When discussing investing options, the single most common referenced metric has got to be the average return. Reams of books and blogs have been written on individual asset classes and composite portfolios with the highest average returns looking both backward and forward, and amateur and professional investors alike spend more time than they probably want to admit thinking about how to maximize their own average return. Long-term averages are both set on a pedestal and also taken for granted, as many people idolize the average to the point where they’re willing to ignore very real risks under the belief that superior performance is inevitable if they only wait long enough.
But what happens when the long-term average return never manifests in your own portfolio even over extended timeframes? Was the data wrong? Did the markets change?
As I blindly swung my arm to swat at the tedious drone of the alarm on the night stand, it was pretty much a morning like any other. I labored out of bed, trudged my way through the early routine on autopilot, and set out on my long morning commute down highway 280 towards San Jose. I always found that stretch of road to be an interesting experience in dual realities, as the stunning views of the bay and surreal scene of clouds pouring over the mountaintops were all too often completely hidden by relentless inner thoughts of important job tasks needing immediate attention. Silicon Valley attracts a certain type of always-on engineer and actively feeds their obsessions, and my blossoming career as a successful product designer at a job I loved had long since shaped me into eager, if anxious, submission.
For anyone not paying attention to the news, the Mega Millions lottery in the United States just topped a billion dollars and is quickly rising even higher. You read that right — a Billion with a B. For the meager price of a $2 ticket, some lucky person will eventually break their way onto the list of the world’s wealthiest people. Talk about an impressive return on investment! Of course the odds of actually winning that money are beyond astronomical, and one in 300 million is a difficult number to even comprehend.
Every once in a while life takes the opportunity to throw you a curveball and dump some good financial fortune in your lap. Whether it’s a bonus at work, a family inheritance, or a lucky night in Vegas, an influx of cash is generally a welcome sight. But because of the rarity of these life events, most people are usually caught a bit off guard and are unprepared for what to do next. Set aside for a moment the fantasies we all have about crazy things we might do if we won the mega lottery — what exactly is one supposed to responsibly do with a financial windfall?
I don’t think many people will be surprised to learn that I’m not a fan of using single averages to describe portfolio returns or over-simplified metrics like standard deviation to measure risk. Both of those numbers obscure so much information that they often lead to disappointing investing decisions and give backtesting a bad name. I personally have a much more nuanced perspective that embraces the idea of unpredictability in financial planning while keeping things in terms that make sense in the real world, although I’m well aware that uncertainty is a very difficult concept to understand and an even more difficult one to apply.
So sometimes even the simplest questions can trip me up. For example:
What expected return would you use for the Three-Fund Portfolio for your own financial planning?
A fellow Boglehead asked a really good question recently, and I think it’s something we’ve all considered at some point:
Why shouldn’t my asset allocation be 100% stocks during the accumulation phase?
After all, the typical justification for a heavy stock portfolio sounds pretty darn compelling. They historically have a higher return than bonds in the long run, which means bonds are defensive assets that reduce volatility but do not necessarily increase returns. On top of that, interest rates are so low today that bonds look particularly unappealing. So if you can handle the bad years and pile as much money into stocks as possible you’ll be much better off and can feel free to be defensive with a larger pile of money once you retire.
Well you know what? If you’re the type of investor with a rock-solid stable job, few financial commitments, and the personality to ride out both short-term and prolonged market pain without sweating your account balances, then putting all of your money in stocks is just fine. The Total Stock Market portfolio is included on the site because I appreciate that it’s a good choice for many people.
But I’m going to go out on a limb and surmise that you’re reading a blog about portfolio theory because you believe that just maybe there’s another side to the story. You’ve come to the right place, as I’m a strong believer in the power of asset allocation in creating positive and pleasant investing outcomes. So for those interested in a different perspective, I’d like to try my hand at making the case for broad asset allocation in all phases of life.
Why consider diversifying away from stocks not just tomorrow but today?
One of the things I’ve always found interesting about engineering — whether it’s making a new product or creating new spreadsheets — is that it’s a continuous learning process. One new design may address an old question but raise a new one, and the search for new insights continues. Sometimes working on a tool requires new methods that are interesting in their own right, and developing them can lead to new ideas you weren’t even looking for.
Financial independence – the concept of establishing a sustainable system where your investments can cover your expenses, making work optional – is an issue of particular interest to me, and from the popularity of the Withdrawal Rates calculator I gather that it is for many others as well. Of all the things money can buy, I have a difficult time imagining something more valuable than the freedom to live on your own terms free of financial worry. While I’ve previously discussed the effect of asset allocation on the retirement half of the FI equation, the natural next question is:
Talk about portfolio growth rates for long enough and people start to glaze over. Numbers get compartmentalized, and the concept of risk gets hazy. After all, if you’re a long term investor you can afford to have have a high risk tolerance, right? Common advice is that if you hold onto your investments long enough, you’re virtually guaranteed a good return.
Like most things in popular finance, I believe that’s a gross over-simplification. So let’s look at a savings and investing example in real-life terms — saving for a college fund. Let’s assume that a proud new parent named Sarah wants to put away enough money each year to save $100k in today’s dollars in 20 years (the absolute amount will be much higher than that due to inflation). How much should she save, and how should she invest the money?