Historical Investment Returns 2017

Worsification: Diversification Gone Bad

The North Carolina State Retirement System's pension fund is a perfect example of what I call "worsification" or diversification gone bad.  If one takes a look at the most recent investment performance report by clicking here.  You will notice six asset classes:

1. Global Equity (publicly traded stocks)
2. Fixed Income (publicly traded bonds)
3. Real Estate (partnerships that buy shopping malls and office buildings)
4. Alternatives (private equity, venture capital, hedge funds)
5. Credit (junk bonds and bank loans)
6. Inflation (derivative securities on commodities: eg. futures and options on gold or corn, etc.)

Most folks are familiar with the first two categories which are just traditional stocks and bonds.  But, the next four categories might come as a surprise to some pensioners to discover their retirement is being bet on such items as private equity, hedge funds, junk bonds, and derivatives.  The worst part of the surprise is that the four new categories have all produced returns lower than a simple, traditional, 60% / 40% mix of stocks and bonds.

NCRS 10-year returns
Stocks = 8.0%
Bonds = 6.8%
60/40 Stock/Bond = 7.5%
Alternatives = 5.3%
Real Estate = 3.8%

Increase Your Investment Earnings +180%

The Editor’s Note in The Wall Street Journal Sunday was somewhat interesting.  The editor speaks about the returns an investor with a 401(k) would have earned over the past 12 years.  There is a chart that shows the growth of a 401(k) account where $250 is invested every two weeks and the hypothetical employee also received a company match of 50% or $125 per pay period.  In 12 years the employee would have an account worth approximately $137,000 if all money went into an S&P 500 Index Fund.  He then points out that the lesson to be learned is to “always get the company match.”  This of course is an important lesson.

However, I believe the author missed an opportunity to point out another very important lesson that I firmly believe is vastly understated in its importance with most investors.  I’ve said it before, and I will say it again, BUY MONTHLY AND REBALANCE ANNUALLY.  I took The Wall Street Journal’s hypothetical 401(k) above and made a few tweaks to show everyone just how important diversification and rebalancing truly are.

First, I take issue with the editor’s assumption that a 401(k) retirement account be invested in only one S&P 500 Index Fund.  First, that is not a properly diversified account.  Second, the owner of the account would also miss out on the benefits of yearly rebalancing that can enhance returns by systematically trimming your winners and adding to your losers year after year after year.  So here are the figures that I wish the editor ran, but I have calculated for you.

The article shows the investor would amass $137,000 by consistently investing in the S&P 500 Index fund.  However, if the investor instead invested just 60% of their account in the S&P 500 Index fund and the remaining 40% in a bond index fund AND rebalanced once per year, the investor would have amassed an account value of over $151,000 or $14,000 more than investing in the S&P 500 Index fund alone.

What if we took this a step further?  What if this investor bought one of my books (and actually read it) and discovered that there are several asset classes an investor should utilize in order to be properly diversified.  Let’s take the typical 50-year-old which would again have a 60/40 stock/bond mix as the last example, but with a few tweaks. 

Of the 60% of the account invested in stocks only 30% would be invested in the (large cap) S&P 500 Index, 10% would be invested in a mid cap stock index fund, 10% in a small cap index fund, and 10% in an international stock index fund.  Further assume that the 40% invested in bonds would be allocated 20% to TIPS bonds (treasury inflation protected securities), 10% in long-term bonds, and 10% in intermediate term bonds.  Oh, and don’t forget the annual rebalancing.  This account would accumulate $173,000!

That is a difference of $36,000 or 26% more just by adding diversification and rebalancing.  I should also point out that if you add up all the monthly contributions, you would see that the original investor (in all cases) would have invested about $117,000.  Thus, the original portfolio would have earnings of just $20,000 ($137,000 - $117,000).  By adding the principles of diversification and rebalancing, the account would have earnings of $56,000 ($173,000 - $117,000).  We are talking about earning $56,000 instead of just $20,000, or an increase in earnings of 180% just by diversifying and rebalancing once per year!

Summary

$250 bi-weekly contribution with $125 matching funds (1999-2011)

Total dollars invested: $117,000

                                                                        Ending                                     % Increase

Portfolio                                                           Value               Earnings          in Earnings

S&P 500 Index only                                        $137,000         $20,000           --

Add bonds and annual rebalancing                $151,000         $34,000           +70%

Proper diversification and rebalancing           $173,000         $56,000           +180%

 

Moral of the story:       Investing in an S&P 500 Index fund is not an investment strategy.

Lesson:                       Diversify and rebalance. 


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