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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And today, I wanted to share the highlights from the free market volatility webinar that I did last week with Dimensional Funds. Now, unfortunately, the webinar was not recorded, but I pulled the three most important things from the presentation that I think will benefit just about everybody who's saving and investing money for retirement. For all the links and resources that I mentioned today, head over to youstaywealthy.com forward slash 71.
Okay, so the first thing I want to highlight from our conversation was this conversation or discussion we had around why invest in the stock market to begin with. In other words...
Knowing how it feels when we see our hard-earned money go up and down and up and down on a daily basis or a monthly basis, and then knowing how it feels when things get really ugly, like we've experienced this year a little bit and we've experienced it in the past, but knowing these things, why do we continue to invest in stocks? Why not invest in something more conservative and just spare us this emotional rollercoaster?
So we invest in stocks for two reasons, and here's what we kind of outlined in the presentation. The first reason is to earn a healthy enough rate of return so that you can reach your financial goals.
Two, we want to invest in stocks or typically we need to invest in stocks because inflation is one of the biggest threats to our retirement and we need to invest in stocks or higher returning asset classes in order to combat inflation. Now, most of you know that the stock market has delivered an average annual rate of return of about 10% going back to 1926. And
You might've said something like, well, I don't need a 10% rate of return. What if I can just get 3% or 4% or 5%? What if I just get that year over year and take a more conservative path?
And you can, by the way, you can do this, especially if your financial plan tells you that you don't need a high rate of return to reach your goals. It might be possible to target a lower rate of return while still retiring safely. Maybe you have other income sources or you've been a good saver, or maybe you just live a simple life and expenses are really low.
We call this measuring your risk capacity. And this is different than risk tolerance, which is everybody, every other financial advisor talks about. Risk capacity is how much risk do you need to take to reach your financial goals? Risk tolerance is how much risk can I tolerate? How much risk can I take without losing sleep at night?
So risk capacity is how much risk do I need to take to reach my financial goals? And going through a risk capacity exercise can also work the other way around. You might go through this exercise and realize,
I need to take more risk than I'm comfortable with because I don't have other income sources or I have really high expenses or I haven't been a good saver. And so I need to play catch up here and I'm going to have to take more risk. So it's certainly important to figure that out before you plow money into the stock market, just because
you know, your neighbor told you to, or a financial advisor told you to, or you listen to a podcast like this. We need to figure out how much risk do I really need to take? What is my target rate of return? Because three, four, or 5% might just get you to where you need to be. And maybe you don't have to go investing a bunch of money in the stock market. But here's the thing.
Three to 5% rates of return might sound good, but wait until you see what the numbers look like when you extrapolate that out over long periods of time. And to illustrate this during the presentation, we showed the growth of $1 invested in the S&P 500 starting in 1926. So we went back as far as we could in history because we want a lot of data.
$1 invested in the S&P 500 in 1926. We compared that to the growth of $1 invested in one-month treasury bills, T-bills being pretty much the safest investment you can make as they're short-term, 30 days, one month, and they're backed by the full faith and credit of the United States government. So we compared a growth of $1 in 1926 invested in the S&P 500 versus the growth of $1 invested in one-month T-bills.
As I just mentioned, as most people know, the S&P 500 has had an average annual rate of return of about 10%.
One month T-bills have had an average annual rate of return of just over 3%, again, going back to 1926. So those are the percentages, but here's the crazy part. When we look at the growth of a dollar, $1 invested in the S&P 500 in 1926 grows to just over $8,000 by April of 2020. So $1 turns into just over $8,000 today.
$1 invested in one month T-bills, again, earning 3% average annual rate of return during that same time period, it only grows to $21. $1 grows to $21 versus $8,000 for the S&P 500.
Like I've said on the show, compound interest is magical. And although 3% and 10% don't sound like terribly far apart, like, I mean, there's a big gap, but it doesn't sound terribly far apart. It makes a giant difference in where you end up, even when you're investing for a hundred years, you know, like we're using in this example, going back to 1926.
Now, maybe 3% is unreasonable. And you say, look, nobody is going to put all their money in T-bills. Like that's ridiculous. People are going to invest in something more than just T-bills.
So we can take it up a notch. And for this illustration, we'll just look at five-year U.S. Treasury notes. So still a very safe investment. And the real reason I wanted to use five-year U.S. Treasury notes is that they've had an average annual rate of return of about 5% since 1926. So we looked at T-bills, 3%. Five-year Treasuries have gotten about 5%. So again, 5% sounds pretty good.
However, $1 still only grows to $115 if you start in 1926.
which is, you know, it's six times more than a one month T-bill, but it's nowhere close to the S&P 500. So that's why we invest in the stock market, because most of us need a healthy rate of return in order to grow our wealth and reach our financial goals. Again, three to five percent rates of return likely are not going to get us there, especially while we're in the wealth accumulation phase. Once you're in retirement,
You have to balance out wealth preservation, right? Not losing your money and the threat of inflation. So we don't want to take so little risk that inflation just eats our portfolios alive. And we don't want to take so much risk that our portfolio drops 30 to 40% during recessions. We can't afford to do that.
