mediocre investments

How One Mediocre Investor Prospered After the Market Crash

Philip Brewer — Tue, 02 May 2017 08:30:11 +0000

The mediocre financial advice I've offered in my last few posts boils down to this: Use low-cost funds, establish an appropriate asset allocation, and rebalance it annually.

It's not new advice. My own portfolio was strongly influenced by it back in the early 1980s. By the 1990s, it was pretty much the standard advice you would get anywhere. Many studies at the time showed that a very simple portfolio — just an S&P 500 index fund, plus a long-term bond fund — tended to outperform managed funds, especially after the costs of the managed funds were taken into account.

I haven't seen as many studies in the years since the financial crisis, so I thought I'd take a quick look at how this sort of basic asset allocation held up in the aftermath.

Most people date the financial crisis from 2008, but I tend to date it from June of 2007, because that's when I found out that I'd be losing my job. For that reason, the graphs below run from then through the latest data available as of March 29, 2017.

As it turns out, a mediocre portfolio held up pretty well.

Criteria for success

To decide whether a particular style of investing is a success, it helps to know what your goals are. Most people would include "maximum return" as at least part of their goal, but instead, I suggest that your portfolio provide an investment return that supports your specific life needs.

A portfolio that comfortably beats inflation is part of that. It's also a plus if the portfolio doesn't swing wildly in value — in case your circumstances require you to cash out a significant amount on an emergency basis. It's nice, too, if the portfolio provides a mix of income and growth, so that if changes in what's in fashion among investors push one category of stocks up or down, the overall value of your portfolio doesn't take too big of a hit. (Personally I've always had a sneaking preference for income, even though tax policy has often favored growth.)

With those criteria in mind, let's look at how some of the pieces of a mediocre portfolio have done.

Pieces of a mediocre portfolio

The most basic mediocre portfolio is just an S&P 500 index fund and a long-term bond fund, with the ratio between those two gradually shifting from mostly stocks (for a young person) toward mostly bonds (for someone who has already retired).

Stock market investments

The value of an S&P 500 index fund dropped dramatically during the crisis itself, but it hit bottom well before the end of the recession, recovered all of its losses by 2013, and is now about 50 percent above where it started — meaning that on stock price alone, you've got an annual return of well over 4 percent. With dividends reinvested, your annual return comes to nearly 7 percent (take a look at the 10-year average annual return of your favorite S&P 500 index fund).

(Source: St. Louis Federal Reserve)

Bond market investments

There isn't an exact bond-market equivalent for the S&P 500 index fund, so it's a little hard to say how your investments would have done during the crisis and since. (I poked around at a few major mutual fund companies and found average annual total returns on various long-term bond funds for the past 10 years ranging from 3.6 percent to 6.1 percent, depending on the fund.)

The return on a bond fund depends on interest rates. If you buy a bond that pays X percent and rates go up, your old bond is worth less (because otherwise people will just buy the new bond that pays more). Conversely, if rates go down, your old bond is worth more.

With that in mind, here's a graph of the interest rate paid on a U.S. government 10-year treasury bond:

(Source: St. Louis Federal Reserve.)

Long-term interest rates dropped steadily before and during the recession. They rebounded modestly as the recession wound down, but then plummeted as it became clear that the economy needed, and would continue to need, extraordinary support from the Federal Reserve. Even now, long-term rates are about half what they were before the crisis began.

The upshot is that the value of bonds purchased before the crisis would have soared during the crisis. Bonds purchased during the crisis would also have gone up. Bonds purchased in the aftermath might be up or might be down, depending on exactly when they were bought.

Rebalancing

If you'd just had a portfolio of stocks or bonds, you'd have done ok. Your stocks would have gone down a lot, but they'd have eventually recovered. Your bonds would have gone up a lot, and would have since eased off. But the mediocre asset allocation is more than that. The essence of a mediocre asset allocation is annual rebalancing.

