Most investors base their investing strategy on the false premise that some "guru" can reduce or eliminate risk by predicting the unpredictable.
Mark Hebner, the founder and President of Index Funds Advisors (IFA), (with whom I am affiliated), has a better way. He has come up with a formula to change the way you think about investing. It focuses on the long-term risk of a portfolio. Here it is:
The expected annualized return for any of IFA's twenty globally diversified index portfolios (ranging from very conservative to very aggressive) is about 5%, plus one-half of its standard deviation of annual returns over the last 50 years. Standard deviation is a mathematical calculation that measures the volatility of an investment.
How does this work?
Let's take a globally diversified portfolio of indexes invested 100% in stocks with a 50-year standard deviation of about 15.4%. The expected return of this portfolio is estimated to be 12.7% (5% plus 7.7% [one-half of its standard deviation]). The current annualized return since January 1958 is 12.43%.
What happens if you rely on the advice of most brokers and advisors, looking at past returns of 5 years or less? You chase performance and try to beat the markets by stock picking, market timing and investing in mutual funds that attempt to beat the indexes.
A study of investor behavior over the 20 years ending 2008 found that the average equity mutual fund investor under-performed a 100% stock index portfolio by a whopping 7.3% annualized return.
What about 2008?
"Expected return" is the average of a probability distribution of future returns determined by about 50 years of simulated passive investor returns. Expected return is not a guarantee that it will be the actual return in any time period, because past performance does not guarantee future results. It is based on the old bell curve, where there is roughly an equal chance that returns will be above or below the average. 2008 was a below average year. So far, 2009 is an above average year. Over time, the chances improve that investors will achieve the expected return for a given level of risk of their investments.
I am anticipating your question: You don't have a fifty year time horizon so how is this information helpful to you?
There is an asset allocation that is best for you. Based on the risk of that asset allocation, IFA has a recommended holding period that improves your chances of achieving the expected return. For example, let's assume you have taken a good risk capacity survey. The results indicate that a portfolio of 60% stocks and 40% bonds is suitable for you. You invest your assets in a properly designed, globally diversified portfolio of low cost stock and bond index funds.
After 7 years, you should have a reasonable chance of achieving an expected return of 10%. According to Hebner, about two-thirds of 524 simulated passive investor experiences over 7 year periods fell somewhere between 6% and 14%. The last 7 years ending August 2009 had a return of 6.93% for this portfolio. (See www.ifabt.com for sources, disclaimers and disclosures).
You have two basic choices:
Continue down a path where the returns, after taxes and inflation, have been negative; or
Puts the odds on your side. Give yourself a reasonable chance that your returns for the equity portion of your portfolio will be four times greater than those earned by the average equity investor over the last 20 years.
Dan Solin is the author of The Smartest Retirement Book You'll Ever Read.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.