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by Liz Ann Sonders, Senior Vice President, Chief Investment
Strategist
February 12, 2008
If markets are good at one thing, it's reminding investors that
they don't go up uninterrupted forever. Witness a bruising bear
market for much of 2008 thanks to an unprecedented global credit
crisis. As the chart "Fear Scales All-Time High" below
illustrates, the surge in the CBOE Volatility Index® is
unparalleled.
Fear Scales All-Time High
As of January 31, 2009. The VIX Index
shows the market's expectation of 30-day volatility. It is
constructed using the implied volatilities of a wide range of
S&P 500 index options. This volatility is meant to be
forward-looking and is calculated from both calls and puts. The
VIX is a widely used measure of market risk. Source: FactSet.
We are always quick to remind investors that neither panic
nor greed are investment strategies. Your only real insurance
against the unpredictable is having—and sticking with—a
long-term strategic asset allocation plan.
Mind-set matters: strategic trumps
tactical
In reality, investors should rarely, if ever, react to a
dramatic short-term move in the market. As intriguing as it may
seem to try to catch bottoms and get out at tops in order to
reap big profits (or so you think), the "tactical" (or
shorter-term) approach to investing has its limitations ... and
its risks.
We believe it's the "strategic" asset allocation
decision—and the ability to stick with it through the discipline
of rebalancing—that will ultimately reap the greatest rewards.
These decisions are not a function of short-term market gyrations
or forecasts (mine, yours or anyone else's), but are tied to your
risk tolerance and long-term goals. Developing and maintaining the
right long-term asset mix is by far the most important set of
decisions a client will ever make.
Never before has information about the global economy and markets
been more readily available and disseminated. As a result, global
markets have become very interconnected. In turn, our reaction
mechanisms have kicked in, and investor time horizons have
shortened dramatically—but not necessarily to our advantage.
Yes, the long term is really just a series of short-term events,
but it's how we react to them that decides our ultimate fate as
investors.
Asset allocation and diversification:
investors' "free lunch"
One of the most important areas where Schwab offers advice is the
development of a long-term strategic asset allocation plan. Many
investors assume that their position along the risk spectrum from
conservative to aggressive is largely based on their age and time
horizon. But a more important factor is their risk tolerance. Also
important is judging the difference between an investor’s
financial risk tolerance and their emotional risk tolerance—a
spread that’s often quite wide and only acknowledged during
tumultuous market environments.
I've known plenty of older investors who thrive on the risk
associated with an aggressive investment stance. I've also known
plenty of young investors who can't stomach any losses. Too often,
investors use a rearview mirror to make their investing decisions,
by looking at past performance as a guide to future results. A
mirror is a valuable tool but only when turned on yourself to
judge your own circumstances—tolerance for risk, time horizon,
income needs, etc. As I've often said, there are very few free
lunches in investing. Asset allocation, diversification and
periodic rebalancing are as close as you get.
Risk tolerance: Know what you can
stomach
In the chart "Schwab's Strategic Asset Allocation
Models" below, you'll see our long-term recommendations
regarding different asset classes for three types of investors:
conservative, moderate and aggressive.3 Note the vast
differences in allocations to riskier asset classes, including
international equity, as you move up the risk spectrum.
Clearly, over the long term, given the better performance by the
riskier asset classes, a more aggressive allocation has
historically reaped higher rewards in terms of returns. But there
is a dark side to an aggressive posture's higher returns—the
risk taken in getting there.
As you can see in the table below, "Higher Returns Come With
Higher Risk," since 1970, an aggressive investor would have
earned an 11.4% annualized return vs. an 8.5% annualized return
for a conservative investor. Who wouldn't want the higher return?
Well, it depends on the risk you're willing to take to get there.
What this table further shows is that the 11.4% return came within
a much wider range of annual returns and, most importantly, was
generated only through "stick-to-it-iveness."
| Average annual return |
8.5% |
10.4% |
11.3% |
| Best year |
22.8% |
30.9% |
39.9% |
| Worst year |
0.1% |
-12.9% |
-23.8% |
| Negative years |
0 of 38 |
6 of 38 |
8 of 38 |
| Long-term return estimate |
5.2% |
7.4% |
9.1% |
Source: Schwab Center for Financial
Research hypothetical portfolios.4
The aggressive investor had to suffer eight down years, one of
which generated a portfolio loss of nearly 24%. Many investors are
learning the hard way that their tolerance for a big loss in a
year was less than they thought. And to maintain that aggressive
allocation, you generally have to rebalance in favor of the
asset class(es) that generated those steep losses and away from
those asset classes that had weathered the storm.
Rebalancing to maintain an aggressive allocation is the best way
to generate the higher return. That, of course, is the real
test—a test that is administered more often during times of
increased volatility. Here's a practical way to think about
rebalancing: Your portfolio will tell you when it's time to trim
from or add to an asset class. You don't need to rely on anyone's
forecast of what may or may not happen.
Now let's take the conservative investor. Your average annual
return after 38 years is just 8.5%, but you never had to suffer a
losing year, even though your best year paled in comparison to the
aggressive investor's best year. Never losing money in a year? For
some, it's worth the lower return for the sleep-at-night benefits.
Market timing: a dangerous game
It's enticing to try to "catch" the next big investment
wave (up or down) and allocate assets accordingly. But there are
very few time-tested tools for consistently making those decisions
well.
Unfortunately, rearview mirror investing (or performance chasing)
never seems to go out of style. In one of the more compelling
historical studies of investor behavior, the research firm DALBAR
discovered that investors have done themselves a great disservice
by shortening their time horizons and trying to time asset class
performance via their mutual fund allocations.