At the end of 2007, and again at the end of 2008, you would have sold some of your bonds — which would have jumped a great deal as interest rates fell ahead of and during the recession — and shifted that money into depressed stocks to restore your asset allocation.

New stocks purchased on the last day of 2008 would have been bought with the S&P 500 at 891 (down from close to 1,500 when you started). At the recent price of 2,359, those shares are up 165 percent. At the same time, you would have harvested much of the gains in your bond portfolio.

Really, the rebalancing is where the magic is.

Success

As I mentioned at the beginning, the criteria I'm using as indicators of success are return, stability, and providing a mix of income and growth.

The mediocre portfolio did a fine job of providing a return — especially if you rebalanced annually, thereby automatically buying stocks when they were at their lows.

Stability is always a problematic goal, because it's almost the opposite of growth — the most stable portfolio would be one invested 100 percent in cash, which would show no growth at all. The point here, just as it is with return, is not maximum stability, but rather a degree of stability that supports your life goals. Here again, the mediocre portfolio did fine, especially for older people with a larger bond portfolio, which is where it is most important.

Finally, the mediocre portfolio did a fine job at balancing income with growth. An S&P 500 index fund has produced a pretty good yield, especially compared to cash and bonds during this period of historic lows in interest rates. Annual rebalancing will have automatically shifted money out of bonds as interest rates fell (reducing the fraction of the portfolio invested where income is low) and future rebalancing will be shifting money back into bonds as interest rates rise.

I would hesitate to call its performance better than mediocre, but that's really the point: A mediocre investment portfolio, providing mediocre performance, is all it takes to support your life goals.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The 3 Rules Every Mediocre Investor Must Know

Philip Brewer — Mon, 27 Feb 2017 10:30:46 +0000

Mediocre financial advice can earn you mediocre investment returns — and mediocre investment returns are all you need to save for a house, send your kids to college, and fund your (potentially early) retirement. Mediocre investment advice is pretty straightforward. In fact, the only thing that's complicated about getting mediocre financial results is the stuff that comes before investing: Things like earning money, keeping your debt in check, finding a career, living frugally, and most crucially, building an adequate emergency fund.

Once you've got those things taken care of, you're ready to start investing. If you're at that point, here's my mediocre investment advice: Create a diversified portfolio of low-cost investments and rebalance it annually.

Diversified Portfolio

It's important to have diversity at several levels. Eventually you'll want diversity in investment types — not just stocks, but also bonds, real estate, precious metals, foreign currency, cash, etc. More importantly, you want finer-grained diversity especially in the earlier stages of building your portfolio. Don't let your portfolio get concentrated in just one or a few companies. (For what it's worth, don't let it get concentrated in the stock of your employer, either. That sets you up for a catastrophe, because if your employer runs into trouble, the value of your portfolio can crash at the same time your job is at risk.)

In the medium term — after you've got a well-diversified stock selection, but before it's time to branch out into more exotic investments — you'll want to expand the diversity of types of companies. Not just big companies, but also medium-sized and small companies. Not just U.S. companies, but also foreign companies. Not just tech companies, but also industrial companies and financial companies, and so on.

Diversity wins two ways. First, it's safer: As long as all your money isn't in just one thing, it doesn't matter so much whether it's a good year or a bad year for that thing. Second, it produces higher returns: No one can know which investment will be best, but a diversified portfolio probably has at least some money invested in some investments that will do especially well. (Of course retrospectively, there will have been one investment that does best, and risking having all your money in that would have produced the highest possible return — but that's exactly what a mediocre investor knows better than to attempt.)

Of course, you don't want a random selection of investments, even if such a thing might be quite diverse. You want a reasonably balanced portfolio — something I'll talk about at the end of this post.

Low-Cost Investments

The less money you pay in fees and commissions, the more money you have invested in earning a return.

Getting this right is so much easier now than it was when I started investing! In those days, you could scarcely avoid losing several percent of your money right off the top to commissions, and then lose another percent or two annually to fees. Now it's easy to make a stock trade for less than $10 in commissions, and it's easy to find mutual funds and exchange-traded funds that charge fees of only a fraction of 1%.

