Diversifying your investments, if done properly, reduces risk in your portfolio. Just about all financial professionals subscribe to the benefits of diversifying your investments. I also think diversification is important. But there are two kinds of diversification - one is helpful and the other kind is not beneficial.
The best way to describe diversification is using the old adage of not putting all of your eggs in one basket. Let’s use individual stocks as an example. Â
Beth is an aggressive investor who puts all of her money in the stock market because it has the highest returns in the long run. That is the right strategy based on her age, which is 44. But she decides to put all of her money into one stock. She is a big believer in Apple so all of her investment funds are used to purchase Apple stock. Apple is a great stock. Apple is a great company. But there is too much risk involved in holding all of your money in one stock even for a company as good as Apple. Â
Large cap index funds will grow by anywhere from 8% to 11% per year over the next 30 years with dividends reinvested. Apple has a good shot of achieving a similar or even higher growth rate over the next 30 years. But too many things can go wrong with one stock - things that you are protected against when you hold a basket of stocks in an index fund.
A new competitor could emerge who has better products than Apple.
A new technology could emerge that beats Apple’s technology.
Apple's product development could fall behind in the next 20 years.
International political issues could severely damage Apple sales in China or other parts of the world.
The SEC could discover financial improprieties at Apple.
Changes in government regulations in the United States and around the world could severely impact Apple’s financial results.
Management changes could lead to bad performance at the company.
Now, I am not predicting that any or all of these things will happen to Apple in the next 30 years, but they could. Â
When you own an index fund like the S&P 500 that includes 500 of the biggest and best companies in the world, some of the bad things I listed could happen to one stock like Apple but they won’t happen to all 500 stocks in the index. For every individual company in the S&P 500 that goes through tough times, there will be another company whose results improve dramatically. In an index fund like this, you get results that are an average of all 500 stocks. You get average results but the average results of the S&P 500 equals an average annual return of about 9% per year. That is a very good return.
Owning just one stock is gambling and not investing. You could get really lucky and hit on a big winner. But you could also get really unlucky and lose all of your money. Individual companies can and do go out of business which means their stock price can go to zero.
You should not gamble with your retirement account.
THE OTHER DIVERSIFICATION
Owning a basket of stocks like we just reviewed is what I call good diversification. Everyone should follow that approach for their investments in the stock market.
There is another kind of diversification that is pushed by the financial services industry that is not good. The investment industry has taken diversification one step further by applying the same concept to asset classes like bonds or commodities and even certain types of stock market investments. They call this asset allocation. Â
Asset allocation was invented in the 1950s and it was not effective then and it is not effective now. Under this theory, they say that we should all own a variety of categories of stock market investments. They say that we should own large cap index funds like the S&P 500 but that we should also own mid-cap funds and small-cap funds and international stock funds to name just a few. That way if the US stock market is down one year and the international markets, for example, are up in that same year, your results for that year will be better. They apply the same logic to mid-cap funds and small-cap funds. Â
Unfortunately, all this approach does is lower your overall long term results. And retirement investors should be concerned about long term results, not the results for one particular year. International stocks and mid-cap stocks and small-cap stocks do not perform as well as large cap index funds like the S&P 500 in the long term. Also, when the major US stock market indexes drop like they did in 2022, all stock markets fall. And most of them fell more than the S&P 500 in 2022.
The Asset Allocators apply the same logic to bonds and commodities and other asset classes. Bonds will earn about 4% per year on average in the long term. The S&P 500 index funds will earn about 9% per year. Since all of those other asset classes perform worse than the large cap stock market indices over longer periods of time, how can including them in your portfolio be a good thing for your results?  Ask your financial advisor this the next time they spread your money over all these different types of investments. Â
The investment industry uses all kinds of fancy terms and charts to make asset allocation sound like a great thing, but the math doesn’t work. They also will talk about risk tolerance and tell you that is why asset allocation is a good thing. But asset allocation doesn’t always provide protection in bear market collapses. Look no further than 2022 for an example of when bonds did not provide any risk benefits to portfolios.
You should definitely diversify your stock market investments across multiple stocks and the index funds do that for you, but don’t follow the industry advice of asset allocation. Our Market Signals solution provides much better loss protection than Asset Allocation which provides only the illusion of protection.
Happy Investing,
Phil
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
For those of you who struggle with deciding upon which funds to choose for your 401K, I will be reviewing all of the different categories of funds available to 401K investors. Today, I will be focusing on one of the common 401k investing options - target date funds.
HR departments and most 401K plan administrators tend to push target date funds to their employees. Target date funds are not a bad option. They are just not the best option.
Target date funds are balanced funds that use the asset allocation method covered previously. Target date funds are tied to the age of the employee based on their expected year of retirement. You might see Target date fund options in your plan labeled 2040 or 2050 for example. The year in this case, 2040, indicates the year that the employee is expected to retire.
Based on the age of the employee, a target date fund automatically rebalances the investments in that fund between stocks and bonds. The old industry adage is that younger people should have most of their money in stocks and very little in bonds. As people age, they say that people should decrease their stock investments and increase their bond investments. The reasoning behind this is that stocks on the whole are more volatile than bonds. If the stock market nosedives, a younger person has more time to wait for the stock market to recover. A person nearing retirement doesn’t have as much time for the stock market to recover so they are encouraged to put a higher percentage of their investments in bonds.
In a target date fund, a typical employee might see their portfolio average out to a split of 75% stocks and 25% bonds over the course of their working life. Younger 401K target date fund investors may have 90% in stocks and only 10% in bonds. Older target date fund investors may have only 60% in stocks and 40% in bonds.
Target date funds also tend to allocate their stock investment across the various subclasses of stock funds – large cap, small cap, international stocks, value funds and growth funds for example.
