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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

Invest with Your Eyes Wide Open

Are you prepared for volatility? Before you make an investment, look carefully at its track record by asking these five questions.

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Many investors are convinced that their investment portfolios should always go up. When returns don’t meet these unrealistic expectations, they tend to throw in the towel. It’s a mistake to sell good investments just because they are having a sluggish year or struggling through a bear market. You need to invest with your eyes wide open, knowing beforehand what to expect from your investments in both bull and bear markets. In most cases, when your investments take near-term dips, or fluctuate with the market, you should stay invested and hold on.

SEE ALSO: Be More Like Warren Buffett, Less Like You, When Investing Your Money

Most investors ask only one question before buying a portfolio of investments: “What will my return be?” Usually, they answer this by looking at recently posted one-year returns. Stopping at this question will likely leave you disappointed at some point during your investment journey.

In addition to knowing what the returns of your investments have been recently, be sure to ask the following:

  • What has the portfolio returned on average over the past one, three, five and 10 years?
  • What was the best and worst three-month period during the past 10 years?
  • What was the best and worst one-year period during the past 10 years?
  • What was the best and worst three-year period during the past 10 years?
  • How has the investment performed during past wars, bear markets, terrorist attacks and elections?

As an example, let’s answer these questions assuming you had a moderate portfolio consisting of 75% stocks and 25% bonds, such as a combo of Vanguard Total Stock Market Index Fund (Ticker: VTSMX) and Vanguard Total Bond Market Index Fund (VBMFX), rebalanced annually. You would have enjoyed an average return of 11.98%, 7.43%, 11.14%, and 7.06% over the past one, three, five and 10 years (according to Morningstar) for the period ending 8/31/2017. However, to obtain that 7.06% 10-year return you would have had to endure a worst three-month period watching the portfolio fall 23.45%, a worst one-year period with a drop of 32.03%, and a three-year period that lost 3.98% per year. For the 10-year period ending 8/31/2017, a $500,000 investment into this portfolio would now be worth $999,194.

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Once you know the answers to these questions, you can then ask yourself an even more significant question: “If I want the long-term returns this investment or portfolio can produce, can I withstand the volatility?”

See Also: Time to Take Stock Profits? 4 Steps to Consider Now

Without understanding this risk from the onset, volatility will likely get the best of you somewhere down the road.

Let’s investigate the market’s ups and downs during different periods.

The chart below compares eight different investors. All began investing on Jan. 1, 2008, with $500,000. The first four investors took withdrawals of $20,000 per year starting in 2008. The last four investors didn’t take any withdrawals. You’ll notice how much their portfolios fell in 2008-09 and how long it took to get back to $500,000. Based on this chart you can ask yourself which portfolio is closest to yours and whether or not you could handle similar volatility in the future. This was a really poor period in market history, however, you’ll notice that all the portfolios rebounded after 2008 and went on to provide modest returns.

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Stocks: 80% Total U.S. Stock Market Index Inv (VTSMX) and 20% Vanguard FTSE All-World ex-US Index Inv (VFWIX)
Bonds: 100% Vanguard Total Bond Market Index Inv (VBMFX)
Note: Each portfolio was rebalanced annually, withdrawals occurred at year-end based on allocation

Remember to take downturns in context. Listed below are the worst one-year results for different segments of the stock and bond markets from 1970 to 2016. For example, during the 1973–1974 recession, large-company stocks fell 37%. An investor would have been shortsighted to have sold a portfolio of large-company stocks after these poor-performing years. In the following two years (1975–1976), large-company stocks provided patient investors with 37% and 24% returns, respectively. A $10,000 investment in an S&P 500-stock index fund starting in January 1970 would have grown to $1,002,783 by December 2016, a return of 10.30% per year.

Risk and Return of the Stock and Bond Markets

1970-2016
Asset ClassAnnual Rate of ReturnWorst Year
Large-Company U.S. Stocks10%-37%
Small-Company U.S. Stocks12%-38%
International Stocks9%-43%
Long-Term Corporate Bonds9%-7%
Long-Term Government Bonds9%-12%
U.S. Treasury Bills5%0.03%

Let’s examine risk further by looking at drops occurring during market downturns, wars and terrorism. Again, the question in mind is: If we had similar volatility in the future, could I handle it?

Market Downturns

S&P 500 Index
Market Downturn   Total MonthsTotal Return
S&P 500
Total Return
One Year Later
BeginEnd     
Jun 15 '48Jun 13 '4912.1-20.6%42.1%
Aug 2 '56Oct 22 '5714.9-21.5%31.0%
Dec 12 '61Jun 25 '626.5-27.8%32.3%
Feb 9 '66Oct 7 '668-22.2%33.2%
Nov 29 '68May 26 '7018.1-36.1%43.7%
Jan 11 '73Oct 3 '7421-48.2%38.0%
Nov 28 '80Aug 12 '8220.7-27.1%58.3%
Aug 25 '87Dec 4 '873.4-33.5%22.8%
Mar 24 '00Sep 21 '0118.2-36.8%-13.7%
Jan 4 '02Oct 9 '029.3-33.8%33.7%
Oct 9 '07Nov 20 '0813.6-51.9%45.0%
Jan 6 '09Mar 9 '092.1-27.6%68.6%
Average  12-32.3%36.2%

War

Dow Jones Industrial Average (DJIA)    
WarBeginEndTotal MonthsChange in DJIA
World War lApr '17Nov '1820-19%
World War llDec '41Aug '454541%
Korean WarJun '50Jul '533720%
Vietnam WarAug '64Jan '7310221%
Gulf WarJan '91Feb '91215%
Iraq WarMar '03Dec '1110543%
Average    5220%

Terrorism on U.S. Soil

S&P 500 Index
Attacks of September 11, 2001Days after AttackTotal Return S&P 500
Initial Market Reaction
September 17, 2001
7-4.9%
Market Bottom after Attack
September 21, 2001
11-11.6%
One Month after Attack
October 11, 2001
300.4%
Two Months after Attack
November 10, 2001
602.5%
Three Months after Attack
December 10, 2001
904.3%

Despite all the recessions, wars, terrorist attacks and market crashes, the stock market has been an excellent investment over the long term. The key is to stay invested through thick and thin. When you invest in a portfolio of stocks and bonds, be aware of the potential upside and downside associated with your investments. If you don’t understand the risks at the outset, you are more likely to react poorly during periodic market setbacks and get scared out of the market.

At the outset when you buy an investment, you should plan on worst-case scenarios occurring at some point. If you understand the risk from the beginning, you are more likely to stay invested for the long term and realize solid long-term gains. It is true that past performance isn’t guaranteed to repeat, but it does give us a historical indication of what to expect.

See Also: Retirees Can’t Underestimate This Stock Market Risk

Ray LeVitre is an independent fee-only Certified Financial Adviser with over 20 years of financial services experience. In addition he is the founder of Net Worth Advisory Group and the author of "20 Retirement Decisions You Need to Make Right Now."

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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