Did you know that Santa Barbara and Oklahoma City have nearly identical average annual temperatures?
It’s true, but no one would confuse their two climates. The difference lies in the range of temperature highs and lows:
Annual Average Winter Average Low Summer Average High Santa Barbara 61 42 77 Oklahoma City 61 23 90
The averages may be the same, but the experience is certainly very different.
This is exactly how averages can mislead investors. Research from Russell Investments shows that over the past 47 years, the benchmark S&P 500 enjoyed an annualized return of 12.21%.
A more diversified portfolio — blending U.S. large and small stocks, international stocks, bonds and real estate in a 60/40 mix — produced a still impressive annual 9.63% return, but with a lot less volatility.
Note that standard deviation is a measurement of risk, showing how much returns vary from the average.
In fact, the 60/40 mix delivered 79% of the return with just 62% of the risk over nearly five decades.
And it is worth noting that over the two years 2007-2008, the S&P 500 lost more than 31% while the balanced 60/40 mix was down less than 18%.
To put that into perspective, that means watching a $1 million portfolio fall to $690,000 versus $820,000.
“Statistics are used much like a drunk uses a lamppost: for support, not illumination.”
VIN SCULLY
Like the contrast between Oklahoma City and Santa Barbara, the range of outcomes matters just as much as the average.
Choosing the right portfolio is critical. History clearly shows that there is no “free lunch” when investing — higher potential returns come with more risk.
Perhaps you can live with bigger ups and downs that come with more exposure to stocks in seeking higher long-term returns. But you won’t get those returns if you can’t stick with the portfolio when markets tumble.
And research consistently shows that human beings are poorly wired to live with lots of risk.
My experience in advising clients over many years is that fear of being in (FOBI) is incredibly powerful, and even those who say they are very risk-tolerant can panic and sell when markets tumble.
The best investment strategy isn’t the one with the higher return, it’s the one you can stick with when it matters most.
