Editor's note: Originally published on August 11, 2014
For those with short term memories, it seems that the market for risk assets can only go up. Weak earnings season, prices go up. Ultra-slow “recovery”, prices go up. Geopolitical unrest? No problem, prices go up. Bad weather, prices go up. Since the 2008 financial crisis, Central Banks flooding markets with liquidity have punished savings and rewarded stock investors. And even though most pundits say they expect some amount of monetary tightening to occur at some point, there seems there is no substitute for risk assets for now. It seems like we are on a roller coaster that only goes up.
But for those who can remember the world before Quantitative Easing, it may be a good time to stand back and take a look at the entire roller coaster… the one with significant drops and curves. If you do, you might consider that if you are lucky enough to have recovered your 2008 investment losses over the last four or five years at the expense of your country’s balance sheet, it may be a good time to think about protecting that recovered wealth.
But that can be a very hard thing to do. Not because there aren’t great ways to do that, but because your investment advisor and your own emotions are not likely to let you leave this party until it is too late. The entire financial services industry is built upon the ideas of buy and hold investing and risk management via long-only diversification. It serves them well, and you maybe not so well. Sure, over very long time periods a 50/50 portfolio of stocks and bonds should deliver about an 8.6% average annual return (before fees). But there have been five year periods when average annual market returns would have been negative, and ten year periods with an average annual market return of just 1%. Besides, because most investors are late buying into up markets and selling into down markets, their long term average annual returns won’t be 8.6%, but something closer to 5% for equity investors and 2.5% for diversified asset allocators. Moreover, 20-40% drawdowns of diversified portfolios happen periodically, and that requires a 25-67% gain just to get even again. Do you have the time and the stomach for that? Unless you take responsibility for the protection and growth of your own wealth, that is the ride you should expect. Don’t let anyone tell you that relative returns are an acceptable benchmark. You can’t eat relative returns.