How to Pick a Winner

In 2015 the University of Kentucky men’s basketball team entered the NCAA tournament with a record of 34-0 and was deemed the “biggest favorite in modern NCAA tournament history”, according to USA Today. The oddsmakers installed UK as even favorites to win the championship. That means someone could place a bet on the field and if any one of the other 67 teams not named Kentucky won, you cashed in. For those of you fortunate enough to have forgotten what happened, we lost. We lost. In investors’ parlance, a diversified bet on 67 teams had a far better return than the bet on the overwhelming favorite.

Similarly, the Russell 3000 Index (essentially the entire U.S. stock market) gained 2633% from 1980-2014. But, just 7% of those companies (roughly 210 of them) pulled the index to its wonderful performance. In fact, 40% of the companies in the index suffered catastrophic losses defined as losing 70% or more of their value and never recovered; 64% of stocks underperformed the index.

So, how do we ensure we only invest in the 7% that will be spectacular and avoid the companies that get destroyed and never recover? Answer: We don’t, because no one knows. We cast a wide net to make sure we benefit from the winners. Here’s how:

The engine:

For those still accumulating assets for retirement, the U.S. stock market will be the primary engine that pulls us where we need to go. Large companies, small companies, companies in growth mode, those that are more mature – a diversified, appropriate mix will give us access to the growth we need for the future.

Pessimism:

Over long periods of time the U.S. stock market goes up. For instance, the S&P 500 index of large company stocks has produced an average annual return of 8% since 1957. The 10 years between 1999-2009, however, is known as the “Lost Decade” as stocks returned a dismal average of -0.95% during that time. We know this will happen occasionally so we also keep part of our money invested in bonds. How did investment-grade bonds perform over the “Lost Decade?” An average annual return of 6.33%.

Optimism:

We also often invest in two other asset classes: real estate and international stocks. Here’s why: While we know their returns are more volatile (big swings), when they perform well, they hit it big. Over the 20 years through 2019, real estate investment trusts gained an average return of 11.6%; International stocks returned 7.0%. The swings between good years and bad, however, were the most of any asset class. We want exposure to both of those asset classes for those years they outperform the U.S. stock market.

How much of each category of investments one holds depends on a variety of factors such as age, amount of accumulated savings, income requirements, etc. that are specific to each of us. Our job at Moneywatch is to establish the mix for each client that we believe is best for them.

Steve Byars, CFP®