Humans yearn for a linear and logical investment experience, one in which every result can be explained with indisputable cause and effect. But the reality is that investment results aren’t always good and don’t always make sense, and this is an uncomfortable truth for most. In times of distress, our capacity to scrutinize supporting data is…er…not its most robust. And this lack of scrutiny can lead to assumptions based on flawed data, which can ultimately prove unhelpful or even harmful to investment results.
This creates a fertile market for the investment industry to launch products into. Deep down, we want to believe we aren’t trading in short-term comfort for long-term results when we swap investment strategies in troubled times, but often that’s exactly what we are doing. For example, despite mountains of evidence to the contrary, many still cling to the possibility of low-risk/high-return (with high persistency). And industry products and strategies are constantly emerging—grounded in some light data mining and heavy marketing—that reinforce this belief for investors. The Greatest Hits album here would include chart toppers such as Peak Oil Theory, Internet stocks void of earnings, and segregated fund maturity guarantees.
The 8% Myth
But, perhaps the king of all the investing myths is the widely accepted baseline assumption that 8% is a plausible average long-term return for stocks. More than any other investment strategy, the 8% myth is based on flawed data. A quick review of the last 45 years of stock market history shows that despite over- and undershooting, there has NEVER been a calendar year when the U.S. stock market delivered an 8% return. That’s 45 consecutive New Year’s Eve parties where guests could reflect on many things, but not “The market did 8% again.” And yet, we look past that inconvenient data set and assume 8% is a reasonable expectation for the next 12 months. Somewhere, Jerry Seinfeld just twitched.
So, where did the 8% myth originate? This number is widely accepted to come from U.S. historical data. According to the Morningstar and Ibbotson Associates SBBI database, since 1926 the S&P 500 has on average earned an 11.8% annual return. In today’s dollars, after inflation has been removed, the U.S. market has had an average annual compounded return of 8.6%. However, this number doesn’t take into account the realities every investor faces during the course of their investment lifetime. Portfolio volatility over long periods, asset allocation, fees, taxes, time weighting of deposits and withdrawals, and currency conversion are all significant factors that will shape the outcome of a portfolio’s growth as well as the “average” amount of growth stocks may yield in a given portfolio.
Despite the inherent good sense of an approach that factors in all of these realities, the investment industry continues to propagate the 8% myth. After all, it’s easier to front like you possess awesome forecasting intuition than to openly address the fact that the investor world is inherently risky and uncertain. It’s also an approach that people respond to: the 8% return is widely accepted as true, and thus is easy to sell to investors looking for a “safe bet” based on historical record. Unfortunately, in accepting this as true, investors also position themselves for a lifetime of buying high/selling low if/when the 8% doesn’t materialize as expected. Many are disappointed with the lumpiness, or absence, of expected results and subsequently abandon their strategy for whatever sounds and feels better in the moment. This ongoing reinvention of investment strategy, all while the market delivers a return, is a prescription for something between discomfort and insanity.
The Truth About Investing
Nearly two decades into my career, I am more certain than ever about the uncertainty of the investor experience. It’s not lost on me that this is not an especially robust marketing message for anyone building their business in my industry—you’re not exactly selling the sizzle when you tell people there is no guarantee. But this understanding makes me a better investor. The idea of tactically maneuvering into low-risk/high-return investing is incredibly seductive, but ultimately a real impediment to a successful result. The truth is we’re playing jazz here, people. We have some parameters to help us keep time, but within those constraints it may get crazy. Fits and spurts of disappointment, elation and legitimate chaos will ensue, and you will have to ride them out.
The good news? Those parameters, while not always intuitive, do put us in the way of the market when it is surging. And while the S&P 500 hasn’t delivered an 8% calendar year return in any of the past 45 years, it has delivered a return in excess of 12% in 25 of the past 45 years. After observing market returns over longer periods of time, it appears the system is rigged in our favour—after all, the market goes up considerably more than it goes down. It just doesn’t feel that way here in the eye of the storm, otherwise known as January 2016.
Our Approach for 2016
So, what’s our approach for this year? To enthusiastically and diligently control what we can and let the cards fall where they may, knowing we have the odds of success in our favour. Things we can control:
Construct our portfolios to be broadly diversified. The statement that you own “banks AND energy companies” doesn’t qualify: roughly 8,000 securities spread over 40 countries is the investing universe. Let’s start there and work back.
Dialing in your exposure to risk based on you and your individual comfort level. Basing risk tolerance on some arbitrary model crafted by someone who doesn’t know you is a non-starter. Everyone’s definition of risk is different and warrants meaningful discussion, not a questionnaire.
Ensure your investment costs are low. The cost review exercise may be short on instant gratification but it’s long on improving your overall result. Cost is a variable we can control, which means more money residing in your portfolio to compound instead of finding its way elsewhere. Short term: boring. Long term: thrilling.
Cultivate discipline and confidence knowing your ducks are in a row,and recognize that market volatility is not an excuse to reinvent your strategy every time things get a little crazy. It’s a stretch, but you might even feel smug if you take this approach. Investing is humbling and hubris is to be avoided, but a disciplined investor who patiently and strategically builds a well diversified, cost-efficient portfolio, customized just for them, while the rest of the world is feverishly selling…well, to me that should warrant at least a slight spring in your step.