So when you're in retirement, this question has changed a little bit. Again, you may not need 9, 10% rates of returns. I hope not. You could target a lower rate of return, but you've got to balance that wealth preservation and the threat of inflation. Okay, so that was the first highlight from our presentation. The second highlight was how the market has responded after other pandemics and other major economic events.
It's important to remember that the current crisis, and you guys know this, the current crisis is not the first time in history that we've experienced substantial periods of volatility. Now, you might say, Taylor, this time is different. We've never experienced something like this before. But remember,
It's always different. No two events are the same. No two events ever feel the same. It's always different, but history does have a weird way of repeating itself. And since we don't have a crystal ball, I don't know the future. The best thing we can do is to lean on decades and decades and decades of real academic data to just try and draw an intelligent conclusion going forwards.
One exhibit that was shown during the presentation to share how the market has previously responded to other crises. For example, the OPEC oil crisis in 1974. One year after that crisis, a balanced portfolio of 60% stocks, 40% bonds was down 5%. But three years later, it was up 37%. And five years later, it was up 69%.
The crash of 1987, one year after the crash, a balanced portfolio of 60% stocks, 40% bonds was up 19% after the crash of 1987, which makes headlines all the time. So on the news, they're always drawing parallels back to 1987. But still one year after that event, a balanced portfolio was up 19%. Three years later, it was up 33%. And five years later, it was up 76%.
Lastly, the dot-com crash in 2000, it took a little bit longer, but still one year later, a balanced 60-40 portfolio was up 2%. Three years later, up 2% as well. But then five years later, it was up 51%. So I'll link to this data in the show notes if you're interested and you want to dig in a little bit more. Again, those can be found at youstaywealthy.com forward slash 71. But the
But the conclusion is that there's always going to be a, you know, what we'll call a crisis of the day or a potential major event looming that could mean the beginning of the next market drop. As we all know, predicting future events correctly is pretty much impossible, at least doing it consistently. You might get lucky once, but doing it consistently is pretty much impossible.
Volatility in the market is part of investing. It's normal. A market going straight up with no volatility, that's not normal. So if you want to enjoy the benefit of higher potential returns, like we outlined a few minutes ago when we looked at the growth of a dollar, you have to be willing to accept increased uncertainty. It's just the way it works.
Okay, the last highlight of the presentation, and sorry if you hear my kids near the room, I am working from home. So it's part of the joys of doing this. But the last highlight of the presentation was the discussion around how to invest going forward. Okay, we know all of this. We're starting to come to grips with it. We've digested all this great information, but how should I think about investing going forward?
I'll be talking at length about this soon. I'm going to do a whole series on how to build a portfolio and portfolio construction and investing. But in short, there are three things that we think you should focus on. And we talked at length about these during the presentation. Number one, maintain a globally diversified portfolio. U.S. stocks move in a different direction at different times than international stocks. So look at your portfolio. Do you mostly own U.S. stocks?
If so, now might be a good time to improve the diversification of your portfolio. That's some real low hanging fruit right in front of you right now. Number two, not all bonds are created equal. We saw this in Q1 of this year. I talked about it on the podcast when corporate bonds and municipal bonds went all wacky on us and had really significant drops.
If you own bonds in your portfolio, be sure to know what kind of bonds you own, what their credit rating is, the maturity, all of that. As mentioned on this podcast multiple times, we believe in owning U.S. government bonds and staying away from these lower-grade bonds, even investment-grade corporate bonds. To us, the juice just isn't worth the squeeze.
taking credit risk as laid out in many academic papers just doesn't seem to make sense when you're pairing bonds with stocks. Now, if you're only investing in bonds and nothing else, then the conclusion can change. But if you own a diversified portfolio of stocks and bonds, to us, taking credit risk, meaning even if you own investment-grade corporate bonds, just doesn't seem to make sense. And I think this year in 2020 in Q1 was a great example of
All right, number three, consider tilting your portfolio towards small cap and value oriented companies. I previously referenced the book, The Investment Answer on this podcast. So if you want to dig deeper on this, go check out that book, buy a copy. It's only 100 pages or 120 pages. But in short, small cap companies and value oriented companies have historically done much better than their counterparts.
The challenge is, is that sometimes it takes a long time in order to reap the benefits of owning these asset classes. It wouldn't be uncommon for these asset classes to underperform for 10 plus years, which could be really painful for investors who don't fully understand the philosophy and approach to targeting these asset classes.
But if you're looking for ways to optimize your portfolio, to take it to the next level, say, hey, I'm doing pretty good, but I want to optimize. This can be a tweak that's in your control to consider making tilting that portfolio towards these smaller cap value oriented companies.
And this is a tweak that I personally believe in and that something that we implement in our firm. So again, the investment answer is a great book if you want to dig into that, but I will be sharing a lot more during an upcoming series on investing in portfolio construction. So get ready for that. If you have any questions, please send them my way.
The response to the webinar was overwhelmingly positive. I had a lot of fun. And based on the feedback, we're going to be doing more of them in the near future. So keep your ears out for the details about the next one. Until then, you can find the links for today's episode by going to youstaywealthy.com forward slash 71. Thanks so much for listening. And I'll see you back here in two weeks.
This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.