.
Value: 13.30%
Best / Worst Returns:
Growth: 51.19% / -30.26%
Value: 46.03% -21.77%
•
A Look at a Diversified Equity Portfolio
For the sake of comparison, let's take a look at what a diversified 100% equity portfolio looks
like. For this illustration, the portfolio consists of:
35% Russell 1000 Growth Index
35% Russell 1000 Value Index
15% Russell 2500 Index
15% MSCI EAFE Index
-2007 AVG.
1988
High
MO
The first thing you'll probably notice is the lack of extremes. A diversified equity portfolio, while
never the top performer, was also never at the bottom either. This portfolio held in a narrower
range just above the midpoint. So, by investing in value, growth, and some foreign stocks, you
take out the extremes and have a portfolio that isn't nearly as volatile as holding just one or two
asset classes.
Average Annual Return: 11.59%
Best / Worst Return: 32.88% / -20.25%
A Look at a Balanced Portfolio
So far we've taken a look at a few individual asset classes and a 100% stock portfolio, so what
happens when you add some bonds into the mix? For this portfolio, we're going to look at
holdings of 45% stocks and 55% bonds. The portfolio holdings include:
• 15% Russell 1000 Growth
30
believe analysts can outperform average stock market returns by finding value
others have missed or that the stock market is efficient and leaves no money on
the table?
-
Reading
The Benefits of Diversification: A Look Back at the Past 20 Years of
Stock Market Performance
http://genxfinance.com/diversification-and-stock-market-performance-history/
A Properly Diversified Portfolio Will Help You Capture Most of the Market's Gains
While Reducing Volatility
Diversification is the single greatest factor in determining long-term investment returns. Don't
put all of your eggs in one basket. You've probably heard that phrase before, and for good
reason. When investing, the less diversified you are, the more risk you're generally taking.
Investing in a single stock can provide tremendous returns, but it can also wipe out most of, or
your entire investment. Even if you don't invest in a single company, the same can be said
about investing in just one asset class or sector of the market. While the chances of your
investment dropping to zero is greatly reduced, you'll be sure to experience a good deal of
volatility. Some years will be great, while others will leave you in the dust as other types of
investments perform better.
This is where diversification comes in. As you spread your money out across different stocks
and different asset classes, you're in a better position for weathering the inevitable volatility of
the markets. Some of your holdings will be up, and others will be down. But instead of betting on
one or two and hoping for the best, you can take a hands-off approach that will allow you to
realize most of the market's gains while minimizing the impact of losses.
The Periodic Table of Investment Returns
Below, I want to introduce to you one of the best ways to illustrate the importance of
diversification. It is called a period table of investment returns. To begin, I want to show the table
in its entirety. I've included some of the most popular asset classes, and you can click on the
image to see a full-size version. This table covers the past 20 years.
1988
-2007 AVG.
High
34
S KOOS
EL
de
946
&
X
V x2000
72
O 000
2010
OUVRE
02
23
OPEA
FUL
KOKYO
2104
ons 20000 2000
996
22
66
UN
2000 OG Oro 2006 OK
5829 1902
Sri
3
2000
2009
.22
414
CAN
03
SO
05
393
800
2
R3000
38
12
or
See
3000V
8.43
O S 00S 00005
243
repare 20000
es
32L
Aandoy Rootv
Low
000
22:47
2006
(The last column is "average return".)
28
bottom with roughly 6-8% annual returns. You can project back even further, and the overall
average returns will not differ much.
So, if you invest in stocks over the long run, you're bound to do pretty well. But what you have to
decide is how much volatility you are willing to stomach. If you don't mind 20% returns one year
and the possibility of 20% losses the next, then you can be comfortable in an aggressive 100%
stock portfolio. If you like the high return of stocks, yet aren't comfortable with such drastic
performance swings, then a more balanced portfolio may help you stay the course. You'll still
see the bulk of the upside, but significantly minimize the downside, and reduce your volatility a
great deal. A good 401k plan should have enough investment options to allow you to create a
diversified portfolio that works for you, or many of the target date funds accomplish the same
thing.
(The following table shows the performance of S&P500 (Large Stock portfolio)]
1988
-2007 AVG.
High
Low
S&P 5000
Diversified Balanced
Portfolio
Lipper General US
Government Funds
Average
Russel 20000 Value
Diversified Equity
Portfolio
Lehman Brothers U.S.
Aggregate Bond Index
Russell 20009 Growth
MSCI World
MSCI EAFE
S&P Goldman Sachs
Commodity Index TR
So, what can we gather from this at first glance? It becomes fairly obvious that there are no
easily recognizable trends. Some of the colors are all across the board. Just look at the Russell
2000 Value block. On more than a few occasions, it would go from one of the best performing
one year to nearly the worst the following year, and vice versa. And at only 3 times over the past
20 years did one asset class remain the top performer for two years in a row. You can already
begin to see that by investing in a narrow band of companies or an asset type, you're probably
going to experience a good deal of volatility. But, let's examine this chart in a little more detail.
