Why do our clients at Total Wealth Planning not want us to provide investment performance like the S&P 500 Index? To answer this, it is important to understand the risks associated with a particular investment. Placing all of one’s assets in an index such as the S&P 500, which is concentrated in large-cap US companies, is a high-risk and volatile strategy. When working with clients, we gauge each individual’s capacity for accepting risk. We have an established process that begins with collecting responses to risk tolerance questionnaires. We then have discussions about their cash flow needs and determine how much risk each has experienced before becoming a client.
We have not had a single client indicate that he or she is willing to experience declines of 50% in value. Spoiler alert: accepting this amount of volatility is absolutely unnecessary and will likely provide disastrous results. In fact, over the last 25 years, the S&P 500 index has experienced losses of at least 50% on two occasions—once during 2000-2002 and then again in 2008. During these challenging periods, investors can rightfully lose patience with this investment, often selling after it has fallen in an attempt to protect what is left. Furthermore, this less diversified strategy often creates a cycle of market timing, and ultimately, underperformance.
At Total Wealth Planning, our approach is based upon Nobel Prize-winning research, which emphasizes a more diversified approach across multiple asset classes. This cutting-edge academic research proved what should appear obvious, but is often forgotten — that market timing does not work! It also proved that being appropriately diversified provides the best chance for success and is a superior approach to investing. This strategy is one we have implemented for clients for over 35 years so it is time-tested as well.
In terms of investment returns, if an investor experiences a 50% loss, it requires a 100% gain in order to recover all that is lost, which can be a tall order. Returning to the examples where these declines occurred in 2000-2002 and 2008, in both cases it took over five years for the S&P 500 to recover what was lost. If the investor was retired, and living on the portfolio, he would have been forced into selling this investment while values were down. This breaks the cardinal rule of investing, which is to never sell low, since it does not allow the opportunity for a recovery.
A traditional concept of investing is that more risk provides an opportunity for higher returns (and larger losses). When comparing our client portfolios to the S&P 500 Index, our strategies typically provide the desired effect of reducing volatility (i.e. are less risky). In other words, they “win by not losing”. With less risk, expectations should be for investment performance to be lower than the S&P 500. Interestingly, however, there are several extended periods where even with less risk, the diversified portfolio generates higher rates of returns, such as from 2000-2009. This occurs when the S&P 500 Index is not the best performing index, which is often the case. In fact, in the decade of the 1970s and the early 2000s investing in a money market fund would have provided a better return than the S&P 500 Index! A diversified portfolio would have significantly outperformed both of these, however.
A crystal ball would obviously be helpful when it comes to investing. Why didn’t investors place all of their money in Google before it grew, or Apple after they re-hired Steve Jobs? Even investing in the NASDAQ, which is an index of mostly technology stocks, would have been a great opportunity after the declines in experienced 2002 and 2008. However, without a crystal ball, and without the benefit of hindsight, it is best to limit risks and avoid an outcome where little or no investment return is generated for an extended period of time. Very real financial challenges could result where a retiree may need to go back to work later in life or reduce the standard of living, or both.
For comparison, the typical worst-case scenario for a diversified portfolio is that it underperforms an index for a period of time. However, most important, when this relative underperformance occurs, while it sometimes may not feel great, it is unlikely to result in jeopardizing one’s retirement goals.
In conclusion, it is essentially a trade-off: does Total Wealth Planning speculate on a particular index such as the S&P 500 and risk a tragedy? Or do we lower volatility with multiple asset classes and know that we will achieve a competitive rate of return and not jeopardize retirement goals? Clients come to us to achieve the latter!
About the Author: David D. Wilder CFP®, CTFA, MST, AIF®, CEPA – Principal & Chief Investment Officer. As Chief Investment Officer, Dave chairs Total Wealth Planning’s Investment Policy Committee and leads and manages the investment management team. He is primarily responsible for investment research, preparing and communicating Total Wealth Planning’s economic and investment outlook. As Principal, Dave is responsible for investment advice, with extensive client contact and client-relationship management. He has a Master’s in Tax Law (MST) from Villanova University and is a CFP®, a Certified Trust and Financial Advisor (CTFA), and a Certified Exit Planning Advisor (CEPA).
