In celebration of SMI’s 30th anniversary, we’re highlighting core beliefs and principles that guide our work. The essential service we offer includes stock market investing strategies, so it may seem obvious that we believe in the stock market. However, especially when the market gets bumpy, as it has this year, it’s worth reiterating why we believe so much in the value of the stock market.
On February 19 this year, the S&P 500 closed at an all-time high, only to plummet 1,149 points over the next 16 trading days in a stunning -34% decline. Never before had the market fallen so far so fast. Three days later, it had regained nearly 400 points. By early June, it had zigged and zagged its way back to within 154 points of its February high. But its path was — and still is — highly volatile, with many days of triple-digit point gains and losses.
While the stock market isn’t usually this exciting, it isn’t for the faint of heart. In fact, to invest in the stock market, it’s best to check your heart at the door. But not your brain. If you look at it logically, investing in the stock market makes complete sense.
Nothing grows like stocks
If the stock market were a plant, it wouldn’t be a sunflower, reaching ever upward. The market is more like a zucchini plant, growing up, then sideways, with sudden downward swoons thrown in for good measure. Zucchini plants never win beauty contests, but they are productive. Similarly, while the stock market can get ugly, history has shown it to be a long-term builder of wealth.
In fact, the stock market offers most investors their best hope of generating returns that will outpace inflation and taxes. That’s the main reason to stick with the stock market through all of its thrilling ups, painful downs, and frustrating sideways moves.
Lessons from history
According to Vanguard, a bond-only portfolio would have generated an average annual return of +5.3% from 1926 to 2018, versus +10.1% for a stock-only portfolio. But these average returns look better than they are. That’s because inflation and taxes relentlessly reduce the value of investment dollars. Inflation has averaged roughly 3% per year over many decades. While taxes are variable based on income and other factors, they reduce annual investment returns even further.
If you earn +5.3% from a bond portfolio, but surrender 3% to inflation and another percent or two to taxes, you haven’t made nearly as much progress as it first appears. The fact is those bond returns are largely just protecting your buying power, not adding to it.
Only stocks have a long-term track record of significantly outpacing inflation and taxes. Most people need that extra “oomph” to meet their retirement savings needs — very few are able to save so much that merely protecting their buying power is sufficient.
Of course, it’s important to recognize that long-term averages are made up of many highs and lows. Since 1945, the stock market has averaged one correction (a decline of 10%-19% from its most recent high) or bear market (a decline of 20% or more) roughly every other year. That makes stock market investing a “two steps forward, one step back” type of dance. And, as the recent past has illustrated, at times the market forces us to take two steps back before letting us take any steps forward.
Managing the risk
Because no one knows how the stock market will perform, it’s wise to mitigate that risk by making sure your portfolio is built around your risk tolerance and investing time frame. SMI’s two main investing strategies take different approaches to this.
Fund Upgrading is a strategic asset allocation strategy. In essence, that means you will usually maintain some exposure to the stock market and that your biggest strategic decision is how much of your portfolio to allocate to stocks and how much to bonds. (Since 2018, Fund Upgrading has incorporated protocols that can move us out of stocks when the market is trending significantly lower.) That stock/bond choice is guided partly by the results of a risk tolerance questionnaire but mostly by your investing time frame. The younger you are (i.e., the longer your time frame), the more risk you can afford to take. While a stock-heavy portfolio will be more volatile, its long-term rate of return would be expected to be higher than that of a bond-heavy portfolio.
While many investors might prefer to avoid the volatility of stocks, most can’t afford to choose all bond-type investments. If they did, they’d miss out on the gains necessary to outpace inflation and taxes.
Our May 2019 cover article, The Crucial Role of Diversification in Reducing Risk, demonstrated how asset allocation affects returns and volatility. It compared seven mutual fund portfolios, starting with a portfolio that invested only in the stocks of small-growth companies. Over a 30-year time period, that portfolio generated impressive +10.2% average annual returns. However, those returns came at a high cost: the volatility of this portfolio was 38% higher than the stock market as a whole.
Each subsequent portfolio was increasingly more diversified, with the final one spreading its investments across funds in five stock-based asset classes while also including bonds and some inflation hedges such as gold and real estate. This portfolio generated still-impressive average annual returns of +8.7%, but with volatility 18% lower than the stock market.
SMI’s other main investment strategy, Dynamic Asset Allocation (DAA), is a tactical asset allocation strategy. Instead of maintaining a stock/bond allocation as Fund Upgrading does, DAA monitors the momentum of six asset classes (U.S. stocks, foreign stocks, real estate, bonds, gold, and cash), keeping you invested in the three showing the highest momentum. It is a more defensive strategy than Fund Upgrading, with the ability to more quickly move out of harm’s way in a downturn. In a rising market, it would be expected to underperform Fund Upgrading, as it never is invested more than two-thirds in stocks.
However, depending on how the overall market performs, DAA’s defensive capabilities can help it generate impressive gains — even outpacing Fund Upgrading at times. From 2000 to 2019, the U.S. stock market generated an average annual return of +6.4%, while DAA would have generated an average annual return of +10.1%. That’s largely because there were two big bear markets over those 20 years. When the market was generating double-digit losses, DAA was generating small gains.
Because of the unpredictability of the market and the very different designs of Fund Upgrading and Dynamic Asset Allocation, SMI believes most investors would benefit by taking a blended strategy approach, such as what we simply refer to as “50/40/10.” This portfolio consists of 50% DAA, 40% Fund Upgrading, and 10% Sector Rotation (our highest risk/highest potential reward strategy). Our research indicates that 50/40/10 offers an unusually attractive combination of superior returns and relatively low volatility.
Sticking with the stock market
So, who needs the stock market? Most investors. Typically only the oldest and most conservative investors should consider a 100% bond portfolio. If your financial situation allows you to eliminate the volatility of stocks and invest only in bonds, great! There’s no point in taking more risk than necessary. But for everyone else, including most retirees, SMI recommends at least some exposure to the stock market.
Assuming you’ve implemented an investment strategy based on a careful consideration of your risk tolerance and investing time frame, and assuming you’re willing to stick with your strategy even when the market gets ugly, maintaining some exposure to the stock market remains your best hope of generating the investment returns you’ll need to achieve your financial goals.