Value vs. Growth Stocks
Both the growth and value monikers come from the fundamental analysis of companies. Value
stocks are companies that are relatively cheap when compared to its peers, have a low P/E
ratio, and tend to offer dividends. Value stocks tend to be mature companies that are not as
focused on rapid growth of the company. On the other hand, growth stocks tend to be just the
opposite. They may be priced relatively higher with higher P/E ratios and are generally younger
and focused on growing the company. This means it is not likely the company will issue
dividends, and instead reinvest in the company to spur additional growth. Two different types of
companies, so let's see how they did over the past 20 years:
1988
--2007 AVG.
High
ROSO
RXU
2000
COM
Vo
20000
16€
w
000
UT
22
24
.
200
28
GO
.
21.03
You may find this shocking, as there are quite a few instances where in the same year, there
can be a significant disparity between these two types of stocks. They are, after all, both stocks.
People tend to think that investing in stocks is investing in stocks, but as you can see,
depending on what type of stocks you invested in, you could have wildly varying results. In
some cases, one may have outperformed the other by 20% or more in the same year, and in
some years, one saw a significant positive return, while the other saw a substantial loss. Again,
this clearly illustrates why it may not be a good idea to put all of your eggs into one basket.
Average Annual Returns:
Growth: 8.81%
29
Reading
Stock Market Strategies: Are You an Active or Passive Investor?
ECONOMIC RESEARCH
FEDERAL RESERVE BANK ST. LOUIS
"October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July,
January, September, April
, November, May, March, June, December, August, and February.
-Mark Twain
If you ever ask an economist which stocks to buy, chances are you won't get a
specific answer. Instead, you might hear about the "efficiencies" of markets. In fact,
there's an old economics joke about market efficiency: Two economists walk down
a sidewalk-one is older and wiser and the other is younger and less experienced.
The younger economist says, "Look a $20 bill" and bends down to snatch it. The
older economist says, "Don't bother! It can't be real or someone would have
already picked it up."
The joke is meant to exaggerate the belief held by many economists that markets
quickly adjust to new information. Financial markets are said to be "efficient" if
they leave no "money on the table" for very long. If there's an opportunity to make
a profit, buyers and sellers will swoop in and take it. Hence the joke--a $20 bill left
on the street for any length of time might not be a real $20 bill at all.
Making Money in the Stock Market
Savers have many investment options to choose from. Investing in stocks has risks,
but over time, the stock market tends to have higher average returns than other
popular investment options (see the boxed insert "Stock Market Returns Over
Time"). Investors earn money on their stock purchases through dividends and
capital gains. Dividends are shares of a company's net profits paid to stockholders.
Dividends are often paid quarterly and are commonly associated with established,
profitable companies. Capital gains are the profit from the sale of a financial
investment-for example, when a stock is sold for more than the original purchase
price.
Stock Market Returns Over Time
Historically, average returns for stocks (as indicated by the S&P 500) have been higher than for other investment options, such as govern-
ment bonds leg.3-month Treasury bills IT-Bells) and 10-year Treasury bonds IT-Bonds]).
Year's
S&P 500
3-Month T-bills
10-Year T-bonds
1928-2015
Since 1928
9.50%
3.45%
4.96%
1966-2015
9.6196
4.926
Last 50 years
6.71%
2006-2015
Last 10 years
7.25%
1.14%
4.7195
NOTE: Data are geometric averages.
SOURCE: Damodaran, Aswath. "Annual Returns on Stock, T.Bonds, and T.Bills: 1928-Current." New York
University Stern School of Business, January 5,
2016; http://pages.stern.nyu.edu/~adamodar/New_Home Page/datafile/histretSP.html. FRED (Federal
Reserve Economic Data), Federal Reserve Bank of St. Louis.
Every investor hopes to earn high returns-dividends plus capital gains-while
minimizing risk. An effective way to minimize the risk of investing in stocks (a
relatively risky financial asset) is to diversify. Diversification means to invest in
various financial instruments-not just a specific one. So a diversified
stock portfolio could include stock purchases across industries, company size, and
even geography. Diversification reduces risk because it is unlikely that all the
stocks in a portfolio will react the same way to market events. For example, if you
invest all of your money in the stock of a single company that owns several beach
resorts along the Gulf of Mexico, a severe hurricane could devastate your portfolio.
In other words, don't put all your eggs in one basket.
One financial instrument designed to provide investors with diversification is a
mutual fund. A stock mutual fund is an investment product that pools the money
of many investors to purchase a variety of stocks to make a profit for the investors.
Most investors simply don't have the time or money to create and manage such a
fund on their own, so mutual funds offer a cost-effective way to diversify. A variety
of stock mutual funds are available based on different investment strategies (e.g.,
growth funds or value funds-see the boxed insert "Stock Fund Investment
Strategies") and management strategies (active or passive).
