When
it comes to investing in the stock market, the risk that everybody
talks about is the ups and particularly the downs, the bearish periods
when the market falls dramatically and keeps falling for months or even
years. (Think: 2000-2002 or 2008)
The real damage isn't the fall itself, but the fact that many investors watch the ongoing free-fall with increasing horror until they can't
stand the pain any more, sell out of the market at or near the bottom,
and then lick their wounds on the sidelines and miss the recovery. Over
the course of this round trip, they lose real money, while those who had
the fortitude to hang on recovered their losses.
Recently,
professional advisors have begun talking about a different dimension of
risk, which is just as insidious, just as potentially damaging to the
wealth of their clients, but much-less-widely discussed. It's called "frame-of-reference"risk.
Frame-of-reference
risk can be defined as the risk that people will look at the
performance statement of their diversified investment portfolio and
notice that its return is falling short (sometimes far short) of the
market index they're most familiar with-typically
the Dow or the S&P 500. They abandon the diversified investment
approach and concentrate their holdings in the local market right as the
other investments they sold are about to take the performance lead.
To see why this is a risk at all, consider the bull market in tech stocks in the late 1990s. Let's
compare the rate of return in the late 1990s and early 2000s of U.S.
stocks compared with an ABCD portfolio consisting of equal parts U.S.
stocks, foreign stocks, commodity-linked equities and real estate
investment trusts-a diversified mix of risk assets, rebalanced each year.
In 1995, the diversified portfolio got walloped by the U.S. market-a
difference of more than 16 percentage points. In 1997 and 1998, the
differences were even more pronounced: almost 23% and just under 30%.
This was a time when many investors were telling their advisors that the
rules of investing had changed, that technology, clicks and eyeballs
were the new standard by which stock values should be measured.
If they abandoned
their diversified ABCD strategy at or near the bottom, in late 1999,
these investors would have been concentrated in U.S. stocks in 2000,
when the diversified approach beat the U.S. market by more than 22
percentage points. They would have missed the great return of a
diversified portfolio in 2002, when it outperformed U.S. stocks by 21%.
The next three years also saw the diversified portfolio beat a
concentrated U.S. stock holding, as commodities, real estate and foreign
stocks delivered solid returns.
The advantages of buy and hold are relatively straightforward-even if they're
not easy to appreciate during a market downturn. But what, exactly, are
the advantages of hanging onto a diversified portfolio?
One answer lies in
the mathematics of returns. Gains and losses are not symmetrical, and
the differences become greater with magnitude. A loss of 10% requires a
modest 11% gain to get back to the original portfolio value. But a 20%
loss requires a 25% gain, a 30% loss doesn't recover until the portfolio has achieved a subsequent 43% gain and a 50% loss doesn't get back to even until the battered portfolio has gone up 100%.
When a portfolio
holds different asset classes, which move up or down out of sequence
with each other (which, in the vernacular, are "not highly-correlated"), it tends to smooth out yearly investment performance. Portfolios that deliver smoother returns don't
have to experience extreme recovery to stay in positive territory. As a
result, they will have higher terminal values than choppier portfolios,
even if the average yearly return is the same.
Another answer
lies in the idea of reversion to the mean. When one asset class (like
U.S. stocks) is soaring, and everything else is lagging, that means the
soaring asset class is getting relatively more expensive than the
others. Eventually, prices will return to normal in both directions, and
the other investments will have their day in the sun. So when someone
abandons a diversified investment approach after years of
underperformance, she loses twice. She has already paid the "penalty"(so
to speak) for being diversified when diversified was losing to U.S.
stocks. Then, when she goes all-in on U.S. stocks, she loses the "benefits"that
eventually follow when those other asset classes go up faster than the
Dow. The late 1990s and early 2000s were a perfect example of this.
This can be summed up neatly by looking back at the investor's dilemma during the tech bubble. People who held a diversified mix of the four asset classes-U.S. stocks, foreign stocks, commodity-linked investments and real estate-enjoyed
a 13.05% average yearly return from 1994 through 1999. They achieved a
9.96% return in the subsequent five years, from 2000 through 2005.
Were they happier
with their higher return in the first five years? No. They were firing
their advisors, because the U.S. stock market happened to be gaining
23.55% a year, and they felt like losers. Were they unhappy with the
lower 9.96% yearly returns the diversified portfolio delivered in the
subsequent five years? No; in fact, they were ecstatic, because their
portfolios were outperforming at a time when the U.S. market was losing
value.
Of course, many
investors today are facing this frame-of-reference risk head-on. The
U.S. market has been booming since the bottoming out in March of 2009,
while the rest of the world has been mired in a recessionary hangover.
Commodities-most notably oil, but also gold-have been retreating lately. Real estate had a bad stretch after the Great Recession. It's
easy to question the value of those other assets in a portfolio with
the benefit of hindsight. But with the benefit of historical
perspective, the underperformance of broad asset classes usually
reverses itself, and we never know exactly when that will happen.
At times like we
are experiencing today, when the U.S. markets are enjoying a long
uninterrupted run of good fortune, frame-of-reference risk starts to
come out of the closet and threaten your financial health. All we know
about frame-of-reference risk is that, just like the more well-known
volatility risks, it lures investors to abandon their long-term strategy
at the wrong time-and when people give in to it, it becomes a net destroyer of wealth.
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Sincerely,
Bill Morrissey, CFP® and Tammy Prouty, CFP®
Sound Financial Planning, Inc.
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