Expat Investment Advice: How to Obtain Consistent Portfolio Returns
By Chad Creveling, CFA and Peggy Creveling, CFA
Investors generally claim they value consistent portfolio returns, but in practice often act in ways that increase both volatility and portfolio risk.
Why are consistent portfolio returns important?
Because strategies that consistently compound modest returns outperform investment strategies that generate more variable returns but also generate the occasional home run. A more subtle reason is that consistent performance makes it psychologically easier for investors to stick with their investment strategies over the long run.
Slow and Steady Wins
The table below shows an investment strategy that generates a return of 6% per year every year for five years compared with a more variable investment strategy that generates exceptional returns in some years but modest returns in others. The average annual return for both strategies is the same. The ending portfolio value is not. The consistent return portfolio has more wealth at the end of the period than the more variable return portfolio.
Why is this? A portfolio worth $100 that falls by 10% to $90 must earn an 11.1% return to get back to $100. The more variable the returns, the better the good years have to be to compensate for the bad years. This effect is amplified when adding the cash flows in and out of the portfolio.
In a recent study published by Financial-Planning.com, Craig L. Israelsen looked at the consistency of rolling five-year annualized returns for 12 major asset classes and a portfolio comprising each of the 12 asset classes in equal proportion. The time frame covered the 18-year period from 1998 to 2015, which included the financial crisis in 2001–2002 and 2008, and 14 five-year rolling periods.
Rolling 5-year annualized returns for 12 major indexes and a 12-index model over the 18-year period 1998–2015
Data source: Lipper; calculations by Craig L. Israelsen, "The Power of Portfolio Consistency," Financial-Planning.com.
Engines and Brakes
As expected, the equity asset classes provided higher average growth but higher volatility of returns. The fixed-income asset classes generated lower returns but much greater consistency.
Of 14 rolling five-year periods, the S&P 500 had five with a negative annualized return—three of which occurred sequentially in 2002, 2003 and 2004. Meanwhile, U.S. fixed-income asset classes had no five-year rolling periods with a negative return.
Perhaps more surprisingly, the 12-asset-class portfolio also had no five-year rolling periods with negative returns. Even more importantly, the portfolio produced returns nearly as high as the equity asset classes but with much lower variability of returns.
For the 12-asset-class portfolio, the equity provided the engine for portfolio growth while the fixed income acted as a brake against volatility.
The Only Free Lunch in Investing
Diversification provides about the only free lunch in investing. Unfortunately, many investors tend to chase recent performance, try to time the markets, and make investment decisions based on emotion and unrealistic time horizons. These are all behaviors that work against investors in the achievement of consistent portfolio returns.
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