Stock Fund Investment Strategies
Growth fund managers focus on investing in companies expected
to have faster-than-average growth-and higher-than-average
returns. These companies tend to be riskier than average.
Value fund managers focus on investing in companies with stock
prices that suggest they are undervalued. These companies tend
to be mature companies that pay dividends and are less volatile
than companies selected for growth funds.
Investment Management Strategies: Active and Passive
The active management investment strategy relies on a staff of highly paid analysts
to build a portfolio of stocks. The goal is to earn high returns that "beat"
(outperform) the stock market. Such analysts use research, forecasts, and
judgment to recommend whether to buy, hold, or sell the given stocks. Analysts
are always on the lookout for the best values or companies with strong growth
prospects. Active investing relies on differentiating between a stock's value and the
market price. Warren Buffett-often called the most successful investor in the
world-says, "price is what you pay; value is what you get." A stock's value is based
on projected future earnings and growth prospects for the company. If a stock is
determined to be undervalued-that is, believed to have a greater value than
indicated by its market price-managers will buy it for their mutual fund. When the
stock price rises above its value, they will sell it and earn capital gains for investors.
Fund managers might also sell stocks in the portfolio that are predicted to
underperform the market. This buying and selling accrues transaction
costs (which reduce net gains). The most successful mutual funds are those that
consistently outperform average stock market returns.
The passive management investment strategy is based on the efficient market
hypothesis (EMH), which states that a stock's current price reflects all relevant
information about its current and future earnings. How is this possible? Stock
prices change when information about the company (or the economy) changes.
Imagine you hear the reporter on your favorite stock market news channel
announce Chatport Technologies has just received a patent on a revolutionary new
product. You consider buying Chatport stock because you predict the new product
will reap huge profits for the company and its shareholders. Just as the reporter
says the words "received a patent," the graph on the screen shows the stock price
has increased 10 percent. As it turns out, you were not the only investor who, upon
hearing the news about Chatport, decided the stock was undervalued and is willing
to pay a higher price for the company's stock.
When news indicates a stock is undervalued, market participants respond by
buying the stock, bidding its price up to its fair value. When new information
25
indicates a stock is overvalued, investors quickly sell, putting downward pressure
on the stock price, moving it back to its fair value. The EMH says that new
information about a stock is "priced in" almost instantly-raising or lowering its
price. For this reason, the EMH says the market price is the best reflection of a
stock's value based on current, available information. And, if prices reflect all
available information, EMH suggests that the best strategy is to buy and hold a
diversified portfolio and to minimize investment costs.
The passive strategy holds that the stock market is so efficient that active
managers will not consistently beat the market because they will not be able to
consistently pick undervalued stocks. And the extra research and transaction costs
involved with actively managed mutual funds (which are passed on to investors)
will offset gains. Although some actively managed mutual funds do outperform the
market, data consistently show that a majority of them fail to outperform market
averages reported by various indexes (such as the Dow Jones Industrial Average,
Standard and Poor's (S&P) 500, and Wilshire 5000).
Application of EMH: Index Funds
One type of mutual fund that follows a passive management strategy is an index
fund. The goal of an index fund is to "replicate the market," by simply buying the
stocks included in a stock market index, such as the S&P 500 index. For example,
for a given index fund, if Chatport Technologies were to represent 1 percent of the
value of the S&P 500 index, the index fund manager would invest 1 percent of the
mutual fund's assets in Chatport stock. The S&P 500 index includes 500 of the
largest publicly held companies in the United States, which means that mutual
funds that replicate the S&P 500 index hold a diversified blend of large company
stocks. An advantage of index funds is generally lower investment costs: Rather
than paying the research and transaction costs of active management, index fund
managers simply buy and hold the stocks on a given index. Some research
estimates that passive investment strategies save U.S. investors around $100
billion annually-one of the reasons economists tend to favor index funds over
picking individual stocks.7
NOTE: The S&P 500 has increased 215 percent from its lowest closing value during the Great Recession
(676.53 on March 9, 2009) to its most recent high (2130.82 on May 21, 2015).
SOURCE: S&P Dow Jones Indices LLC, S&P 500© (SP500). Retrieved from FRED (Federal Reserve Economic
Data), Federal Reserve Bank of St. Louis, February 29,
2016; https://research.stlouisfed.org/fred2/graph/?g=3gAs.
Conclusion
Investors who choose to invest in stocks through a mutual fund have a decision to
make. Do they prefer an active or passive management strategy? Mutual funds that
use an active management strategy rely on the research skills of analysts to
differentiate between a stock's value and its market price. Index funds, which use a
passive management strategy, rely on the efficiency of the stock market to price
stocks at fair value. Both types of mutual funds provide investors with diversified
portfolios of stocks. In the end, the choice is up to individual investors: Do they
26
believe analysts can outperform average stock market returns by finding value
others have missed or that the stock market is efficient and leaves no money on
the table?
-
Purchase answer to see full
attachment