The downside of an up market: Are your clients’ expectations reasonable?
Establishing reasonable expectations is a critical part of handling a client’s attitude about their portfolios.
Ironically, bull markets can provide one of the greatest challenges with this. Indeed, unusually high returns can set expectations that are both unrealistic and unachievable over long time frames. On the other hand, during periods of poor stock performance, clients can become unduly pessimistic and may abandon their portfolio game plan, often at exactly the wrong time.
For instance, during the exuberant 10-year period from 1989 to 1998, the S&P 500 had an average annualized return of 19.2%. More recently, in the nine-year period from Jan. 1, 2009, through Dec. 31, 2017, the S&P 500 delivered an annualized return of 15.25%.
Does that level of performance represent a reasonable expectation? No.
The reality is that the average 10-year rolling return of the S&P 500 over the past 48 years has been 10.93% (6.65% after factoring out inflation). The performance of U.S. stocks from 1989 to 1998 and 2009 to 2017 was quite a departure from the longer-term reality. Sadly, investor expectations of performance can be upwardly mobile — even when such expectations are clearly unrealistic.
Here’s the problem: Too-high expectations can lead to performance chasing — and clients late to the game can get burned. Latecomers to the tech boom of the 1990s, for example, got creamed in 2000, 2001 and 2002.
Unrealistic upside expectations are hard to manage, and clients face a high probability of being disappointed even if their portfolio delivers what would otherwise be deemed an acceptable level of performance.
On the other hand, after a messy bear market, it can be difficult for investors to remember that investments actually do produce positive returns over the long term.
So what is a reasonable expectation for a portfolio? Let’s use the 10.93%, 10-year rolling return since 1970 as a reasonable return expectation. (Even if you don’t feel that figure represents a reasonable performance expectation, bear with me here.)
Let’s now examine how often a 100% large-cap equity-based investment portfolio has delivered performance close to that reasonable rolling 10-year return of 10.93%. (Obviously, an investment portfolio that consists solely of large-cap U.S. stocks is not diversified — more on that later.)
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To measure this, I imposed upside and downside performance bands of 500 basis points above and below the mean 10-year return of 10.93% (the upside and downside performance bands are shown by the red lines in the “Performance of a large-cap portfolio” chart). This created an upside 10-year performance limit of 15.93% (10.93% plus 5%) and a downside 10-year performance limit of 5.93% (10.93% minus 5%).
As shown in the chart, a 100% large-cap stock portfolio was outside of the 500 bps limits 36% of the time (14 of the 39 rolling 10-year periods).
In other words, nearly 40% of the time, the large-cap portfolio produced returns that were significantly different from the mean 10-year rolling return. Since 2005, the rolling 10-year returns have been lower than the average 10-year return of 10.93%. In fact, during the 10-year periods that ended in 2008 and 2009, the rolling 10-year return for the S&P 500 was negative. This is the type of downside performance volatility that can rattle even the most resolute investor.
Now let’s consider the rolling 10-year performance of a multi-asset portfolio that includes seven equally weighted portions of large-cap U.S. equity, small-cap U.S. equity, non-U.S. equity, real estate, commodities, U.S. bonds and U.S. cash (see the “Performance of a multi-asset portfolio” chart). Clearly, this represents a more diversified portfolio than simply investing in large-cap U.S. stock.
A diversified portfolio that was rebalanced annually generated a mean 10-year rolling return of 10.33% over the past 48 years. But, unlike the 100% stock portfolio, the multi-asset portfolio has delivered more consistent 10-year rolling returns. In only 28% of the periods (11 of the 39 rolling 10-year periods) was the 10-year rolling return outside of the 500 bps bandwidth limit.
And when it was outside the limit, the departure was quite minor — on both the upside and downside. Unlike the U.S. large-cap portfolio, a multi-asset portfolio never produced a negative rolling 10-year return. Furthermore, the lowest 10-year return was 3.19% for the 10-year period ending in 2016.
Of course, there is a trade-off when building a diversified portfolio. You’ll notice that the multi-asset portfolio never had the 10-year annualized returns near 20% that the 100% large-cap U.S. stock portfolio generated in the late 1990s. For some investors, missing the upside can be as painful as experiencing the downside — perhaps because their ego is at stake.
This is where client education can, we hope, create the proper expectations. When building a diversified, multi-asset portfolio for a client, it’s vital that the advisor inform the client that the performance benchmark is not the S&P 500 — despite the fact that the index is often cited as the “stock market return.”
The S&P 500 is a perfectly acceptable benchmark for a client who has a 100% large-cap portfolio. If the client’s portfolio is diversified, however, it’s crucial that an appropriate performance benchmark be identified and communicated to the client. Failure to do so creates a situation where performance expectations become misaligned. In short, if you build a multi-asset portfolio, use a multi-asset model or multi-asset index as the performance benchmark.
To summarize, having a multi-asset investment strategy and the courage to stick with it during up and down markets is a characteristic of successful investors. Long-term investors learn that portfolios ultimately regress to their mean, particularly as the investment holding period lengthens.
For equity portfolios, that mean return is somewhere around 10% for periods of 20-plus years. But, as we have seen, a 100% equity portfolio can experience significant performance variation above and below its mean return over shorter time frames.
It’s precisely that variation that can lead otherwise logical clients to engage in unwise behaviors, such as selling low and buying high. Conversely, portfolios that utilize broad diversification generate returns that are far more stable, and thus consistently closer to the expected mean return. This type of stability is likely to produce a better experience for the client.
When expectations are reasonable, appropriate benchmark indexes have been selected and portfolio performance is less volatile because of broad diversification, the advisor-client relationship can be much less volatile as well.