Now that the stock market is again approaching record territory, our human nature is again making us feel like risk takers. If you're wondering just how risky your portfolio is, take a look at these numbers.
The last 40 Years
I turned to my friend Paul Merriman, and his outstanding web site FundAdvice.com, for the data on the past four decades of the markets. And based on Merriman's data, I developed this chart to illustrate just how much investors could have lost.
The worst case scenario is dependent upon what portion of the portfolio was invested in equities. For example, the worst 12 month period was only a 4.8 percent loss for a pure bond portfolio, but a 51.1 percent loss for a pure equity portfolio. A 50 percent equity portfolio lost 28.5 percent over the worst 12 month period.
Of particular importance was that time proved to be one heck of a diversifier over the past 40 years. In every case, the worst scenario over a 60 month period was better than the worst 12 month period. In fact, with the exception of the 100 percent equity portfolio, the worst 60 months was better than the worst single month.
Why your portfolio is probably riskier
Though I have full confidence in Merriman's data, this is a mathematical chart. Unfortunately, human beings are emotional rather than mathematical. Our portfolios are riskier for two reasons -emotions and expenses.
Emotions lead us to buy high and sell low. The Merriman data assumed the disciplined rebalancing I write about so often. So the worst 7.0 percent loss, over the worst 60 month period for a 60 percent equity portfolio, was based on the assumption that investors bought more stocks as they went on sale. Most investors, however, do just the opposite.
As an example, a 60 percent equity portfolio should be well over 10 percent higher than the 2007 pre-crash year-end close. In non-mathematical reality, few investors had the fortitude to buy stocks after the so called "black swan" end of capitalism in 2008.
Expenses also take from returns. Merriman assumed a one percent management fee and low cost vehicles in the returns. This is much lower than the average mutual fund with total costs of two percent.
Investing is risky - it always has been and always will be. If you can keep expenses and emotions in check, the odds are good that you will be rewarded for doing so. Merriman's data also shows that a 90 percent equity portfolio returned 12.1 percent annually while a 10 percent equity portfolio earned 7.5 percent annually.
Risk was rewarded, but only if investors had the discipline to keep costs low and their eye on the long range horizon and not on the Cramer's of the world. It seems to be unavoidable that most investors will generally do the wrong things. Successful investors know to buy equities when the herd is panic selling and then sell back to them when the herd gets greedy. It is these investors who can take comfort in Paul Merriman's data.