Don’t Give Stocks 100% of Yourself

Go ahead, invest 100 percent of everything you have in stocks. Or, even better, please don’t.

A recent New York Times column suggesting that investors allocate 100 percent to stocks clearly disagreed with that point of view, using a relatively non-controversial argument: Stocks have a higher expected return than bonds, and the longer your investment period, the greater the probability of capturing that higher return.

Ergo, buy stocks, hang on, and collect your prize.

The problem, of course, is that investors fail to hang on. You wouldn’t know it by looking at mutual fund returns because those returns ignore the timing of investors’ buy and sell decisions, and assume instead that investors bought and held their fund shares for the entire period. But if you’ve ever looked at a fund’s performance and thought, “That’s not the return I got,” you know that the actual return depends on when you bought and sold the fund.

To bridge the gap between a fund’s return and the return investors actually achieved, Morningstar compiles “Investor Return” data for funds, which takes into account the impact of inflows and outflows. I looked at mutual funds in Morningstar’s U.S. large cap category and compared the average fund return with the average Morningstar investor return.

The numbers are telling.

U.S. large cap mutual funds returned 4.9 percent annually to investors from 2001 to 2015 (the longest period for which the data is available), but the average investor captured only 3 percent of that return during the period.

Other stock categories shed a similarly unflattering light on the average investor’s buy and sell decisions.

U.S. small cap mutual funds returned 7.2 percent, whereas the average investor’s return was 5.9 percent. Developed international funds returned 4 percent, whereas the average investor’s return was 3.2 percent. And emerging market funds returned 8 percent, whereas the average investor’s return was 6.5 percent.

So the average investor has only captured roughly 75 percent of stock mutual fund returns over the past 15 years. This realization may help solve the stock allocation riddle. Consider that the S&P 500 Index has returned 10 percent annually to investors from 1926 to 2015. The Morningstar data implies that the average investor would have captured just 7.5 percent of that return.

Here’s the rub: You wouldn’t have needed a 100 percent stock allocation to get a 7.5 percent annual return. In fact, just a 40 percent allocation to the S&P 500 and a 60 percent allocation to five-year U.S. treasuries would have yielded a 7.5 percent annual return from 1926 to 2015, and with less than half of the volatility (and sleepless nights) of the S&P 500.

Granted, the returns for U.S. stocks and bonds are likely to be lower from today’s vantage point because both U.S. stocks and bonds are expensive in historical terms. But that doesn’t alter this basic truth: The average investor (the investor who can’t actually buy and hold for huge spans of years) is likely to be as well off — or even better off — with a modest stock allocation as with a 100 percent allocation.

This is, of course, a crucial perspective. Stock allocation in a portfolio has a greater impact on the expected risk and return of that portfolio than any other allocation decision investors make — more than regional allocations, more than large cap versus small cap, bonds versus cash, more, even, than the much-obsessed-over decision about active versus passive management.

For the truly superhuman among us, a 100 percent stock allocation may be the most profitable course. Everyone else in the markets would do better not to swing for the fences.

Source: Bloomberg Gadfly,