One Good Reason Your Portfolio Lost to the S&P 500 in 2013

If your portfolio underperformed the S&P 500 in 2013, there is evidence you are doing something right.

Jan 23, 2014 at 12:26PM

If I were to offer you the opportunity in the coming year to have above-average returns while taking on below-average risk, would you take the offer? Isn't this the goal of portfolio -- to achieve sufficient returns to accomplish your goals without assuming more risk than necessary? If you answered yes, it's likely that your portfolio underperformed the S&P 500 in 2013. But there is a perfectly legitimate reason for this underperformance.

What did you expect?
Allow me to clarify my idea of maximizing returns while minimizing risk. Let's say you're a long-term investor with a time horizon of more than 10 years, and you are comfortable with a moderate asset-allocation of 70% stocks and 30% bonds. Let's also assume that the long-term average annual return for stocks is 10% and the average for bonds is 6%.

By doing some simple math, you can project an expected long-term annualized return. First calculate what each asset is expected to contribute to your portfolio. Multiply your stock allocation percentage (70%) by your expected return (10%), and you arrive at 7%. Now do the same for bonds (30% times 6%), and you get 1.8%. Now add those two products together (7% plus 1.8%), and you get a total expected long-term portfolio return of 8.8%.

Over the course of your projected investment time frame, you will expect your portfolio to outperform that 8.8% estimate in some years and underperform that mark in other years

The purpose of portfolio construction
If your ultimate goal were achieving high returns while paying no heed to market risk, you might put all of your eggs in one basket and invest in a single security or asset you believed would provide the best return over a given period of time. But this investing behavior borders on gambling; it is a roll of the dice.

The ultimate purpose of constructing a portfolio is diversification; you want to achieve reasonable returns while taking on a level of market risk that you can accept. To do this, you simply build a portfolio that has a mix of asset classes

2013 demonstrates the power and simplicity of diversification
So why build a diversified portfolio? Because no one knows with certainty what financial markets and economies will do in the future. Now look back at 2013 for an example. A reasonable expectation for the year would have been for stocks to put in an average performance and for bonds to put in a below-average performance. But who would have expected stocks to record their best performance in 15 years? Further, considering the tremendous amount of negative press for bonds, who would have expected only a mildly negative year?

Returning to my simple portfolio example of 70% stocks and 30% bonds, and the calculations for total portfolio return, plug in the 2013 numbers for each asset class using index funds. For your stock allocation, assume you began the year with 70% in the SPDR S&P 500 (NYSEMKT:SPY) exchange-traded fund and 30% in Vanguard Total Bond Market ETF (NYSEMKT:BND). The stock ETF had a total return of 32.3%, while the bond ETF lost 2.3%.

Now calculate what each fund contributed to your portfolio. Your stock allocation return is 22.6% (32.3% times 70%), and your bond allocation return is -0.7% (-2.3% x 30%). Now combine the two (22.6 minus 0.7%) for a total portfolio return of 21.9%.

Success in maximizing returns and minimizing risk
If your 2013 portfolio results were anything similar to my example, you had a successful year. Consider the expected long-term portfolio return of 8.8% and compare that to a 2013 return of 21.85%. Any time you can more than double your expected return with only a moderate level of market risk, there is cause to celebrate. You did not match or beat the S&P 500, but that is not the goal for Fools like you and I. The likely reason you underperformed the stock index in a year like 2013 is because you did a good job of constructing a diversified portfolio.

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Fool contributor Kent Thune has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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