When it comes to expected return, we love big numbers. We gravitate to it like paparazzi to a celebrity. We do it with performance and projections because it sells.
But there’s one tiny problem. Our expectations change with the market.
A while back I covered how asset allocation lowers volatility. In it, I showed how four different asset mixes performed against an all stock and an all bond portfolio. It looked like the graph below. It showed how volatility lowers as you decrease the amount of stocks in your portfolio. But did it?
Of course it did. It was a simple exercise to prove a point. But it also showed how much better an all stock portfolio performed over the same period.
Given the three portfolios below, which would you choose?
I bet one of you said, “Look how much more I’d have with stocks!” We love big numbers, remember.
Stocks have been the best performing asset in the long run. So why not go 100% into stocks? Because they may perform great, but stocks don’t move in a straight line. Still, that doesn’t stop us from doing exactly that. Stocks get us that bigger number. Or so the projections say.
And it doesn’t end there. We do this with past performance too. What do think a 30% performance like 2013 does to us? Another big number.
We make investment decisions based on what happened last year. Whether it’s the S&P 500’s 30% run in 2013 or the wash out in 2008, money followed the great performance and fled the poor one. In other words, current market performance skews our expectations.
Think back to the market crash. The S&P 500 fell 37%. In the middle the meltdown, would you still see that big number in the far off future? What were your expectations then? Would you stick with the plan? Or would you reenact the Titanic? Bail out and save what you can.
But why? We like to focus on the current results while ignoring the process. Investing is very much an adventure that pulls at every emotion possible. Big returns sell possibility. Losses lower expectations. Go figure.
It helps to have your expectations grounded in reality.
What’s Realistic?
There’s a problem with expected returns – an unknown future. In the absence of certainty we make an educated guess about what might happen. Historical returns go into this, along with your time horizon, and allocation.
Below are the historical annual returns for the more common asset classes you’d find in a retirement portfolio.
| Asset Classes | Historical Annual Return |
| U.S. Large Cap Stocks | 10.2% |
| U.S. Small Cap Stocks | 12.3% |
| International Stocks | 10.4% |
| Emerging Market Stocks | 15.7% |
| REITs | 11.6% |
| Short Term Treasury Bonds | 3.6% |
| Long Term Treasury Bonds | 5.5% |
| Municipal Bonds | 4.3% |
| Corporate High Yield Bonds | 6.9% |
| Inflation | 2.3% |
You can see that big returns like 2013 are far from normal. Don’t be overly optimistic and fall prey big numbers.
In any given year, one of these asset classes will outperform the rest. One will underperform. But which one? This is why we diversify. A portfolio built to manage risk will outperform stocks over time.
