Purveyors of prudent investment advice generally recommend global balance, broad diversification and periodic rebalancing of your accounts. And if you followed these tenets of wise investing in 2014, you were likely disappointed with the results.
This is not to say that a diversified portfolio did poorly, but investment outcomes are all relative. When your diverse mix of U.S. and international stocks and bonds deeply lags a simple index of U.S. stocks like the S&P 500, it can seem that you’re in the right game but using the wrong equipment.
The S&P 500 posted a total return of 13.7 percent in 2014. Morningstar’s balanced target risk indexes returned from 4.0 percent to 6.6 percent on the conservative to aggressive spectrum. These are relatively low returns considering a balanced benchmark of 60 percent global stocks and 40 percent bonds has averaged over 10 percent annual returns since 1973.
While the U.S. economy gathered strength and the dollar appreciated greatly, U.S. stocks performed in such a way that following any sophisticated investment policy or portfolio theory may have left you underwhelmed. U.S. stocks weren’t immune to struggle but continually absorbed significant body blows and responded by posting new all-time highs repeatedly.
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The problem here is misdirected attention. You’ll likely hear or see a brief performance update of the S&P 500 or Dow Jones Industrial Average at least a few times a day on the radio, evening news, morning newspaper or smartphone app.
This provides a nugget of information that doesn’t have much relevance when evaluating how most people’s portfolios have fared. You don’t hear or see news reports of how a diversified mix of stocks and bonds did each day. But, for most people, this information would be far more reflective of what they own.
PUT LOSERS IN CONTEXT
When you own a diversified portfolio, the reason usually is because you want to reduce risk, not because you want to build great wealth. For that, concentrated investments may generate significantly higher (or lower) returns with much more fluctuation than most people can stomach. In a diversified portfolio, not every investment will be in favor at the same time. You are guaranteed to hold investments that look mediocre relative to others in the portfolio. And the longer some investments look mediocre, you may even develop a hate for them. If you don’t look at your investments and occasionally wonder “Why do I keep this investment?” you’re probably not diversified enough.
While many people are challenged to understand opportunity cost given the option to invest money or spend it, most people are quick to understand opportunity cost when they see which investments are not performing well. It becomes clear when you look at your statement and think “I could have owned (insert best performer on your statement) instead of this dog.”
Unfortunately, this mentality shifts many investors into a reactionary, transactional mode, and more often than not the most active investors fare worst. Transaction costs eat away at returns and usually the investment purchased has already made the easy returns, while the investment departed is past the worst of the underperformance that gained your attention.
LOOK PAST PERFORMANCE TO YOUR GOAL
If you are the responsive type, averse to trailing performance, 2014 returns would prompt you to sell:
• International investments (which from many perspectives are on year-end clearance sale).
• Small U.S. stocks (even though historically they have well outpaced the larger, more mature companies).
• Alternative investments (e.g. commodities, inflation-protection, hedging strategies) which have different return drivers than stocks or bonds.
• Actively managed mutual funds. It has been the worst year in the past 25 for active managers trying to outperform passively held index fund investments.
The most important part of any year-end evaluation of your investments is not the overall return in relation to whatever portion of global markets happened to lead this lap. Rather, the focus of your investment review and financial plan should be the fit with your needs, wants and wishes.
Looking at the return of any specific investment can block the view of the life goal. The numbers in the spotlight at any particular review point can be distraction from the actual purpose of the investment.
For most people, the purpose is to position your assets and future income so that they can support your known future liabilities (your essential living costs and expense of your most cherished lifestyle goals).
Beyond this core focus of your investments, you can hope that investment returns (and your ability to live within your means) provide a margin of safety for the unknown liabilities and obligations. Any returns that are above those needed to cover your essential needs can pad your margin of safety. This will allow nonessential accumulation of multigenerational assets, charitable opportunity or simply the ability to do something beyond what you imagined.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at bhjadvisors.com.