The next table shows the results for Target Date funds or Balanced funds. I am using Vanguard’s Target Date funds since they are used quite a bit for 401K plans and because Vanguard is a good performing asset manager with low fees. Target Date funds only became popular less than 20 years ago so we can only compare the 10-year performance results.
From these results you can see evidence of what I pointed out earlier for target date funds. When a person ages, Target Date funds shift more money out of the stock market and into the bond market. Since bonds have much lower investment returns than stocks, the overall returns from target date funds are higher when a person is younger. You can only expect to earn about 6.5% per year in Target Date funds over the long run.
The performance of Target Date funds is also negatively affected by the stock investments that they choose for their funds. These funds take the balanced approach one step further by including different types of stock investments. They like to include international stocks in their assortment as well as small-cap and mid-cap stocks. This, too, lowers investment returns as you saw from the previous analysis of the results for these kinds of stock investments.
The performance of Target Date funds also highlights a point that I make frequently - that the Asset Allocation method pushed by the investment industry doesn’t work. The Vanguard 2040 Target Date fund that has produced a 6.5% annual return over the last ten years lost 17% in 2022. The S&P 500 Index produced a 10.9% annual return over the last ten years and lost 18% in 2022. So, the asset allocation method reduced losses by only 1% in the bear market of 2022 but it lowered average annual returns over the most recent ten year period by 40% (from 10.9% down to 6.5%).
Target Date funds are the default option of HR departments and plan administrators because they are deemed to be safer. But that supposedly safer option comes with significantly lower returns than the large-cap index funds. Those lower returns are costing 401K investors hundreds of thousands of dollars or even millions of dollars over their working life.
A much better way to obtain the safety that Target Date funds are supposed to provide is by using our Market Signals investment service. You can potentially double your investment returns and get the peace of mind of knowing your money will be protected in a market crash.
Happy Investing,
Phil
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
SUMMARY:
Did you know that outside of Bear Markets that the stock market returns about 15% per year? And did you also know that the stock market provides excellent returns about 86% of the time?
Bear market declines only represent about 14% of trading cycles on average. But bear market crashes happen about once every seven years. For this big problem (bear market crashes) that only happens occasionally, the investment world has come up with a small number of solutions that only hurt your long-term investment results.
STOCK MARKET HIGHS AND LOWS
The stock market is a great place to invest your money in the long term. The stock market has produced more wealth, and more millionaires than any other asset class in history. In the long term there is very little risk when investing in the broad stock market. Individual stocks can and do go to zero, but the broad stock market always goes up in the long term. The only danger associated with investing in the broad stock market are those painful and annoying Bear market crashes. They happen about every 6 to 7 years on average and these bear market declines can generate losses of 40% or 50% of your investments. The table below shows the stats from the worst bear markets from the last 50 years. The market always bounces back from these declines, but it can take up to seven years to get back to even.
Bear markets have two components - the crash and the recovery. The declines or crashes last about 11 months on average. Some crash periods have been very short like the Covid Crash of 2020 and some take a long time like the financial collapse of 2008. The recovery leg of a Bear market lasts two or three times as long as the crash. The rebound or recovery phase can be very powerful and can produce some big gains. All our worries about stock market investing are associated with the Bear market crashes.
But if we separate out the periods when stocks are crashing in Bear markets from all other time periods, the Bear market crash only represents about 14% of stock market trading cycles. The other 86% of the time, the stock market (as measured by the S&P 500) is climbing by about 15% per year on average. On an annualized basis, stocks lose about 39% of their value in the Bear market crash cycles. So, 86% of the time, investments are growing very rapidly (15%) and only 14% of the time are stocks losing money.
THE OTHER PROBLEM WITH BEAR MARKETS: TIME
It is bad enough that bear market declines are so severe, but the other issue with bear markets is time. Bear markets are not short-term events, typically. If we look back 50 years, the average duration of a bear market is about 4.5 years. This counts the time between the previous peak and the recovery back to that peak. So, your money basically earns nothing over 4.5 years (not including dividends). On the high end, the 1970’s bear market lasted 7.5 years and the 2000 crash lasted 7.2 years. The 2020 Covid crash was quick, lasting only six months. The crash itself takes an average of 15 months from peak to bottom. The longest declines in the last 50 years happened in the 1970’s (2.5 years) and the early 2000’s (1.8 years). The shortest once again was the Covid crash of 2020 which went from peak to bottom in only about one month. The current bear market (as of this posting) is only about 9 months at this point, but it is following the pattern of the 1970’s bear market, unfortunately. So, in addition to dealing with the pain and suffering of investment losses of 40%, equity markets can go nowhere for as long as seven or eight years or more.
THE WRONG SOLUTIONS TO THE PROBLEM
Because the crashes are so severe (-39%), we are told to put 40% of our money in bonds. We are told to diversify our investments into international equity markets and commodities. The theory is that these other asset classes will not fall as much during bear market crashes and can, therefore, cushion the blow. The only problem is that this is not always true and the S&P 500 has always beaten the other asset classes over the long term. So, the investment community has sold you on the benefits of asset allocation and it doesn’t really work.
THERE IS A BETTER WAY: BEYOND BUY & HOLD
There is now a much better way to invest where you can achieve the high long-term returns of the stock market and lower your risk. Imagine fully capturing those 15% annual gains and not having to worry about Bear market crashes. The Beyond Buy & Bold system can produce investment returns that are double what you are getting from the traditional asset allocations. And, even better, you get the peace of mind of knowing your savings are protected against those inevitable stock market collapses. Learn more by checking out our Market Signals investing service.
Happy Investing,
Phil
Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.
Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.
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