Talking with investors is often enlightening. We often take our years of knowledge for granted. So, when we were talking to a client who wanted a financial plan, we asked, “What do you expect to get in the market?” He said, “Around 15%.” The realization hit: The last nine years of exceptional returns has spoiled us.
We’ve said many times that the long-term average for Large Cap stocks is an annualized return of nearly 10.5%, according to Ibbotson’s 2015 Annual Yearbook that shows the 10-year rolling average since 1926. However, no one year will ever net you 10.5%. Some years you won’t even come close. To make things worse, from Mar. 9, 2009 through Nov. 9, 2018, our historically long bull market has averaged more than 18%. Furthermore, 2017 was one of the lowest years for volatility on record. In fact, the worst top to bottom return was 2.88% but that lasted only a few days, and we were right back to stellar returns.
So how should an investor account for market return when building a financial plan? Rather than focus on, “How much do you expect?” take a look at, “What is your overall tolerance for risk?” and then build the portfolio from there.
We base a financial plan on our Ten Year Rule. Any money you believe you will need within the next 10 years should be invested in fixed-income investments; money not needed within 10 years should be invested in high-quality growth investments like equities. We choose a time frame of 10 years, because as the economy cycles through its stages, historically there is a low chance that 10 years will yield a negative return.
We then manage your overall risk by diversifying across asset classes. Small-Cap stocks will generally outperform Large-Cap stocks, but their volatility can be much greater. While you want to capture some of the growth that Small-Cap stocks can provide, you also want to hold more conservative equity investments like Large-Caps. You also need to diversify within your asset classes between growth and value, and sector diversification. Asset classes don’t all move together. Many are uncorrelated, and this diversification tends to smooth out your returns.
We also harp on rebalancing your portfolio. Throughout the economic cycle, certain asset classes or sectors will outperform. And while your total return might look nice during an expansionary period, the risk you took to achieve that return may be much higher than you can tolerate in a slowdown or recession.
The key is keeping your risk consistent. If you designated 20% of your portfolio toward Small-Cap stocks, and the bull market has favored them, your allocation may now be 25%. Rebalancing can bring your outperformers back in line with your risk profile and allows you to add to underperforming assets. Just as you don’t want to be overexposed to any one sector during a downturn, you don’t want to be underexposed when an economic cycle favors a different sector.
Note that this is not timing the market. This is working with the information the market is giving you. Determining the stage of an economic cycle is mostly done in hindsight since each stage is relative to the next. Thus, it is not easy to predict the best performing asset class from year to year. Having a mixture of asset classes in your portfolio aims to reduce the overall financial risk in terms of the variability of the returns.
If you have questions regarding your risk tolerance asset allocations, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.