Mantras about investing are common and, quite often, dead wrong. Here are five that most clients believe, but shouldn’t, and how to gently break the news.
“It’s not a loss until you sell.” “All you have to do is invest for the long run.” “Don’t miss the 10 best days of the market.”
These timeworn bits of conventional wisdom are burned into the cerebral cortex of most investors. They are conventional, yes, but not necessarily wisdom, warned David Gluch, head of U.S. product management for Invesco. Speaking at IMCA’s New York Consultants Conference earlier this week, Gluch outlined five popular investment myths held by clients and how to gently tell them the truth.
• “My portfolio will be in fine shape if it has more up years than down years.”A common marketing factoid by investment companies is to note that equity markets historically have had more positive than negative years. The S&P 500 was up in 61 of the past 85 years. But it’s not the number of up years that matters, Gluch says; it’s the magnitude of the gains and losses. Between 2000 and 2009, for example, the S&P 500 had six up years and four down years, yet the total return for the decade was a loss of more than 9 percent, he said.
“Frequency is not our friend. It abandons us just when we need it most,” Gluch said. “If you called me up at the end of 2008 and said, ‘What happened to half the value of my portfolio?’ If the answer back to the client was, ‘We outperformed the market 15 of the last 16 years. We have the best batting average in the industry,’ I don’t think that answer would have gone too far toward retaining that client.”
Citing data from Ibbotson, Gluch noted that rolling 10-year returns for the S&P 500 between 1936 and 2010 were up 94 percent of the time. But beating a return rate of zero doesn’t always help a client meet financial goals; if you’re seeking returns of greater than 10 percent, only 54 percent of the 10-year periods were able to meet that standard—odds that are not much better than a coin toss.
• “Missing the market’s best days is the worst thing I could do to my portfolio.” Losses matter a lot more. Tracking the value of a dollar that was invested in the S&P 500 from 1928 through 2010 results in an end value of $71, a cumulative return of more than 7,000 percent. Missing the 10 best days of that period will lower that return to just under $24, a payoff of close to 2,300 percent. But missing the 10 worst days actually boosts the value exponentially—nearly $229, a return of over 22,700 percent.
“We’re not adocating trying to time the market,” Gluch said, a nearly impossible task as some of the historically best and worst days of the market fall within less than a week of each other. But investors shouldn’t avoid the market either, he added; if left in cash, that $1 investment returns a value of little more than $19.
Clients lack an appreciation of how volatile the markets can be, Gluch said. Citing data from Crestmont Research, which tracked calendar year returns from 1901 through 2010, he said the incidence of returns of losses greater than 10 percent or gains greater than 10 percent occurred 69 percent of the time—“Not exactly black swan or unusual events in the context of all of market history. It was just very unusual in the ‘80s and ‘90s.”
• “Market returns are the key to my portfolio’s value.” Clients underestimate how much control they have over the outcomes of their financial plans through their savings behavior, Gluch said. Take three investors, each with a 10-year investment horizon who put 10 percent of their $100,000 annual income—$10,000—into their portfolio each year. Assume one investor sees a zero return on the market, the second a 6 percent return, and the third a 12 percent return. The fellow with the 6 percent return has $137,000 at the end of the period, but savings account for 73 percent of the portfolio. For the 12 percent scenario, the investor sees almost $194,000, with savings accounting for 52 percent of the total.
“The savings still form the foundation of the portfolio, even in a double-digit equity market,” Gluch said. It’s only in an extended time horizon, say, 20 years, when the market does most of the work, he said. In fact, saving more can result in better outcomes even when markets do poorly. The investor in his scenario who has $194,000 at the end of 10 years in a market with a 12 percent return actually underperforms a colleague who saves 20 percent, or $20,000 annually, in a scenario in which the market return is zero. The frugal investor ends up with $200,000 after 10 years.
• “If there’s no sign of recession or recovery on the horizon, I don’t need to prepare for one.” Being a good risk manager means always being prepared for a variety of events, Gluch said. In 2006 and 2007, many industry experts said there was little likelihood of a recession the following year; the result was less investment in government bonds and more investment in riskier equities. The outcome the following year damaged most portfolios.
“There’s a disconnect between the concept of probability and impact,” Gluch said. “Nobody buys homeowners’ insurance based on the probability of their house burning down or getting blown away in a storm. You buy homeowners insurance because of the impact of the event. We like to extend that concept into the portfolio. You need to maintain exposures to a variety of asset classes that are truly low correlated and protect us first from adverse economic environments. We can’t be wholly in or wholly out of asset class exposures at any one point in time.” Clients who wanted nothing to do with equities in 2009 missed the subsequent rebound, he said.
• “I’m diversified—my portfolio has lots of different stocks.” Equities outperform over time, Gluch says, but they don’t outperform all of the time. In different economic scenarios, they often underperform other benchmarks—long-term government bonds beat stocks in the past 11 years, for example, while commodities and T-bills did the same from 1973 to 1981. Stocks are sometimes oversold by the financial industry as a hedge against inflation, Gluch said. From 1966 to 1974, the price-earnings ratio of stocks fell from around 12 to 8.
“You can go through extended periods of time where if your portfolio is dominated by equities, you’re either going to be wildly successful or very miserable,” Gluch said. True diversification is based not on expected returns but on sources of risk—shifting economic environments. So having commodities in a portfolio helps protect during periods of inflation, he said, while long-term government bonds helps in recessionary or deflationary times.
“We need exposure to all of these asset classes all of the time in the portfolio, because it’s very difficult to predict what’s going to happen,” Gluch said.