Still, it's easy to screw this up. Any investment that's advertised is paying its advertising budget somehow — probably with fees from investors. Any investment that's sold by agents or brokers is paying those agents or brokers somehow — probably with commissions or fees from investors.

All those costs come straight out of your return. Keep them to a minimum.

Rebalance Annually

Your diversified portfolio will immediately start getting less diversified: Your winning investments will become a larger fraction of your portfolio while your losers will become a smaller fraction. In the short term, that's great. Who doesn't want a portfolio loaded with winners? Pretty soon though, you start losing the advantages of diversification. Last year's winners will inevitably become losers eventually, and you don't want that to happen after they've become a huge share of your portfolio.

The solution is to restore the original diversity. Sell some of the winners, and use the resulting cash to buy some more of the losers. It's the easiest possible way to buy low and sell high. (Maybe you don't want to buy exactly the losers — not if their poor performance leads you think there's something really wrong with them. But buy something kind of like them. Health care companies probably belong in your portfolio, even if many of them did badly this year.)

There are costs to rebalancing — costs in time and effort (figuring out what to sell and what to buy), and actual costs in commissions and fees. Because of that, you probably wouldn't want to rebalance constantly. You could make a case for monthly or quarterly rebalancing, but even that seems like a lot of effort for a small portfolio. Annually seems to hit the sweet spot.

What Goes Into a Diversified Portfolio?

What I'm going to suggest is that you start with a balanced portfolio of stocks and bonds.

It's not that there aren't plenty of other worthy investment options — cash, gold, silver, real estate, foreign currencies, etc. — it's just that they all have complications of one sort or another, and you can get started on earning your mediocre returns without them.

My mediocre investment advice then is that your portfolio should be a balance of stocks (for maximum growth) and bonds (for income and stability).

Finding the Right Balance Comes Down to Age — Yours

What's the right balance? An old rule of thumb was that 100 minus your age would be a good target percentage for the stock portion of your portfolio. At the start of your career, you'd have nearly 80% of your investments in stocks, and that fraction would gradually decline to about 35% as you approached retirement. The theory was that a young person can afford to take big risks, because he or she has time to wait for an eventual market rebound (and because during the early phase of building up a portfolio, even a large percentage loss is a small dollar amount). This makes a certain amount of sense. In fact, you could argue that a stock market that collapsed and then stayed down just when you started investing would be great — it would give you decades to buy stocks cheap.

That rule of thumb isn't bad, although with people living longer these days, it probably makes sense to keep a higher portion of stocks in your portfolio during the last years before and first years after retirement. Once you hit 50, maybe only cut your stock portfolio by 1% every two years.

When you're just getting started, feel free to keep it very simple. Perhaps just start putting money into a broad-based stock fund (such as an S&P 500 index fund). You can add a bond fund right away if you want, or wait until your annual rebalancing.

There are mutual funds that will manage this balance for you, holding stocks and bonds with a balance that shifts over time to some target date, at which point they'll hold a portfolio suitable for someone who has retired. You don't need them. In particular, they tend to have higher expenses, violating the "low cost" principle. You can do it easily enough for yourself. (Of course if you find that you don't do your annual rebalancing, then maybe paying a fund to do it for you is worth the expense.)

As an alternative to mutual funds, you can use exchange traded funds or ETFs. It doesn't matter.

Once your portfolio of stocks is large, you probably want to move beyond a single fund. Look at the other low-cost funds offered by the same fund family that provides your S&P 500 index fund. Consider adding a fund that includes foreign stocks (especially if the dollar seems strong at the time you'll be buying). Consider adding a fund that includes dividend-paying stocks (especially if interest rates are low relative to dividends).

Follow these mediocre tips, and you'll be racking up mediocre returns in no time! And remember — mediocre returns are all you need to live well and retire well.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: