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The Folly of Chasing Speculative Returns

Last week, a client of mine forwarded an interesting opinion piece by Brett Arends that warns investors about “speculative returns,” a phrase first coined by the late Vanguard founder John Bogle as one of two sources of returns (the other being “investment returns”). As Arends states in his article, Bogle said that stock returns can only come from three things: Dividends, earnings growth, and speculative returns. And speculative returns, such as the ones we’ve seen in the stock market over the last ten years, as Arends says, “have always, always reversed themselves.”

When the current run up in stocks finally reverses itself, some investors will find that the speculative returns they’ve accumulated recently will be partially or mostly gone. These investors, in my opinion, were likely greedy ­­— continuing to keep the same exposure to asset classes that have grown higher and higher, or worse: chasing returns moving from “all-in” on one asset class or sector because it was hot last month or last year to another that is hot this month or this year.

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At AMDG Financial, the investment strategies we create with our clients are designed to prevent you from the unpredictability of speculative returns. Will your portfolio experience ups and downs? Of course it will. But by rebalancing your portfolio on a regular basis, we can position you to capture upside return, no matter when dividends, earnings growth or speculative returns happen. When we rebalance, we pull the higher retuning asset class returns off the table and reinvest them in lower valued asset classes, in keeping with your overall investment policy. This helps to preserve and diversify your future risk of loss.

How Rebalancing Works

Let’s say your portfolio contains a certain amount of small cap and value funds, and the value of those funds has jumped 100%. If you were to continue to hold those funds, and they declined in the future, you would lose that impressive gain. But if you rebalanced to your original investment policy allocation, selling off some of your gains and reinvesting in fixed income or another asset class with a lower allocation percentage from your investment policy, you would have preserved that gain to use in purchasing another asset class “on sale.” Now, your portfolio would be back in balance, and you could wait until another asset class jumps in value. By making these occasional adjustments, you’re prepared when a decline or boom in an equity market or asset class occurs.

When the market soars, it’s tempting to ride the wave for as long as you can. When the market declines, it’s tempting to sell everything and get out. But there’s no “right” time to get in or out of the market. As Professor Robert Merton, a Nobel laureate, explained, to be a good market timer, you must do it twice. “What if the chances of me getting it right were independent each time? They’re not,“ he explained in an article by Dimensional Fund Advisors in 2019, “but if they were, that’s 0.7 times 0.7. That’s less than 50-50. So, market timing is horribly difficult to do.”

What the Evidence Says

Dimensional’s research shows that, on average, as companies grow to become some of the largest firms trading on the U.S. stock market, they begin to lag the market within a few years. Dimensional cites, as an example, Intel, which experienced average annualized excess returns of 29% in the decade before it became one of the Top 10 by market capitalization. However, in the 10 years following, Intel’s stock underperformed the broad market by nearly six percent per year!

In responding to our client who sent me the opinion piece, I explained that in my view, some investors lose sight of what is important in life and in their investment strategy. The small, intentional actions do matter. Rebalancing to a consistent strategy is underrated. Most investors are looking for the “golden egg,” and they miss the golden opportunity to enjoy their lives with a prudent return that supports them in their retirement.

With all the noise in the marketplace, it can be easy to buy into the hype you hear from stock pickers and so-called experts in the media, and hard to know whether the information is accurate or in your best interests. If you see something that raises questions for you, we’re always available to discuss it and provide perspective. It’s part of being what I call an “interpretive” adviser ­­— one who sorts through all your options with you and helps you choose the approach that’s right for you.

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