Investors have spent decades trying to maximize their returns while simultaneously minimizing their risk.
Some investors miss out on great investment opportunities because they are afraid of loss, while others pour everything into volatile investments and lose most of their capital.
So how do you strike the balance between risk and reward?
The most important part of investing is to stay invested in a portfolio that will maximize your ability to meet your financial goals and reduce your urge to sell during the next market downturn. Truth is, most investors experience poor performance for three reasons:
1) They try and time the market
2) They chase returns (i.e. invest based on past performance)
3) They hold way too much cash because they are not confident in their ability to make the right investment choices.
Average Investor Behavior
The average investor’s goal is to mitigate their risk while still participating in the market to enjoy returns, asset appreciation, and more. However, many investors do not actively participate in the market which diminishes most possibilities for return.
According to a report by JP Morgan, diversified portfolios generally perform well over time, even if they are considered extremely conservative.
In the chart below, stocks have returned an average of 11.3% annually since 1950, and a conservative 50/50 bonds and stocks portfolio has returned 9.9%.
In the same report, the average investor generates a mere 2.5% annual return on average. This indicates that the average investor is most likely holding on to cash or money market accounts and leaving most of their capital on the table. We have been hearing hesitation from many prospective clients to invest near the all-time highs in the market since 2013! Since then, the S&P 500 is up over 150% (as of June 29, 2021).
Breaking The Mold with Diversification
As you can see in the graphic below, the average investor does not fare well compared to most other asset classes, and only performs better than commodities and cash.
So should you ignore all other asset classes besides stocks and other high-performing assets? Of course not. However, it might mean that, if you have a long enough time horizon, you have a decent chance of earning higher returns if you own a higher allocation of stocks.
As you can see in the second chart, blended stock portfolios perform the best over a longer time horizon, but they can be volatile in the near and medium term.
Most investors should still hold both and rebalance periodically, which raises the odds of experiencing a smooth investment ride while you wait for the asset returns to sort themselves out over time. Additionally, it is important to adjust your allocation as your goals and time horizon change. For example, as you accumulate more wealth and get closer to retirement, it may make sense to reduce your allocation to stocks.
Regardless of your age or investment perspective, the data indicates that investing in the capital markets yields higher returns than waiting on the sidelines.
Market participation is one of the most powerful wealth-building tools in the world, and you certainly don’t want to miss out on building a sustainable future.