The message that data gives us is quite clear: over very long periods of time, investors who resist both the urge to speculate and the urge to panic do very well, indeed (see Figure 2.1).
What's really interesting about the chart is that it doesn't look like anything happens until about 1980. This is an illusion, given the scaling of the chart, but the visual also demonstrates a deeper lesson. Just as the Colorado River did its work for countless millennia before creating one of the most impressive sights on earth, compound interest does much of its work in the background. For years, its effect might not be apparent. But when its impact does burst forth, the effect can be magnificent.
The chart also shows that there have been bad times over the past nine decades. Undoubtedly, there have been many periods during which it was tempting to abandon the market until it was “safer.” With the power of perfect foresight and the ability to consistently time your way in and out of the market, this might've been a good approach. But as will be discussed in greater detail later in this book, that perfect foresight is a very rare commodity.
So, if we work off the assumption that you don't have the ability to see with perfect clarity what the future holds, it becomes clear that, despite the many fluctuations the market has encountered, the long-term trend has been higher. What that means is that if you want to achieve success, you must participate in the financial markets even though doing so will undoubtedly subject you to a great deal of volatility and perhaps even some sleepless nights.
Remember, having a portfolio that fluctuates in value has almost never prevented someone from meeting their financial goals. However, not benefiting from the power of compound interest and the long-term upward trend of financial markets has prevented many people from living the life they deserve.
Asset Class Returns
One of the main goals of much of the financial industry is to provide you with guidance about what security, sector, or asset class will serve you best in the coming months and years. This has always been the case and it makes sense. Undoubtedly, in the years to come, some sectors of the stock market will do better than others. Perhaps technology stocks will lead the way. Or maybe energy stocks will produce the strongest returns. Or it could be consumer discretionary companies or consumer nondiscretionary companies. Although we don't know which of the sectors will perform the best, we do know that some will do better than others.
It's the same with asset classes. Perhaps small-company stocks will do better than large-company stocks over the next decade. Maybe commodities will outperform real estate.
Figure 2.2 shows the performance of several asset classes and portfolio mixes over a 20-year timeframe (1999–2018). As you can see, some investments have done better than others. The cumulative affect has been that investors in say, real estate investment trusts (REITs) have grown their wealth significantly beyond that of investors who purchased bonds (at least during the 20-year time frame measured in Figure 2.2).
Figure 2.2 Asset Class and Portfolio Performance (1999–2018)
SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar Inc.
Consider that a $50,000 investment in REITs during that 20-year time frame would have grown to $330,311 while the same $50,000 invested in bonds would have turned into $120,585.
That, in one simple example, is why investors place so much focus on asset allocation, economic research, market forecasts, and the like. Picking the correct asset class, or mix of asset classes, can hold the key to financial success.
No wonder Wall Street churns out a constant parade of asset class forecasts!
No wonder the media talks breathlessly about the best or worst performing sectors!
Make no mistake: Buying the right sectors or asset classes can make an enormous difference in your investment returns and ultimately determine whether you achieve financial freedom.
A Twist in the Plot
Everything I wrote earlier is absolutely true. Some asset classes or sectors greatly outperform others. And choosing the winners will produce better results. But here's the interesting thing. Let's look again at that chart with the returns of the different asset classes and portfolio mixes.
This time, though, I'm going to add one bar to the chart. That bar, which you can see in Figure 2.3, represents the performance of the average individual investor across the past 20 years.
It turns out that it almost didn't matter what you bought over the past 20 years! Almost anything would have produced better results than what most people actually achieved!
Sure, buying real estate investment trusts (REITs) was better than buying bonds, and the S&P 500 did better than international stocks. But at the end of the day, buying and holding any of those would have outperformed the average investor's portfolio.
Figure 2.3 The Performance of the Average Investor (1999–2018)
SOURCE: Analysis by Brian Perry. Data from JP Morgan Asset Management & Dalbar, Inc.
The same holds true for asset allocations. Yes, different investors might want to have different investment mixes. And the asset allocation mix is one of the most critical decisions you need to make. But ultimately, nearly any reasonable asset mix would have done better than the actual experience of the average individual over the past two decades.
So, first I talked about the importance of asset allocation and selecting the best sectors or asset classes. But now I'm telling you it didn't matter what you bought, because almost anything would have done better than the average investor. So, what gives?
Time in the Market versus Timing the Market
The difference between asset class performance and investor performance comes about as a result of timing issues – namely, many people are getting in and out of sectors and markets at the wrong time, and all too often buying high and selling low. Moving in and out of the market and spending too much time on the sidelines prevents an investor from leveraging the most powerful tool at their disposal.
But what exactly is compound interest? Well, let's say you invest $10,000. One year later you've earned 10% on your investment, or $1,000. Now assume that in year two you also earn 10% on your investment. Have you earned another $1,000? No. You have in fact earned $1,100, because you earned 10% not only on your original $10,000 investment, but also on the $1,000 worth of gains you'd achieved in the prior year. (Please note that 10% annual returns year after year would be exceptional. I've selected that number simply for ease of math.)
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