Note from the CIO: What’s the Secret to Successful Investing? 13-10-5-3

The stock and bond markets can seem confusing. Why do stocks keep going up when there is so much worrisome news? What will happen to bonds when the Federal Reserve raises interest rates? Why do stocks and bonds go in opposite directions over some periods of time, but move together other times? It would be nice to find order in the complexity.

My original training as a physicist taught me to seek simple, elegant solutions to difficult problems. So, let me offer this answer to the capital markets puzzle: “13-10-5-3”. The historical average return of small company, low priced (“value”) stocks (before fees) is 13.4%.[1]  The historical average return of large company stocks and bonds (with similar characteristics to the bonds used in Abacus portfolios) is 10.0% and 4.8%, respectively. The rate of inflation has run 3.0%. In other words, 13-10-5-3. This principle is to a large extent all most investors need to know.

There is a surprising amount of information in this guideline. It says that stocks (of large and small companies) have earned a return that is 7-10% over inflation, while bonds have earned only 2% over inflation. Stated another way, the return above inflation of stocks has historically been 3.5 to 5 times greater than that of bonds. It is no wonder then that the dominant factor determining the performance of investor portfolios is the mix of stocks and bonds in the portfolio: the more of those 7-10%’s over inflation, and the few of those 2%’s, the better off the investor will be in the long-run.

However, stocks can fluctuate up and down significantly, and uncomfortably, over short periods of time. Your Abacus advisor might have recommended an appropriate amount of bonds in order to protect your shorter-term needs from the uncertainties of the stock market. And here is where perhaps one more number is needed to complete the picture: 40. That is the average number of months from the peak of the market right before a crash in stocks, to the bottom of the crash, and back up to the original peak. This guides our financial planners to recommend bonds to match your short-term needs, and to allocate stocks for your long-term goals.

So there it is: 13-10-5-3-40. It does not explain everything about the capital markets but it simplifies the three essential activities an individual investor should do: make a plan to reach their goals, construct a portfolio as the funding medium of that plan, and stick to it through the various market conditions that will arise over time. The actual numbers going forward may turn out to be different, but I expect them to be substantively similar.

Over an investor’s lifetime, this long-term order and structure of the capital markets will be all that matters, while the continual newsfeed of political events, economic indicators, corrections in stocks, market prognosticators, and even natural disasters, will prove to be irrelevant to the lifetime investor (however important they may be in other spheres of life and society) – if the investor chooses not to react to these matters and instead to act continuously on the plan. It is a simple choice conceptually, entirely in the control of the investor, but at times can prove to be a daunting choice behaviorally. Your Abacus advisor is there to help you make the wiser of those two choices.

Next quarter, we will take a closer look at the meaning of risk and the impact of holding investments for different lengths of time. Until then, I wish everyone a happy final quarter of 2017.

[1] All average historical returns are provided by Dimensional Fund Advisors and are compounded monthly from June 1927 through August 2017.

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