Dave Sather: Fair Returns, Volatility and Benchmarks | Business
As Mike walked through the door, the 70-year-old held his latest investment statement.
Mike is an intelligent and often straightforward man. Never one to pull shots, he rarely stops just to chat. As such, it was easy enough to know he had something on his mind.
Mike sat down and slid a few handwritten notes onto the table. He calculated the performance of his portfolio to three decimal places. I told him he had to lose his touch since he hadn’t put the decimal in fourth place. Mike smiled and quickly got to work.
He said: “The S&P 500 is up 14.06% this year – why am I behind the market?
It’s a fair conversation we’ve had many times before. However, to answer this question correctly, any investor should consider their own goals and their own asset allocation.
Mike is a retired and fairly conservative accountant. Realizing this, when he opened his account, he demanded that 10% or $ 100,000 be kept in cash. I reminded Mike of this and pointed out to him that given the interest rate situation, this money will essentially not earn anything. In addition, after adjusting for inflation, its cash cushion would produce negative returns. He listened and internalized the numbers.
We’ve moved the conversation to Mike’s “volatility tolerance”. I told Mike that while I enjoy the discipline of the stock market, it produces some extreme, if not erratic, volatility characteristics. Mike leaned back in his chair and asked me what I meant.
Most people know that the stock market averages about 10% per year. However, it is a very bumpy race.
We always tell our clients that if they want to invest in the stock market, they need to focus on the long term, which is where they want to be in 10 years or more. This leaves enough time to absorb the volatility while producing a good result. Investors should be prepared for the equity portion of their portfolio to decline 40% over a year and 60% over a two-year period.
When I reminded Mike of this, he vaguely recalled the conversation. He quickly told me that at his age he didn’t want that kind of volatility for his entire portfolio.
With that in mind, we took a look at what Mike had. About half of its assets were in stocks. Although he is retired, this would give him the best opportunity to beat taxes and inflation. However, the rest were diversified into assets that would give a 70-year-old some stability. In doing so, we have emphasized that the more stable assets you want, the lower your overall returns will generally be.
Simply put, Mike owned 45% stocks, 10% cash, 35% short-term fixed income, and the rest of real estate. We then showed Mike how to identify the right indices for each component of his portfolio so that he could develop a fair composite benchmark.
After he did the math on his composite benchmark again, a smile appeared when he said, “Well, I guess that’s no fault.” I asked if I could get that in writing from him, and he curtly said he would drop it in the mail.
It was also worth mentioning that Mike was collecting Social Security every month. It works like a near fixed income asset that doesn’t require any management. Although Mike has contributed for decades, he never considered it to be part of his investment mix.
Human nature is such that we always want the stock market’s returns when it is rising, but don’t want the volatility that comes with it. As such, we need to know why we are holding investments. In doing so, any smart investor should recognize that different time frames offer better opportunities for success with each asset class.
If you need quick cash, then money market or CDs are great. However, if you are trying to maintain your purchasing power over decades, then the stock market offers the best opportunities. With this opportunity, you have to endure the volatility. For most people, a combination of assets offers the best compromise and the best opportunities for successful investing.
Dave Sather is a Chartered Financial Planner and President of Sather Financial Group, a “paid” investment and strategic planning firm. His column, Money Matters, is published every two weeks.