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What to say when clients ask, 'How is my portfolio doing?'

When clients ask how their portfolios are performing, advisors have a dizzying number of ways to answer. Over a five-year period. Over 30 years. Compared to a certain sample portfolio.

But some metrics are more useful than others. Here, I’ve highlighted several performance measurements that might help your clients trust the plan by encouraging them focus on longer time horizons and more intuitive risk measures.

As shown in “Performance Almanac,” we begin with raw performance over 11 different time periods that all end on Dec. 31, 2018. The individual asset class (there are seven in this analysis) with the best performance in each time period is highlighted in yellow. A multi-asset portfolio that equally weights all seven asset classes is in the purple column, while a typical 60/40 portfolio is in the column highlighted in green. Inflation data (the CPI) is also included in orange-red.

Israelsen-Performance almanac-June 2019 issue

The first performance time frame is the most recent three-calendar-year period from January 1, 2016, to December 31, 2018. The best performing individual asset class among this group of seven was large-cap U.S. stock (as represented by the S&P 500 Index) with a three-year average annualized return of 9.26% (that is a geometric mean return). The next closest asset class was small-cap U.S. stock (Russell 2000 Index) with a three-year return of 7.36%. The other five asset classes (non-U.S. stock, U.S. bonds, cash, real estate and commodities) each had considerably lower returns over this particular three-year period.

The seven asset portfolio (that was rebalanced at the end of each year) produced a return of 3.79% while the 60% large U.S. stock/40% U.S. bond portfolio had a 6.47% return. Finally, inflation grew at 2.04% per year between 2016 and 2018.

The dominance of large cap U.S. stock continues over the most recent five-year and 10-year periods — with real estate being a close second over the five-year period and small U.S. stock and real estate slightly behind over the 10-year period. Real estate (Dow Jones U.S. Select REIT Index) is the winner over the past 15, 20 and 25-year periods with small cap U.S. stock fairly close behind. Large cap U.S. stock is also close to real estate, except for the 20-year period from 1999 to 2018 when it lagged considerably.

Over the longer time frames (30, 35, 40, 45 and 49-year), the winner is either large cap stock, real estate or small cap stock. These three asset classes are clearly the “engines of growth” in a portfolio. Non-U.S. stock (MSCI EAFE Index) has had solid returns if looking at a time frame of 35-years or longer, but in more recent years this particular non-U.S. stock index has lagged the performance of U.S. stock significantly.

U.S. bonds (Barclay’s Aggregate Bond Index) has had a heyday over the longer time frames also, producing an average annualized return of 6.98% or better over the past 35, 40, 45 and 49-year time frames. This, of course, coincides with a precipitous decline in U.S. interest rates that began in 1982. Declining interest rates have provided a dramatic tailwind for U.S. bond returns. This tailwind might be turning into a headwind based on interest rate movement over the past 24 months.

Over the longer time frames (30, 35, 40, 45 and 49-year), the winner is either large cap stock, real estate or small cap stock.

U.S. cash returns (as measured by the 90-day Treasury bill) produced an annualized return of 4.8% over the past 49 years. However, in recent years, the return has been under one percent during several time frames.

The performance of commodities has been notorious in recent years, producing a disastrous average annualized return of -14.52% over the five-year period from 2014 to 2018. But, you will also notice that the CPI’s lowest return (or growth rate) of 1.52% also occurred during that time frame. That’s not coincidental. The performance of commodities (in this case the S&P Goldman Sachs Commodity Index) generally thrives when inflation heats up. Over the past 49 years, the performance of S&P GSCI averaged 6.51% – likely higher than many might have expected based on recent poor performance.

The seven-asset portfolio in this analysis produced a 9.48% average return of the 49-year period compared to 9.43% for the standard 60/40 portfolio. Both portfolios were rebalanced annually. There were, however, several advantages demonstrated by the seven-asset portfolio: A lower standard deviation of return over the past 30-year and 49-year periods, fewer occurrences of a negative calendar-year return (seven vs. 10), a higher average rolling five-year return (9.93% vs. 9.77%), higher average rolling 10-year return (10.23% vs 10.06%), and lower correlation with the S&P 500 Index (0.81 vs. 0.97).

Losses are Emotionally Painful

In the middle of the data table are three rows showing standard deviation of return measurements for each individual asset class as well as the two portfolios. Generally speaking, the lower the standard deviation the better. This is probably fairly well understood by those who had a statistics class in college. However, the absolute size of the standard deviation of any asset class or portfolio is not an intuitive fun fact that resides in nearly anyone’s head. For example, if you were to ask clients how much standard deviation is too much for them … 10% …15% ... 20%? Do you honestly think they would have the slightest clue how to respond?

Standard deviation figures are only valuable when comparing them against each other. As stand-alone measures, they are simply not intuitive because we don’t have a well-developed sense of standard deviation “range”. This is precisely why I’ve included four rows of “Draw Down” measurements in the middle of the table. These other measurements of risk are far more intuitive.

For example, the number of years with a negative return over the past 49 years is super intuitive. The percentage of time the asset class or portfolio produced a positive return is something even high schoolers can grasp. The worst one-year return, or what we might think of as the “emotional pain meter” is also easy to understand. As is the worst three-year calendar-year drawdown, which is a measure of how bad the overall loss was over a three-year period.

A dramatic spike in performance, while temporarily enjoyable, is worrisome because it reveals a roller coaster potential that will eventually come back to bite you.

For large cap U.S. stock, the worst three-year drawdown was -37.61%. It was only -13.37% for the seven-asset portfolio and -13.28% for the 60/40 portfolio. Portfolios with more than one asset class generally offer significant protection against large draw down declines. However, it’s important that the combined asset classes have low correlation with each other. This is why I’ve included the correlation coefficients for each asset class and portfolio relative to the S&P 500 Index in the last row of the table.

Rolling Performance

A very useful way of viewing past performance is over rolling time periods. This allows us to see the central tendencies of performance — not just what has happened recently. For example, the average rolling five-year return is shown in the bottom portion of the data table. There were 45 rolling five-year returns over this 49-year period from 1970 to 2018. The average return over those 45 rolling five-year periods was 10.76% for large cap U.S. stock and 12.15% for small cap U.S. stock. For the seven-asset portfolio it was 9.93%. Now, look at the next row down at the maximum five-year return (among those 45 rolling five-year returns). For large cap U.S. stock, it was 28.56% – or nearly three times higher than its average rolling five-year return. That type of dramatic spike in performance, while temporarily enjoyable, is worrisome because it reveals a roller coaster potential that will eventually come back to bite you. This is yet another way of assessing volatility.

By comparison, the seven-asset portfolio had a maximum five-year return of 18.38%, which is less than two times larger than its average five-year return. Large cap U.S. stock and the seven-asset portfolio produced fairly similar average five-year rolling returns, but the multi-asset portfolio did so with a more reasonable spike, suggesting that its downside will also be less painful. This is borne out in the “Worst One Year Loss” measurements and the “Worst Three-Year Calendar-Year Drawdown”. The multi-asset portfolios had substantially less painful downside losses compared to the individual asset classes of U.S. stock, non-U.S. stock, real estate and commodities.

Volatility really matters because clients have to live through it. And if there is too much or it lasts too long, they just may leave.

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