarded by the historically high returns of stocks and bonds. The S&P 500, for example, has returned about 15% a year on average over the five years ended in 2020. That’s about 5% more than the historical average over the last 95 years. The Bloomberg Barclays US Agg bond index has returned over 3.5% over the same period, a reasonably good return amid low interest rates.
While it’s possible that we are at a new peak, we don’t really know. In 1996, the Federal Reserve talked about irrational exuberance, as valuations reached new highs. However, the market kept going up for four more years after that. Even missing a few good days in the stock market can be detrimental to your wealth. So you definitely don’t want to stay out of the markets for years. It’s worth taking a level of risk commensurate to your financial situation if you have a long term view.
Don’t get caught in the sunk cost fallacy, Talk to a Financial Advisor in Austin TX
Trying to capture the highs without experiencing lows is simply market timing. It would be great if we could do it reliably, but evidence and common sense indicate we can’t. As a recent example, a study by Vanguard shows that over 80% of investors that changed their allocation during Covid have done worse than if they had stayed the course.
Now, some investors may be asking our two questions because they have been on the sidelines for a while, they have missed on the rebound, and are wondering what to do now. In business and economics there is a concept called sunk cost. A sunk cost is a cost that has already been paid and cannot be recovered. Because of this, a sunk cost should have no impact on your decisions going forward. If you have missed out on recent growth because of bad timing, that is a sunk cost. Use that as a learning opportunity, that market timing does not work, and to help you gauge the level of market risk you are willing to take. But don’t try to time the market a second time to make up for the first mistake. Instead, check out the steps below, build an asset allocation based on your goals, and transition your portfolio towards it.
Have a philosophy you can stick with
Markets are uncertain and unpredictable. That’s just a fact. The best way to sail through that uncertainty is to rely on some time tested principles about investing, like the following:
- Risk and reward are related
- Use your goals to guide your investment plan
- Maximize diversification
- Reduce costs where you can
All these principles have both theoretical and practical justifications. They won’t give you a sure win, but, unlike market timing, they will work as intended.
Risk and Reward are related
The first principle of investing is that risk and reward are related. Typically, we expect higher risk investments to earn higher returns, on average and over time. The qualifier in italics is crucial. In any given period (a quarter, a year, 5 years, etc.) it is possible and quite likely that lower risk investments earn higher returns than riskier investments. That’s simply what risk means. However, over long periods of time investments with greater volatility have yielded greater returns. This relationship is shown in the figure below.
Risk and Return are Related
Notes: For illustrative purposes only. Dev stands for developed markets and EM stands for emerging markets. Core bonds comprise bonds issued by governments, government agencies, and corporations, and can be global in nature.
Historically, equity markets have strongly outperformed short-term bonds. It is plausible to think that riskier emerging market economies can outperform developed economies. And while the evidence is not conclusive on the subject, emerging markets have outperformed developed markets since 1960. A good source of long-term returns is the Credit Suisse Global Investment Returns Yearbook.
Maximize Diversification and control costs
In addition to showing a plausible risk-return relationship, the figure above illustrates the availability of different investment instruments to investors. It is possible to invest in all these categories (called asset classes) by using broadly diversified mutual funds and ETFs at a very low cost. While US stocks, bonds, and real estate may be pricey, stocks and bonds in foreign countries are less so. And stocks and bonds respond differently to economic news over time, which can help smooth out ups and downs over long periods of time.
Advanced diversification
Talking about the stock market as a whole may miss some important characteristics about risk and returns. Not all stocks are the same. Certain characteristics of companies, like size, profitability, and investment activity, can be important to returns over long periods of time. For example, when we hear that “stock market” valuations are at an all time high, that is an average statement. It turns out that this result is driven by the exceptional outperformance of a group of growth companies with low profits. Companies with good profitability and low price relative to their earnings, what we traditionally call good value companies, have underperformed over the last 5 and 10 years. So not all areas of the stock market are the same. Emphasizing value and quality stocks using company characteristics (an approach called factor based investing) can have higher returns on average and over time. However, over finite periods of time, this strategy may lead to underperformance (as it did in the last 5-10 years). So, it is important to understand the philosophy and principles behind it, and implement this type of strategies only after discussing them with a knowledgeable advisor.
Use goals-based investing to improve performance, In Austin Planning with a Fee-Only Fiduciary
We are big proponents of goals-based investing. Your goals should drive your investment plan, because the priority and the horizon of each goal dictates in large part how much risk you can afford to take. Goals can help you decide your allocation to stocks vs. bonds and how to select the right bond portfolios. For example, you can take more risk for a long term goal like retirement, with a greater allocation to stocks. With this type of goal you can use a core bond portfolio that tilts relatively more towards long term and corporate bonds.
The idea of goals based investing is to build your investment portfolio by creating a portfolio for each of your goals. The immediate advantage is increased clarity, because you know the purpose of your different investments. This leads to better monitoring, which allows for more dynamic adjustments as you are working towards your goals, and better long-term performance as a result. Give it a try.
Use the levers you can control to reach your goals
So, as you can expect from us, no easy silver bullet. The difficulty comes from the fact that returns are in large part unpredictable, regardless how much information you have at your disposal. And sailing through uncertainty requires you to stick with your investment philosophy. Think about returns as having two components. One is the expected or average part. Low interest rates and high stock and home valuations are telling us that perhaps (although we don’t know for sure) the market is expecting lower returns than the market experienced historically. The other part is the unexpected component. In a given period, this is usually the bigger determinant of returns. Think 80/20 unexpected vs expected.
We can’t decide what returns the market will offer on expectations, nor control the unexpected part. All we can do is to create a plan based on a sound theory and practical evidence (the 20%), monitor performance, and make adjustments to the levers we can control, like the size and time horizon for our goals, the level of risk we take, how much we save, and how much we spend. If we use all these levers, we don’t have to rely on luck or guesses about what the market is going to do to reach our goals.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
