Investing and Expectations
Over the past five years, the S&P 500 has gained about 12% per year while bonds have gained about 4% per year. International stocks have earned only about 2.3% over that time period.
What does this have to do with investment results over the next five or even ten years? Almost nothing.
Looking at past performance for future returns is like driving your car forward using only the rear view mirror.
The past performance trap
Far too many investors get caught up in the trap of looking at past performance to make decisions about future returns. This is a natural mental shortcut that humans have evolved to follow: if something worked in the past, it will probably work in the future. It works pretty well in rush hour traffic, in that you know some routes are typically easier to drive than others. But we still check traffic reports for accidents and changes to our routes because we know circumstances change.
Turning to investments, some things do tend to persist over very long periods of time (30 or more years). For example, the stocks of smaller companies tend to do better than those of larger companies in the long run, even though this hasn’t been the case recently. There are absolutely no reliable indicators for future stock returns over anything less than a 20 or 30 year period, and even then the record is mixed. Stocks also tend to appreciate faster than the cost of living over the long run, making them a good hedge against inflation, but in the short-term their volatility can mean significant losses are likely to occur.
Bonds tend to be less volatile than stocks, and so are good for short-term investors who need capital preservation and current income. But historically, bonds may not keep up with the cost of living over time. So an investor looking to preserve purchasing power over the long-term will want to focus on investments with higher potential returns like stocks.
Looking to the future
Can investors use historical patterns of past performance to predict the future results of investing? Certainly, but even looking out over 30 or 40 year periods, doing so can lead to some very big mistakes if you aren’t careful. For example, over the past 40 years or so, long-term government bonds have provided historically high returns. But with bonds, in order to earn high future returns, you have to start from high current interest rates. When the 30-year Treasury is currently yielding about 2.7%, it’s almost impossible to earn more than that over the next 30 years.
History can be a starting point, but just as you check traffic before hitting the freeway, you need to understand how current conditions can impact your investment expectations as well.
So what’s an investor to do?
Don’t invest without a plan
We begin with academic research that shows how portfolios can be structured to capture excess returns over the long-term. By starting with proven factors like small company exposure and value investing, we tilt the odds in our favor over full market and business cycles.
Investing is largely about assessing probabilities and designing a portfolio that can provide decent results in the most likely circumstances while not giving up too much when things don’t play out the way you expect. For example, most aggressive investors don’t want bonds in their portfolios because they typically expect to make more money investing in stocks. But in a market like 2008 (or 2015 for that matter), the bonds may be the only thing earning a positive return.
On the other hand, since stocks have typically lost money about 1 out of every 4 years, risk-averse investors looking for short-term capital preservation should typically have more bonds in their portfolios since they are less volatile than stocks or most other assets.
Most investors take their human nature with them as they delve into the world of stocks, bonds and investment portfolios. Those human tendencies are the reason most individual investors achieve a disappointing long-term rate of return.
Investing is serious business, and as such requires a serious plan. At Blankinship & Foster, we can help you determine an investment strategy that is grounded in academic research, tempered by an understanding of current conditions, and best suited to balance your need for long-term savings and short-term capital preservation.
