Trounce The Market With Less Risk
Over a lifetime, stocks trounce bonds more than 800-fold. Contrary to conventional thinking, LESS risk taking can lead to HIGHER returns. Active investing can significantly outperform balanced, buy-and-hold strategies. Most of us tend to think of investing in terms of the experiences of our lifetime, and in fact, of that limited span during which we were vaguely aware of economic events in the world at all. (Nope, you can’t count those teenage years…) But it is important to view things in a greater historical perspective. The chart below does that. (click to enlarge) Source: Stocks, Bonds, Treasury Bills and Inflation 1926-2010 If you zoom in on the graph, you’ll quickly grasp one salient fact: over the long run, if you can stand a bit of risk, you’ll certainly be richly rewarded for that risk. From 1926 to today, an investment in the lowest risk strategy, short term government bonds, grew your money 19-fold, but barely outpaced inflation which eroded the value of the dollar 12-fold over that same period. In stark contrast, investing in small caps grew your money 16000-fold. Yes, you read that right! Put another way, a $1000 investment grew to just over $16 million. Here are a couple of other important observations: If time is on your side, you are seriously shortchanging yourself by not investing in the stock market. A small increment in your yearly return makes a huge difference over time. Look at how a 4 percent difference between large cap stocks and long term bonds increases returns by more than 40 times over that period. Thanks to the incredible magic of compounding, the earlier you start the better off you’ll be. The more you depend on your investments for income today, the less you can (safely) earn, ironically enough. (The corresponding corollary to that in the banking sector is that the more you need a loan, the less likely you will get one. Oh well…) It may take you 20 years to recover from a market break! If you invested in the market in late 1928, you were not back to square one until 1946 !!! (If you think we have that problem solved, just talk to some Japanese investors. Or view this article on my blog.) Even government treasuries can be a poor investment. See the period from 1965 to 1970, when treasuries dropped, yet inflation was raging. Faced with the complexities of investing, sticking your head in the sand and your money under your pillow just ain’t the way to go! Just look at that inflation line. It means your $1.00 invested in 1928 buys you about 8 cents in 2015 prices. So you cannot afford to be on the sidelines. In fact, if you are not investing, you have almost a complete certainty of seeing your assets shrink. So given all of these conclusions, how should you invest your hard-earned money for the best results? Or if you’re among the fortunate few born with a silver spoon in your mouth, how should you protect your leisurely-inherited millions? The short answer is: it depends… For those of you not quite happy with that decidedly hedged answer (Ever wonder what the word hedge funds really means?), please read on. I promise to give you a more concrete response. A traditional approach would be to spread your assets widely among several groups of investments. Take a look at the following graph showing how several different categories of exchange traded funds performed in the last big stock market crash in 2008. (click to enlarge) As the graph makes clear, while the stock market was plunging, other market sectors (mortgage-backed securities, short and long term treasuries, corporate bonds and government backed securities) were rising. So by mixing your asset classes, you can significantly smooth out the volatility of your portfolio. This is particularly important for retirees, since you can choose to withdraw only from areas that have risen in value, as opposed to selling at the worst possible moment, when asset values are at all time lows. A number of mutual funds and ETF’s already subscribe to this strategy. The chart below shows the performance of the Janus Balanced Fund, plotted against the SPDR S&P 500 ETF Trust ETF (NYSEARCA: SPY ), which is a proxy for the S&P 500 index. This has averaged a 9.85% return over 20 years, with fewer big drawdowns than the S&P itself. (click to enlarge) (click to enlarge) If you pay close attention to the percentage comparison, you will note that the balanced approach actually beat the S&P 500 in overall return with less volatility along the way! Some people mistakenly assume that this “spread your marbles out evenly” strategy argues against an actively managed approach. Nothing can be further from the truth. The next two graphs show an active approach that picks the best stocks in the US stocks universe (according to our proprietary formula), times the buys according to certain technical criteria related to momentum, and rebalances the portfolio on a weekly basis. Here is a relatively low-beta (low volatility) approach, that still wallops the results of the JANUS fund shown above, as well as the S&P. (click to enlarge) And for those of you willing to sit tight through a little more volatility, how does a 16 fold return on your money over a 12 year period grab you? But don’t complain about the 50% drawdown… (click to enlarge) Source: quantopian.com Strategy back-testing based on universe of 8000 plus US stocks from 1993-2015. Graphed results are NOT based on historical performance. Real results may differ significantly from back-tested results. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: The author currently holds positions using some of these strategies. We do not currently hold position in the Janus fund. The active strategies mentioned require margin accounts and the ability to short stocks at certain times.