January 22, 2023
by Stephen Stofka
This week’s post is about expectations, investing and gambling. After last year’s slump in asset prices, investors may be disappointed in the recent performance of their portfolio. A 60/30/10 (U.S. stocks/bonds/cash) had a 3-year return* of 3.65%. A 5-year return was 5.53%, according to Portfolio Visualizer (2023). Investors tend to weight losses more than they do gains. Following portfolio losses during the financial crisis, many investors turned to more conservative assets, selling their beaten down stocks at a low. Following this past year’s selloff in both bonds and stocks, investors might be tempted to shed both. Let’s take a look at the averages.
Only three years out of the past fifteen has a balanced portfolio had a negative return. When a stock fund loses 35% in a year, investors can feel the loss so deeply that they liken stock investing to gambling. A gamble is a win or lose event with a high return and a low probability of winning, a probability so low that it outpaces any winnings I might get. For example, if I could bet a $1 and win a million, that is a 1,000,000 to 1 leverage. But my chances of winning might be 1 out of 300,000,000. Take that probability and turn it upside to get its inverse of 300,000,000 to 1. Compare that to the leverage and the ratio is 300 to 1. The gambler is at a distinct disadvantage. That’s how lotteries raise money for parks and common areas and how casinos stay profitable.
A prudent portfolio is not a win or lose bet but a series of erratic steps, the familiar model of the random walk. In any year, our expectations should be guided by historical averages, not the last erratic step. In the fifteen years since the year of the financial crisis, the average of the annual returns of a 60/30/10 portfolio, rebalanced annually, was almost 7.2%. (Note: this is slightly higher than the annualized growth rate). A more conservative 50/40/10 asset mix averaged 5.6%. Last year’s portfolio loss of 15.55% was unusual and not likely to be repeated. Investors who were spooked by market losses last year risk losing positive gains in the following years if they let one year’s return dictate their allocation targets.
Losses in both the stock and bond markets last year made rebalancing counterintuitive. In a simplified model, bonds go up when stocks go down. To rebalance, an investor sells some bonds and buys stocks, selling high and buying low. Likewise, when stocks climb, bonds show a negative return. For twenty years, Callan (2023) has charted seven asset classes and their returns, demonstrating the wisdom of asset diversification. In 2021, a mix of large and small cap stocks returned about 21% while a mix of domestic and foreign bonds fell 3-4%, depending on the mix. Rebalancing toward a target allocation, an investor would have sold some stocks and bought bonds. In 2022, both stocks and bonds had approximately similar negative returns. An investor may have found that their allocation changed little except that the cash portion of their portfolio might have grown a bit.
An unusual year like 2022 can distract or confuse an investor’s strategy. A casino or lottery wants to draw our attention to the unusual event – the win – and away from the average – the loss. If gamblers were to focus on the averages, few would play. Investing is the opposite of gambling and our focus should be trained on the averages.
*CAGR – compound annual growth rate
Callan. (2023, January 16). Periodic table. Callan. Retrieved January 21, 2023, from https://www.callan.com/periodic-table/ Note: this chart ranks the annual returns of seven asset classes for the past twenty years. Go to the web site, then click the PDF link for the free chart.
Portfolio Visualizer. (2023). Backtest portfolio asset class allocation. Portfolio Visualizer. Retrieved January 20, 2023, from https://www.portfoliovisualizer.com/backtest-asset-class-allocation