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The tough math of market losses

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Last year was a great run for the S&P 500. Its 12-month total return of 31.49% was over three times higher than its 50-year average annualized return of 10.60%.

So how about this year? There are interesting patterns to note.

Shown in the graph “S&P 500: past 50 years” are the annual returns of the S&P 500 from 1970 through 2019. Highlighted in purple are those years when the calendar-year return eclipsed 30% (shown by the horizontal black line). It’s worth noting that, since 1970, we don’t see two years in a row with a 30% or higher return. In fact, the average return in the year after a 30%-plus return was 13.4%, including two years in which the following year’s return was negative (1981 and 1990).

None of this predicts what the return for the S&P 500 will be in 2020. However, it should be clear that when any investment has a return well above its mean (or average), it’s simply a matter of time before performance adjusts to more normal levels.

Performance adjusting to normal levels suggests smaller positive returns, as well as negative returns for an equity index such as the S&P 500. As we can see from the 50-year graph, there have been 10 years over the past 50 in which the S&P 500 produced a negative annual return (shown by red-colored bars in the graph). The average return in those 10 years was -14.08%.

S&P 500 Past 50 years Craig Israelsen

Negative returns are painful, of course. And the ugly mathematical reality is that gains and losses are non-symmetrical. For example, a loss of 14.08% requires a gain of 16.39% to break even. A loss of 20% requires a subsequent gain of 25% to break even. A loss of 35% requires 54% to be made whole.

The larger the loss, the disproportionately larger gain is needed to break even. A loss of 50% demands a 100% gain to recover fully. A loss of 75% requires a 300% gain to break even. You can see the asymmetry in these examples

When investing exclusively in equities, the road is naturally rocky. Even so, there are clearly more up than down years (as shown over the past 50 years, the S&P 500 produced positive annual returns 80% of the time). Nevertheless, the years in which there are losses produce a disproportionate amount of damage because of their asymmetrical relationship with gains.

Is there a smoother performance path to be had? Of course. Building a portfolio that broadens diversification across multiple asset classes creates a pattern of performance that can minimize the magnitude and frequency of damaging negative returns.

craig israelsen-2019 performance index portfolio

In “2019 performance” you’ll see the performance of 12 key indexes (equity and fixed income) as well as the overall performance of the 12 indexes combined into a portfolio. The indexes are the following: S&P 500, S&P Midcap 400, S&P Small cap 600, MSCI EAFE Index NR, MSCI EM Index GR, S&P Global REIT, S&P North American Natural Resources, DBLQ Optimum Yield Diversified Commodity Index Excess Return, Barclays U.S. Aggregate Bond, Barclays US Treasury US TIPS, Barclays Global Treasury and the 90-day U.S. Treasury bill.

Not surprisingly, the best performing index in 2019 among these 12 was the S&P 500. The lowest return was achieved by the Treasury bills (or cash) at 2.06%. The equal-weighted combination of all 12 indexes produced a return of 16.57%, which was well below that of the S&P 500.

This is not surprising. The S&P 500 is a 100% U.S. equity index. The combination of the 12 indexes creates an investment model that is approximately 66% equity and diversifiers (such as real estate, natural resources and commodities) and 34% fixed income.

How has a broadly diversified portfolio of 12 indexes performed over the past 20 years? A longer time horizon is a better measure of the real character of an investment philosophy.

Craig Israelsen 20-year performance real estate and stocks

As shown in “20-year performance” the best-performing index over the past two decades (2000-2019) was real estate (specifically the S&P Global REIT). This REIT index produced an average annualized return of 10.68%, or 462 basis points higher than the S&P 500 return of 6.06%. Interestingly, a broadly diversified 12-index portfolio (equally weighted and annually rebalanced) also outperformed the one-dimensional S&P 500 by 76 basis points.

Not shown in the graph, but worthy of note, is that the 12-index portfolio bested the performance of the S&P 500, and did so with 32% less volatility (as measured by the standard deviation of annual returns).

There are two key observations in this analysis from which your clients may benefit.

First, the S&P 500 is seldom the correct performance benchmark for most portfolios. If you’ve built a broadly diversified portfolio for your clients, it would be most appropriate to use a broadly diversified index.

Second, being invested in a broadly diversified portfolio is relatively boring, but boring doesn’t have to be a negative. Sure, years with performance of 30% or better will seldom, if ever, occur. But diversifying is a steadier approach without the dramatic ups and downs. Understandably, some clients are not ideal candidates for such an approach, because it lacks the sizzle they may need. But for many clients, it just may be the right recipe.

At least the math of gains and losses will be on their side.

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