Recently a client asked how his portfolio was doing, and my answer was that he was doing well because the portfolio return over the last decade was above the return target he had established in his financial plan. So, after a decade of work, contributing to retirement and sticking to his plan, he was a good bit closer to achieving retirement than we thought he would be ten years ago. He then asked if he could have done better, and I think my answer surprised him.
I told him he could have done better – that it was always possible to do better – but he could have done worse as well. I wasn’t trying to be flip, as it was a good question. One of the reasons it was a good question is that it tied back to risk. My favorite definition of risk is from one of my favorite books on investing, and the definition is “Risk means more things can happen than will happen.” What did happen in the timeframe we were considering was one of the longest economic expansions in history, and a market – at least a large cap U.S. market – that has gone over a decade now without entering a bear market. Other outcomes could have happened, and in early 2009, few would have bet on the path we followed.
The portfolio we constructed had a good bit of U.S. equity, so the client has benefitted from the long bull market. But the portfolio also had a bonds and non-U.S. stocks. When we designed the portfolio, we wanted to include a number of different asset classes. The asset classes are meant to work over the long-term to provide the return clients need without exceeding the amount of risk they take on. The asset classes don’t move in concert and to the same degree as this chart shows, so there will always be leaders and laggards. While the laggards diminish return in some circumstances, they become the leaders in others. The goal is to bring together asset classes in a portfolio in such a way that the client will earn at least the target return over the long term in spite of ever changing economic and market environments.
To return to the client’s original question, he could have done better. We could have added even more U.S. equities to the portfolio. The client could even have gone so far as to invest everything in a levered-S&P 500 fund that returns twice what the S&P returns (though he would have seen losses of 30% or more several times over the last 10 years). The problem with that portfolio is that it would only have succeeded in a very narrow set of paths. There are any number of paths that were plausible in which it would have failed to achieve the target return and achieving that target return is our primary goal in investing.
Beyond benchmarking portfolio performance against the target return for a plan, it is important to measure performance against market benchmark. However, doing so isn’t as simple as comparing an individual investment to a benchmark. In the next post, I will walk through how we build portfolios and how we establish and measure portfolio performance against market benchmarks.