Investing and Expectations

| May 2, 2016 | 0 Comments

During the first quarter of 2016, large company stocks were up about 1.3 percent while the bond market gained about three percent. Over the past five years, the S&P 500 has gained about 12 percent per year while bonds have gained about four percent per year. International stocks have earned only about 2.3 percent over that time period.

What does this have to do with investment results over the next five or even ten years? Almost nothing.

Far too many investors get caught up in the trap of looking at past performance to make decisions about future returns. This is a natural mental shortcut that humans have evolved to follow: if something worked in the past, it will probably work in the future. It works pretty well in rush hour traffic, in that you know some routes are typically easier to drive than others. But we still check traffic reports for accidents and changes to our routes because we know circumstances change.

Turning to investments, some things do tend to persist over very long periods of time (30 or more years). For example, the stocks of smaller companies tend to do better than those of larger companies in the long run, even though this hasn’t been the case recently.

There are absolutely no reliable indicators for future stock returns over anything less than a 20 or 30 year period, and even then the record is mixed. Stocks also tend to appreciate faster than the cost of living over the long-run, making them a good hedge against inflation, but in the short-term their volatility can mean significant losses are almost certain to occur.

Bonds tend to be less volatile than stocks, and so are good for short-term investors who need capital preservation and current income. But historically, bonds may not keep up with the cost of living over time. So an investor looking to preserve purchasing power over the long-term will want to focus on investments with higher potential returns like stocks.

Can investors use these kinds of historical patterns to predict the future results of investing? Even looking out over 30 or 40 year periods, it can lead to some very big mistakes if you aren’t careful.

For example, over the past 40 years or so, long-term government bonds have provided historically high returns. But with bonds, in order to earn high future returns, you have to start from high current interest rates. When the 30-year Treasury is currently yielding about 2.7 percent, it’s almost impossible to earn more than that over the next 30 years.

History can be a starting point, but just as you check traffic before hitting the freeway, you need to understand how current conditions can impact your investment expectations as well.

So what’s an investor to do? Investing is largely about assessing probabilities, and designing a portfolio that can provide decent results in the most likely circumstances while not giving up too much when things don’t play out the way you expect. For example, most aggressive investors don’t want bonds in their portfolios because they typically expect to make more money investing in stocks. But in a market like 2008 (or 2015 for that matter), the bonds may be the only thing earning a positive return.

On the other hand, since stocks have typically lost money about one out of every four years, risk averse investors looking for short-term capital preservation should typically have more bonds in their portfolios since they are less volatile than stocks or most other assets.

A CERTIFIED FINANCIAL PLANNER™ professional can help you determine an investment strategy that is best suited to balance your need for long-term savings and short-term capital preservation, while adapting to current conditions.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director and chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.

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