As you can see in the chart "Market Strong ... Investors
Wrong" below, for the 20 years 1988–2007, the S&P 500®
index had an annualized return of 12%. Unfortunately, the average
equity fund investor had significantly lower returns—only 5%
annualized (barely nudging out inflation).
Market Strong ... Investors Wrong
*Measures returns of
investors in equity mutual funds. Source: Bureau of Labor
Statistics, DALBAR Quantitative Analysis of Investor Behavior 2008
(www.dalbarinc.com).
Most interesting, though, was the difference in returns between
"systematic" and "market timer" investors. For
those who were consistent in their investments, the annualized
return jumped to 6%—still only half that of the S&P 500 but
much better than for the average investor. On the other hand,
those investors who tried to outsmart the market by timing their
inflows and outflows saw their returns plunge into negative
territory—generating an annualized loss of 1% over the period!
Time horizons: the longer, the better
According to a recent study by Bain & Company, the length of
time that individual investors hold mutual funds has shrunk
precipitously over the last 50 years. In 1960, investors held
their funds, on average, for eight years. Today, that holding
period has dropped to less than a year—10 months, to be exact!
And the trigger for selling and/or buying is often short-term
performance chasing: buying last year's hot performer and running
from last year's loser.
In the chart below, "Longer Time Horizon = Lower Downside
Risk," you can see the power of long holding periods when it
comes to minimizing downside risk. The longer you extend your time
horizon, the less likely you'll experience a loss over that
holding period.
Longer Time Horizon = Lower Downside Risk
Source: Schwab Center
for Financial Research with data provided by Standard and
Poor’s. Every 1-, 3-, 5-, 10-, and 20-year rolling calendar
period for the S&P 500 Index was analyzed from 1926 through
2007. The highest and lowest annual total returns for the
specified rolling time periods were chosen to depict the
volatility of the market. Returns include reinvestment of
dividends. Indexes are unmanaged, do not incur fees or expenses,
and cannot be invested in directly. Past performance is no
indication of future results.5
Patience and stick-to-it-iveness
Admittedly, the development of a long-term strategic asset
allocation plan isn't the hard part—it's sticking to it that
often becomes the real challenge. The best way for an aggressive
investor to have generated the 11.4% annualized return since 1970
was for that investor to have remained aggressive throughout the
period, including during eight down years. That meant rebalancing,
typically in favor of underperforming asset classes and away from
outperforming asset classes. The same goes for the rebalancing
associated with maintaining a conservative allocation.
Adding to underperforming asset classes and trimming outperforming
asset classes goes against the emotions of fear and greed that
often drive investment decision making. But if we learn from our
mistakes, use our brains over our hearts and look to our
portfolios as rebalancing guides, we can expect a more successful
investing future and maybe even get a free lunch along the way.
Is your strategic asset allocation
up-to-date? Take action online.
- Log in to Schwab.com and click on the Planning &
Advice tab.
- Clients can click on Portfolio Checkup for four easy steps
to check your allocations and manage your portfolio.
- Click on the Investor Profile Questionnaire in step 1 to
make sure your risk tolerance is aligned with your portfolio
Important Disclosures
1. Market drop is represented by
S&P 500 index.
2. The Chicago Board Options Exchange SPX Volatility Index (VIX)
reflects a market estimate of future volatility. VIX is
constructed using the implied volatilities of a wide range of
S&P 500 index options. This volatility is meant to be
forward-looking and is calculated from both calls and puts.
3. See Schwab.com/portfoliocheckup for five strategic asset
allocation models, including Moderately Conservative and
Moderately Aggressive.
4. Data from Ibbotson Associates, Inc. The return figures for 1970
through 2007 are average, maximum and minimum annual returns of
three hypothetical portfolios, which are rebalanced annually with
dividends and interest reinvested. Conservative is 15% large-cap
stocks, 5% international stocks, 50% bonds and 30% cash. Moderate
is 35% large-cap stocks, 10% small-cap stocks, 15% international
stocks, 35% bonds and 5% cash. Aggressive is 50% large-cap stocks,
20% small-cap stocks, 25% international stocks and 5% cash.
Indexes are S&P 500 index (large-cap stocks), Russell 2000
Index (small-cap stocks), MSCI EAFE® net of taxes (international
stocks), Lehman Brothers U.S. Aggregate Index (bonds) and
Citigroup 3-Month Treasury Bill Index (cash). CRSP 6-8 was used
for small-cap stocks prior to 1979; Ibbotson Intermediate-Term
U.S. Government Bond Index was used for bonds prior to 1976; and
Ibbotson U.S. 30-Day Treasury Bill Index was used prior to 1978.
Long-term return estimates are weighted averages of Schwab's
long-term return estimates for each asset class: large-cap stocks,
9.0%; small-cap stocks, 10.7%; international stocks, 9.1%; bonds,
4.8%; and cash, 3.2%.
5. The highest and lowest annual total returns for the specified
rolling time periods were chosen to depict the volatility of the
market. Returns include reinvestment of dividends.
The S&P 500 index is an index of widely traded stocks. Indexes
are unmanaged, do not incur fees or expenses and cannot be
invested in directly.
This report is for informational purposes only and is not an
offer, solicitation or recommendation that any particular investor
should pursue any particular investment strategy. All expressions
of opinion are subject to change without notice. All charts and
research have been compiled from publicly available, proprietary
and/or licensed data.
Past results are not a guarantee of future performance.
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