The "invisible hand" of economic forces rewards investors who take some risk. The reward is inevitable if you wait long enough, and financial markets refer to it as the "risk premium." For instance, small companies bring more risk to the table, but as a group they generate average annual returns of 12 percent per year compared to the broad market's 10 percent. That extra 2 percentage points is the "risk premium."
If the invisible hand wasn't doling out the extra money, nobody would ever bother to invest in risky, small companies. Conditions like this are what make economics so fascinating.
Here's another reason economics and the stock market are so fascinating. I was shocked to notice the other day that the average return for the broad market averages over the past 15 years was only about 5 percent per year. The annual average return is closer to 10 percent for the past 10 years, and again, close to 10 percent for the past 20 years. Anyone stuck with the 15-year return just won the lottery at the wrong time.
If you had actually won the lottery or inherited some money in May 1998 and invested it all in the Vanguard 500 index fund (representing about 70 percent of the entire market value of the stock market), your average return, including reinvested dividends, would have been just 4.6 percent.
Starting five years earlier, however, your 20-year average return would have been about 8.2 percent during a period that included two major crashes -- but one that benefited from the dot-com bubble.
So the 15-year look-back is an anomaly when we're conditioned to think of 10 percent stock market returns during rolling 10-year periods. However, this low-return period offers a laboratory for exploring strategies that contribute to higher returns.
Diversification across different asset classes is the primary engine leading to greater success. While Warren Buffett counsels everyone to just invest in a 500 index fund, a mix of other asset types would have created a dramatic improvement over the broad market average. For example, the result of creating a mix of 12 different asset types was outlined by Craig Israelsen in the June issue of Financial Planning magazine. He shows what can be accomplished through a combination of cash, bonds, international bonds, inflation-protected bonds, small-cap stocks, mid-cap stocks, large-cap stocks, REITs, commodities, international stocks, natural resources, and finally, emerging markets stocks.
The 15-year annual average rate of return for this mix of investment types was 8 percent -- a far cry from the 4.6 percent of the all-stock index. Not only was the return much higher, but the standard deviation was lower than that of a 70/30 mix of big company stocks and bonds.
The term "standard deviation" refers to the amount that performance from year to year will deviate from what would have been the straight line of average annual performance. One standard deviation is where you can expect returns to be -- either above or below the straight line average -- at least 62 percent of the years you are invested in that combination of assets.
In other words, it is a measure of how much risk (down) and reward (up) can be normally expected compared to just a straight line of average returns.
The standard deviation was roughly the same for the 12-investment mix in the Israelsen study as it was for the 70/30 mix of stocks and bonds. However, the annual rate of return for the conventional stock/bond mix was only 4.3 percent. That for the 12-asset mix was 8 percent. Twice the return for the same level of risk is something that gets our attention.
In the seminars I have been giving for more than 30 years, I have always encouraged investors to diversify across different asset classes. The composite result of a typical asset mix creates what I dubbed years ago as "The Path of Minimum Regret."
In the aftermath of the downdraft in the market and the subsequent recovery, the broad market averages represented a "lost decade," with a zero percent return as of December 2010. By comparison, a mix of asset classes along the lines of the 12 investments here earned an annual average of over 6 percent per year during everyone else's "lost decade."
With the possibility of the market's typical "summer doldrums" just around the corner, there may be a window of opportunity to invest more aggressively after a dip in stock prices.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505 or firstname.lastname@example.org.