Charles Ellis was an early proponent of indexing. His quote addresses two important points: First, we should expect the stock market to rise over time, but take us on some ups and downs along the way. Second, the more educated we are about risk (the reason we should expect to earn a return), the better able we are to stay invested to enjoy the market’s superior risk adjusted returns over time.
The figures below illustrate Ellis’ point. They graph 50 years of monthly rolling period returns for Index Portfolios 90, 70, 50, 30 and 10 and the S&P 500. The figures show that the chance of incurring a negative return declines as the time horizon increases. In these studies, the chance of negative returns virtually disappeared when returns were graphed in monthly rolling five-year periods.
Figure 8-29a provides the percentage of periods that Index Portfolio 90 investors experienced gains versus losses over several periods of times. Investors are often surprised to see that on a daily basis, 48% of the daily returns are negative in an Index Portfolio 90. However, at 5-year monthly rolling periods, only 2% have been negative over 541 monthly rolling 5-year periods. And, out of 481 10-year periods, not one had an annualized loss. Figures 8-29 c-f show that Index Portfolios with lower risk than Index Portfolio 90 experience fewer periods of losses vs. gains, with Index Portfolio 70 showing 1% negative returns over 5-year periods, and zero periods of negative returns for Index Portfolios 50, 30 and 10.
Figure 8-29a
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Figure 8-29b
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Figure 8-29c
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Figure 8-29d
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Figure 8-29e
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Figure 8-29f
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Risk and return are inseparable. This means that investors must often face bedeviling trade-offs between risk and return. There’s no way around these decisions, since they’re required in order to build portfolios. The result of all this is the “eat well/sleep well dilemma.”
That is, if investors want to eat well and earn higher returns with stocks, they need to be prepared to take more risk and go through the volatile roller coaster ride of fluctuations in the value of their portfolio. But if they want to sleep well, they must take less risk; that is invest in fixed-income investments such as bonds, and accept that they’ll earn lower returns.
James K. Glassman aptly summarizes the investor’s choice: “In the stock market (as in much of life), the beginning of wisdom is admitting your own ignorance. One of the many things you cannot know about stocks is exactly when they will [go] up or go down. Over periods of days, weeks and months, no one has any idea what stocks will do. Still, nearly all investors think they are smart enough to divine such short-term movements. This hubris frequently gets them into trouble.”