Who Needs a Strong House When the Weather is Fine?

One of my least favorite things about prognosticators, whether it be sports, investments or Oscar favorites, is that when people make predictions, they only bring them up again when they are right. It is rare when people look back and say, “Wow, was I wrong. You definitely shouldn’t have listened to me.” Well, I’m not a prognosticator, but I am here to shake up that trend and grab my fork to eat some crow.

Near the end of 2018, I wrote a blog about why investors should build diversified portfolios (akin to building durable homes) to prepare for a variety of market scenarios. e.g., drawdowns, volatility, muted returns, etc. Thinking back, it was probably as persuasive as when I told my six-year-old nephew not to play Star Wars so loudly in my house at 6:00 a.m. And, if that’s the case, well then good, because wow… was diversifying the wrong call.

As you well know, in 2019 the S&P 500 Index was up over 30% and shockingly, bonds were up nearly 9%, so a traditional 60/40 portfolio earned over 22%. And, the most unpopular kid in the class (aka alternative strategies) brought up the rear returning on average about 6.8%. So, my terrible suggestion of looking at something like alternatives delivered a lesser return for likely a higher cost—basically the opposite of what advisors are trying to do for their clients.

All the Glory to 60/40

We’ve been hearing for years how important diversification is, how you should consider alternatives because returns are going to be muted, and how we may have more drawdowns. But those who ignored this have been handsomely rewarded. Not just on a return basis, but also on a risk-adjusted one. As you can see from the chart below, the historical average of a 60/40 has provided investors a Sharpe ratio of about 0.61. But over the last decade, that number has doubled to 1.29 and is higher than at the peak of the tech bubble.

Chart: Rolling Ten Year Sharpe Ratio 60/40 Portfolio

Past performance is not indicative of future results. Source: Morningstar. 60% is represented by the S&P 500 Index. 40% is represented by the Bloomberg Barclays US Aggregate Bond Index.

Because we are big proponents of mean reversion, charts like this one and this one and this one made us confident that things would have to revert somewhat—but they didn’t, and they continued climbing higher. And, it could keep going higher still.

While I am somewhat surprised by what happened last year, I can honestly say that after that, I haven’t seen any compelling evidence that makes me not come to the exact same conclusion I had back then. I can’t find any reason that I should pivot away from alternatives and move towards a more traditional 60/40 portfolio because I believe that the more traditional route is going to deliver all of my return needs for the next decade. In fact, having looked at the assumptions by those smarter than me, I feel even more confident that future returns will be much less than those to which we have been accustomed. Look at the capital market assumptions we’ve gathered over the last couple of months:

Historical 60/40 Portfolio (Ibbotson) Data: 8.04%
Using Capital Market Assumptions: 3.96% (uses 60% of all equity categories and 40% of all fixed income categories including cash and TIPS)
Estimates are for illustrative purposes only, are not a guarantee of performance and are subject to change.

Not only are these returns much lower than we’ve had in the most recent decade, but they are also lower for most asset classes compared to the same projections at the end of 2018. Using very basic averages here, a traditional 60/40 is expected to garner just under 4% for the next 7-10 years—still positive which is great, but much lower than that which we are accustomed. And, if you factor in a 2% inflation number, and 0.5-1% in fees, your return looks closer to an average of 1-1.5% per year. If that’s all I’m going to need, then there’s no reason to make a change. However, given I must fund my own retirement, healthcare is expensive (and getting worse), and I apparently need to have access to every streaming service available—then the returns I’m going to need to retire are a bit higher.

FOMO vs. Oh No

One thing that comes up frequently in discussions with our clients is that they get fired more often for lagging on the upside, than outperforming on the downside. While I don’t work on a day-to-day basis with end investors, I can 100% understand where this thinking is coming from. When the market experiences drawdowns (i.e., longer than the five second ones experienced in the last decade), everyone suffers together so you can chalk it up to “well, that’s just what happens when you are invested and I’m not going to punish my advisor for that…and besides, everyone was down!” That coupled with the infrequent occurrences of meaningful declines, and the opportunities to show your clients the benefit of downside protection are fleeting. On the other hand, markets are up most years, so the number of opportunities to disappoint them by lagging are more likely.

This then leads to that fear of missing out (FOMO); and every year that keeps happening, the feeling gets stronger. And by the way, while this is all occurring, your clients are getting poached by other advisors who put together some great “hindsight is 20/20 portfolio” showing them that if they just had invested with them, they could’ve performed much better. It is enticing. And, because we are all humans FOMO is a powerful force in our lives. (I mean, remember when people were disappointed that they couldn’t get a ticket to FYRE Festival?)

However, while that is how clients ‘feel’ the math behind it just isn’t there. The compounding effect of losing can get away from you quickly and take significant upside returns to get you back to whole as the chart below showcases.

Implications of a significant market drawdown

Source: Analytic Investors. For illustrative purposes only. Drawdowns shown are for the S&P 500 Index.

It was just a couple of years ago, when the market came out of its 2008 decline and trumpets were blaring about how if you would have just stayed put, you would have been fine. (You know, as long as you didn’t need to access your investments or anything silly like that). But just as FOMO is powerful, so too is the fear that grips investors when things start to go awry. And the reality is A LOT of investors ‘panic sold’ during the financial crises and then kept modest amounts of equities for years due to their fear. (They may still be afraid of equities today and thus likely haven’t fully recovered.) Emotionless behavior typically does not exist in times of crises and we often do exactly the wrong thing at exactly the wrong time, and that can have powerful implications.

While fighting FOMO, it is critical to illustrate how important minimizing losses can be. Consider the dollar growth of $1M in an alternatives portfolio and a traditional 60/40 portfolio over the last 20 years (Importantly, keep in mind that alternatives have lagged stocks by 9.5% over the last 10 years and a 60/40 portfolio by over 5% for the last ten years).

01/00-12/19 Growth of Hypothetical $1M Investment
Alternatives* $4,081,033.65
S&P 500 Index $3,242,098.68
U.S. Barclays Aggregate Bond Index $2,668,746.12
60% S&P 500 Index/40% Barclays Aggregate $3,171,378.90

*Data from 01/01/00 – 12/31/19. Average includes Arbitrage, Managed Futures, Long/Short Equity, Macro, Multi-Strategy, Fixed Income Hedge.
Source: EurekaHedge.com

The alternatives didn’t grow to a larger dollar amount because they have outperformed in the recent past (not even close!) Rather, they did because they protected on the downside during some pretty large market declines. While the feeling of FOMO can be powerful, the “oh no” on the downside has a significant impact.

What Now?

Honestly, we could see a repeat of 2019, and at this point, I wouldn’t be shocked at all. I absolutely can’t control what ends up happening in stock and bond markets, but I can control having a disciplined, consistent approach to my portfolio. It may not be the most exciting thing I can do, and there’s often plenty of noise suggesting it’s the wrong thing to do. But the best thing advisors can do for their clients is to get the emotions out of it. Easier said than done, I know.

Don’t let FOMO keep you from staying diversified, and don’t let big declines keep you out of stocks. Results may have varied, but building a well-diversified portfolio was the right thing to do in 2002, 2008 and 2011 – and also in 1997, 2003 and 2019.

So, while my premise last year may have resulted in lower returns in 2019, I’m sticking with it for 2020…

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