April 28, 2022
Written By: Andrew Hallam
Everyone knows how it feels to ride a bike with a flat tire. Perhaps you pulled a long-neglected bike from your garage. You were 12 years old, hankering for a chocolate bar, and it was the only way to get to the 7-11 corner store.
Or perhaps you were flying along with the breeze in your hair and the tire exploded under a pile of broken glass. Either way, riding with a flat takes a heck of a lot of effort.
When I was a young bike racer, my fellow competitors and I bought tires that could handle maximum pressure. Bicycles with really low tire pressure, as most people know, are really tough to pedal. Pump them up hard and the bike rolls well. That was why we Tour de France dreamers grunted over our pumps. Before every race, we forced 120 psi (pounds per square inch) into those skinny tires.
At the time, it didn’t make sense to stop at 80 psi. That would slow us down. At least, that’s what we believed. However, tires with higher air pressure burst more easily. Sometimes, they even blew right off the rim. This happened to me more often than I can count. I still remember leading a pack of hungry riders close to the finish line. I then hit a sharp stone, a thorn or a chunk of glass. And when my tire blew, my competitors streamed by. I was the fastest on that day, but that didn’t mean a thing. If I had less pressure in those tires, I likely would have won.
How fast a tire rolls, and how well a bike racer performs can be two separate things. The racer with the highest-pressure tires takes more risk. Sure, their wheels might roll a bit faster. But if they don’t make it to the finish, or they lose precious time changing a flat, they’ll likely lose no matter how tough their thighs.
This is similar to investing. For example, a portfolio allocated 100 percent to stocks is like a high-pressure tire, running 120 psi. Sure, over time it’s supposed to roll further than a balanced portfolio of, say 80 percent stocks and 20 percent bonds, or a traditional 60/40 portfolio. But how the allocation performs and how the investor performs are often two different things.
For example, during a 30 or 40 percent global stock market decline, a portfolio allocated 100 percent to a global stock index will fall 30-40 percent. Not only does the investor suffer a puncture, but such declines could also break their spirit. Such an investor might vow to “dollar-cost average no matter how stocks perform,” but emotions can derail the best-intentioned plan. The investor might hesitate to get back on their bike until markets return “to normal.”
This is common, and it can cost investors money as they sit on the sidelines, waiting for prices to rise again. Or, even worse, they are lured to speculate. They might be tempted to buy gold or Bitcoin in an often-fruitless effort to reduce short-term losses.
Most investors overestimate their tolerance for market volatility. They believe they can ride out anything until a blow brings them down.
In contrast, a portfolio that includes a bond market index is like a rider running tire pressure of 70-80 psi. Such lower-pressure portfolios (and riders) have lower odds of getting flats. For example, if the stock market crashed 30-40 percent, their portfolios wouldn’t fall as far. Psychologically, this can help investors stay on the road.
If you believe I’m a wimp who’s simply making this up, that’s good. Skepticism is important. Morningstar’s research, however, says there could be something to this. First, let’s look below at how three portfolios performed over the 25 years ending December 31, 2021.
How Did The Allocations Stack Up?
25 Years Ending December 31, 2021
|100% US Stock Index||80% US Stock Index, 20% US Bond Index||60% US Stock Index, 40% US Bond Index|
|Compound Annual Return||10.18%||9.47%||8.54%|
The fund rating company, Morningstar, takes great interest in assessing how funds perform, compared to how investors perform in those funds. Like bicycle racers with different tire pressures, they often aren’t the same thing. For example, the ten years ending December 31, 2020 should have been easy on investors’ nerves. Over that decade, US stocks experienced just one calendar year decline: a drop of just 5.26 percent in 2018.
It’s rare to have a decade with only one calendar year decline. Psychologically, that was one of history’s easiest decades to be invested 100 percent in stocks.
Yet, Morningstar found that investors in 100 percent equity funds and ETFs underperformed the performance of their funds by quite a bit. If we average investors’ underperformance in US stock market equity funds, international equity funds, and sector funds, investors underperformed their funds by an average of 2.17 percent per year over the ten years ending December 31, 2020.
Morningstar also found that over the same 10 years, investors in balanced (multi-asset class) funds underperformed the posted returns of their funds by just 0.69 percent per year. In other words, diversification helped these investors stay the course.
If Morningstar’s research extended over 25 years (from 1996-2021, as per the table above) the behavioral difference between how equity fund investors performed, compared to their funds themselves, would likely have been worse. After all, this 25-year period included two painful bear markets: 2000-2002 and 2008-2009. In other words, it’s entirely possible that the average investor with a balanced allocation beat the average investor with 100 percent stocks.
Even though an allocation of 100 percent US stocks beat an allocation of 60 percent stocks, 40 percent bonds by 1.64 percent per year (from 1996-2021) if the balanced allocation gave the more conservative investors a behavioral advantage of more than 1.64 percent per year, they would have beaten the average investor with high pressure tires.
Broad diversification, after all, helps calm investors’ nerves. And that’s what’s most important: staying on the road; continuing to pedal; adding regular sums to portfolios through thick and thin. Or, if such an investor were retired, maintaining their nerve and withdrawing something close to an inflation-adjusted 4 percent per year.
Investing is simple. But our emotional makeup means it’s rarely easy. So, consider the risks of investing 100 percent in stocks. History says these portfolios roll well, long term. But the most important question is, “How well do you roll?”
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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