After a strong start to the year, global equities retreated in the third quarter among continued geopolitical concerns and mixed economic news. The rise of ISIS/ISIL in Iraq and Syria, escalating conflict between Hamas and Israel, continued tension between Russia and Ukraine, roiling protests in Hong Kong, and concerns about the sustainability of a relatively unimpeded move up in global equity markets following the global financial crisis drove many investors to the relative safety of bonds and large U.S. stocks during the quarter.
Despite many negative global data points, news from the U.S. offered a few bright spots. The U.S. economy grew at an annualized rate of 4.6% in the second quarter of 2014, following a harsh winter and a decline of 2.1% in the first quarter. Further, the Federal Reserve continues to wind down its asset purchase program (quantitative easing) while committing to maintaining short-term interest rates near zero for a “considerable” period of time as the labor and housing markets slowly recover. With so many pieces of data available and affecting the global capital markets on a continuous basis, many are paralyzed by uncertainty and find it nearly impossible to make investment decisions. Our newsletter this quarter focuses on the importance of maintaining an appropriate perspective when making investment decisions.
Asset class returns for the third quarter and year-to-date were as follows:
|Index||Asset Class||Third Quarter 2014||Year-to-Date 2014|
|Barclays Capital U.S. Int. Government / Credit Index||Fixed Income||0.0%||2.2%|
|S&P 500||Large U.S. Stock||1.1%||8.3%|
|Russell 2000||Small U.S. Stock||-7.4%||-4.4%|
|MSCI ACWI ex-USA*||Foreign Stock||-5.3%||0.0%|
|S&P Global REIT*||Real Estate Securities||-4.1%||10.8%|
When talking with clients, we often emphasize the importance of maintaining a long-term perspective when investing in the stock market. However, we rarely elaborate on exactly what we mean by “long-term.” Is a year long enough? How about five years? Or ten? In an effort to shed light on this issue, we have analyzed historical asset class return data to better understand the patterns of investment returns over various time horizons. Our intent is to show how varying investment time periods might affect an investor who, in our book, does everything “right.” In other words, this investor has a balanced, well-diversified portfolio that is rebalanced on a regular basis and he or she does not attempt to time the market or react emotionally to current events or trends.
What did we find? We found that a five-year time horizon is not long enough to assure a successful investment experience. Over a five-year period, a well diversified, balanced portfolio of 60% stocks and 40% fixed income will produce markedly different results depending on the particular time period examined. This is displayed in the following graph, which presents rolling annualized five-year returns for the period 1974 through June 2014. The best return was for the five-year period ending June 30, 1987, during which the annual portfolio return was 23.7%. The worst result was for the five years ending March 31, 2009, when the annualized return was -0.4%. This makes intuitive sense, given that the end date of this five-year period coincides almost perfectly with the nadir of the financial crisis and the concurrent stock market plunge. The range of performance between these two extreme results is over 24% per year!
While we can conclude that it would be unusual to lose money in nominal terms over a five-year timeframe—the period ending in March 2009 was the only negative return result during the period examined—it would be virtually impossible to accurately forecast investment returns over five years given the variability shown above. Simply put, the investor’s actual experience is highly dependent on the specific five years under consideration. But what happens if we stretch the investment time horizon out to 20 years? The graph on the next page shows rolling annualized 20-year returns for the same portfolio.
What a difference 15 more years makes! You can observe how much smoother the 20-year graph is than the five-year graph. Unfortunately, many investors make decisions based on short-term volatility and the most recent headlines. The market fluctuations that were so apparent when analyzing five-year periods are effectively canceled out over the longer 20-year period. For the 20-year investor, the best result was an annualized return of 14.3% (period ending March 2000), and the worst was an annualized return of 6.8% (period ending March 2009).
This is a range of just 7.4%, less than one-third the range of the five-year results.
In case you are mathematically inclined and crave more detail, the following table provides summary statistics for the varying timeframes. We used quarterly asset class return data for the timeframe 1970 through June 2014. Our balanced portfolio consisted of 5% Money Market, 35% Intermediate-Term Bonds, 30% U.S. Large Cap Stocks, 15% U.S. Small Cap Stocks, and 15% Foreign Stocks.
Are we saying that you must have a 20+ year time horizon in order to invest in stocks? Absolutely not. The potential returns and hedge against inflation offered by equities make them worthwhile for many investors with shorter time horizons. We are simply stressing that the longer your time horizon, the less volatile your average annualized return.
We should also note that many investors’ time horizons are actually longer than they may at first realize. A generation ago, when post-retirement life expectancies were shorter and defined benefit (DB) pension plans were prevalent, the relevant time horizon for equities was thought to end at the onset of retirement. At that point in time, the conventional wisdom was to shift one’s portfolio into income-producing securities, namely bonds. Now, however, many people are enjoying retirements of 20, 30, even 40 years. In fact, according to the National Association of Insurance Commissioners, the joint life expectancy for a 60 year-old couple today is 91.8 years! In addition, far fewer retirees today are covered by defined (fixed) benefit pension plans. As such, this situation places the onus on the retiree to design a portfolio that will provide retirement income not just now, but decades into the future. So, for most investors who intend to use their investments to fund their retirement, the relevant time horizon is the full length of their lives. For individuals and families who intend to pass assets on to their descendants or to charity, the effective time horizon may be even longer, perhaps 50 to 100 years; therefore, equities may play an even more important role.
We wish you an enjoyable autumn and final weeks of 2014. Please let us know if we can assist you in any way.