What is your Actual Investment Return? Anxiety-Adjusted Returns
Let’s talk about the Anxiety-Adjusted Investment Return on your investments.
Last week, I wrote about the only cardinal sin of investing – selling low. As for the reasons to sell low, there are two: emotions (fear and greed), and spending need (sequence of returns risk).
While I think it is relatively easy to mitigate Sequence of Returns Risk, it is more difficult to prevent emotional selling when excrement hits the fan.
Though we all desire to maximize risk-adjusted returns, risk means different things to different people. Perhaps it is better to try and maximize your anxiety-adjusted returns instead!
Let’s figure out what anxiety-adjusted returns mean to you and your asset allocation.
What are Anxiety-Adjusted Returns?
Anxiety-Adjusted Returns (coined here) describe the effect behavior has on long term investment returns. If you sell (even once!) at the wrong time, you may be worse off than if you never invested in the first place. Think about that—one behavioral miscue in 20 years can negate the benefit of participating in the growth of the American economy (which is what stock market investing is).
Essentially, discussion of anxiety-adjusted returns is another way to get at the importance of asset allocation. Asset Allocation, after deciding to invest in the first place, is the most important decision you make when investing. What is my stock/bond ratio such that allows me to be comfortable buying and holding until I need the money?
How can I get the best possible returns understanding that it is only human to want to sell out at the worst possible times?
Well, let’s start with this—what are the best possible returns?
Best Possible Returns
OK, if you want the best possible returns over your life, you should be 100% equities until the day before a market crash. Then you sell! Easy, right?
Actually, you don’t even have to predict every market crash… you can ride right through them when you are young. The importance of sequence risk really starts to heat up 5 years before retirement. In order to get the best possible returns over your lifetime, you might just need to sell the day before the market crashes within 5 years of your retirement date. Perfect, sign me up!
Of course, no one can do that. Timing the market… even only having to be right once in your life, is a fool’s errand.
Since you never can know the day before the market crashes, you must De-Risk starting 5 years Prior to Retirement.
You will never get the best possible returns. It is better to hope for the best anxiety-adjusted returns.
What about the worst possible returns?
Worst Possible Returns
On the flip side, there are binary worst possible returns.
On one hand, one might be to scared to invest at all and keep everything in cash. By definition, you lose because cash loses purchasing power every year via inflation.
Compare not investing at all to that of the overconfident investor.
As seen in the fear/greed cycle pictured above, the overconfident investor does the following: buys during times of exuberance, and sells during despondency.
When everyone is talking hot stock tips around the water cooler you buy. And when panic, capitulation and despondency take root, you sell at the bottom. This is why the overconfident investor has worse returns than a buy-and-hold strategy.
Thus, between FOMO and panic selling, you would be better off not investing in the first place.
In summary, we have the best way to invest (only sell at the perfect time), and the (usual) worst way to invest (buy and sell at the wrong time). What can a guy or gal do? Enter: Anxiety-Adjusted Returns.
How to Get Anxiety-Adjusted Returns
So, how can you get real world, quality, anxiety-adjusted returns?
One word is all you need: Asset Allocation. Ok, that’s two words, but it is harder than it looks. One way to look at asset allocation is to consider how much risk can you tolerate?
Again, risk means different things to different people, and frankly the risk questionnaires do not adequately answer the asset allocation question.
Another way, which is perhaps better as it is more anxiety provoking, is to understand how bad it can get. Remember, you set your asset allocation not for the good days, but for the worst of all possible days.
Know what your stock to bond ratio is, and then know how bad it can get.
As an example of knowing how bad it can get, see the above chart. This is modified from Merriman’s website; I believe he calls it the fine-tuning tables.
Note we have 30/70, 50/50, and 70/30 portfolios, as well as 0% and 100% equity portfolios. Note next the yearly returns, the annualized return and standard deviation.
But really pay attention to the worst 12 months, the worst 36 and 60 months (annualized), and the worst drawdown for each of the portfolios.
Again, here is the key to anxiety-adjusted returns: your asset allocation is set for the worst of times, not the best of times. That is, even though the market spends most of its time doing well, you need to set your asset allocation by imagining yourself in the worst possible situation. What can you stomach and NEVER SELL LOW?
If you are 70/30, can you tolerate a 42% drop and still be down 4.4% annualized 5 years later?
Guess what: that is the cost of being invested in the stock market. The reason you get returns above cash and bonds is because you don’t sell low during these horrific times when everyone is panicking around you. If you sell low, you lose.
If you can’t tolerate that, then what about 50/50 where a 32% drop is only down 2.1% a year after 5 years? Well crap, that sucks too!
Invest for the Best, Expect the Worst
I argue that you need to set your asset allocation with the bad days in mind, not the good days. Right now, there are a lot of good days going on, and not too many people are thinking about market down side.
But don’t misunderstand me. In general, remember, the graph of the stock market over time is up and to the right.
Above, note the rocket ship to the moon. For the last 125 years, returns have been incredible. This is a log rhythmic scale we are talking about… yet look at the growth!
Yet look at the periods of recovery times in red. I don’t think those times include re-investing dividends, but there you go. Anything to bring on anxiety now while the times are good…
Anxiety-adjusted returns means considering asset allocation when times are good, yet never selling when everyone else around you is bailing out and going to cash. Your asset allocation is not for the good times, rather the bad.
Getting Rich vs Staying Rich
Finally, remember that you get rich with concentration, and you stay rich with diversification.
When you are young, you have plenty of human capital, and it is all about savings rate. Be aggressive with your investments and take joy when the market crashes.
When you are old…
See above, as you age, your human capital crashes, but your financial capital starts up an exponential curve. This curve slows down as you do what is prudent—you stay wealthy through diversification.
Total wealth slowly goes up over time as your human capital is turned into human capital.
Summary: Best Anxiety-Adjusted Returns
In Summary, you must take on risk. Understand that you only should take on the amount of risk you accept.
If you cannot take on risk period, then perhaps an annuity with principal protection is right for you. Or, you might even consider a Structured Products as a Hedge.
I almost never would suggest something like that, but being invested in just about anything is better than being in cash. If you can understand the role bonds play in your portfolio, and if you don’t reach for yield, you will be better off with just stocks and bonds in your portfolio. If you don’t sell low. It all comes down to asset allocation and anxiety-adjusted returns.
In order for you to be successful, you don’t need to understand risk-adjusted returns, you need to understand anxiety-adjusted returns. How bad can it get?
Get rich first, then diversify away your anxiety.