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Investments 101 (a review)

The stock market has shown itself to be very volatile in 2015. So volatile, that many have left the market, some see it as a time to look for buying opportunities, others worry about a return to the great recession, and we long-term investors are doing our best to tune the noise out and to keep our faith in the future of the world’s economies.
We’ve all heard reasons for the markets retreat in 2016.  If not, here is a sampling, along with my commentary.

  1. The Chinese economy is tanking – Yes, the Shanghai index peaked last June 12 and the index is down 48% since that date.  Yet, the index remains up 31% over the past two years.  As for the Chinese economy, they do have some problems and the largest is a rate of growth that has decreased to 6.9% – a rate that most countries would love to have!
  2. The Federal Reserve Bank is raising interest rates – Really?  Who did this surprise?  Most people have asked, “Why did it take so long to happen?”  Even so, the economy is showing some weaknesses, particularly given world dynamics.
  3. The price of oil crashed – All commodities have fallen since 2011, although several have shown robust growth in 2016.  Gold, for example, has led other investments for this calendar year, with a 15.7% return.  It remains, however, about 26% below its most recent peak in 2010. Just yesterday, I noticed that gasoline is about 14% more expensive than a week ago and today’s price is still relatively inexpensive.  We have to go back to 2004 to see prices like we see today. This should be good for the consumer which is good for the economy – except if you are a producer of oil.
  4. The strong dollar – I don’t think a strong dollar can decrease the value of the stock market. In fact, we know that citizens of other countries, when they perceive weaknesses in their economies, move money to the United States and they purchase our securities.  This one is hard to judge.
  5. Trump and Sanders – This might have some veracity. I don’t think that most of the investing public, either domestic or international, predicted that these two candidates would be doing as well as they are.  With ideas ranging from protectionist trade and forced deportation to free medical care and university education, these ideas have the heads of members of the status quo spinning.  Markets don’t like uncertainty.
  6. The Cubs might actually make it to the World Series – No one has actually said this has caused the market to be down. I just thought I’d throw it in the mix of wild ideas.

One thing is certain.  The market will survive and it never hurts to review what we know, in order to help us reach financial success.

Below is a graph of returns for stocks as measured by the S&P 500 (blue), 10-year Treasury bonds (green), and Treasury Bills (red) from 1994 through 2015.  During this time period, the S&P500 had an average annual return of 10.7% with a standard deviation of 18.7%, 10-year Treasury bonds saw a 5.9% average annual return and a 9.7% standard deviation, and T-Bills a 2.6% annual return and a 2.2% standard deviation.  It is clear that if we wanted to reduce the risk in our portfolio, we would simply buy T-bills and be content with the relatively flat line for the twenty years.  While that may make one sleep better in the near term, it is likely that one may not eat well in the long term, for taxes and inflation will greatly reduce the return.  So, what can we do to reduce the volatility?  The answer, as always, is diversification.

Investment returns 1994-2014

When we invest 60% of our portfolio in the S&P500 and 40% in ten-year Treasury bonds, it reduces our return by 17.8% (from 10.7% to 8.8%) , while the riskiness of the portfolio is reduced by 43.9% (from 18.7% to 10.6%).  Over these twenty years, by replacing 25% of 10-year Treasury bonds with Treasury-bills, the return is driven down to 8.4% with very little, if any reduction in risk. This can be seen in the following chart where the blue line is 100% invested in the S&P 500, the red line is for the 60%/40% portfolio, and the green line the portfolio of 60%/30%/10% which includes 10% Treasury-bills.  As can be seen both of the latter two lines are very similar but they do remove variation in the annual returns of the S&P 500.

Portfolio returns 1994-2014

What does this do to us over the longer-term?  The answer can be seen in the table below, where we assume that $5,000 is deposited to an account at the beginning of the year for both 30 and 40 years.  As can be seen had one been invested in 100% of the S&P500 for every year, instead of the 60%/40%/10% portfolio, their wealth at the end of 20 years would have been 22% greater ($737,708 compared to $603,039).  Due to compounding, this increases over 40 years to 33% greater future value ($1,823,347 compared to $1,370,886).  Clearly, discipline is good if one can handle the inevitable ups and downs.  Most of us cannot.

Interest/Year 8.964% 8.274% 7.925%
Payment/Year $5,000 $5,000 $5,000
Number of Years 30 30 30
Future Value $737,708 $644,997 $603,039
Number of Years 40 40 40
Future Value $1,823,347 $1,507,715 $1,370,886

Another reason to support being well diversified is the following “periodic table” of investment returns.  For each year the category with the greatest return is listed at the top, while the one with the lowest return is at the bottom.  One glance will tell you that there is not one category that is at the top, or the bottom, each and every year. Moreover at the beginning of the year we never know which category will be at the top at the end of the year. You will see that it is rare that any category of investment has the same placement in two consecutive years. In fact, it occurs only 12 times in the 100 year-pairs below.

periodic table of investment returns

So, what do we do?  One needs to have a plan to remain well diversified with a riskier mix of investments the further in the future the money is needed.  Short-term goals will be funded with cash type investments, intermediate term goals with a balanced approach, and long-run goals with a more aggressive approach. At least once per year, the investor should rebalance their portfolio to assure that the mix they wish to have is truly the mix they have.  This will naturally force one to sell those categories that have performed well and to buy those which have not.  To repeat a recent Financial Tip, this assures that you will sell high and buy low – as opposed to the other way around.