Obviously by investing in something that turns out to be a sham, but we’re talking about investments in publicly traded securities here, where it’s extremely rare for that to happen.
Before we discuss the worst mistake made by most investors, let’s look at the investment results of typical equity investors.
As you can see from the table above, the average equity investor has consistently underperformed the S&P 500 no matter what timeframe is selected. In fact, the longer the timeframe in general, the worse the underperformance.
My theory is the typical investor is overly aggressive in their allocations because they want good returns. Then when the equity markets pull back 20%, 30%, 40%, 50% or more as they eventually do, these investors get scared and either reduce their risk exposure, or worse yet, eliminate all risk exposure thereby locking in portfolio losses.
Without fail this happens at or near the market bottoms
Then they compound the mistake by not getting back into the market until it has substantially recovered from its deep loss.
Let’s take a simple example where an investor 100% exposed to the S&P 500 became very scared as the market collapsed during the Financial Crisis in late 2008.
Please note that this same investor probably would have sold their risk assets again during the Debt Ceiling Crisis in the summer of 2011 and again in the Covid-19 pandemic in March 2020, but we’ll just assume a one-time fear adjustment back in 2008-09 for demonstration purposes.
On November 20, 2008 (before the actual bottom on March 9, 2009), they couldn’t take the steep losses of 48% or more and moved 60% of their invested assets into the Aggregate Bond Index by selling some of their SPY and buying the ETF AGG to reduce the risk exposure in their portfolio. This is shown in the graph below and let’s call it the “Panic Portfolio” (Red line in the graph).
Clearly this panic move hurt the investor, both in terms of return, and in terms of the time for their portfolio to recover to its previous high-water mark (Time-To-Recover) as shown in the table below.
It didn’t help much with the severity of the maximum loss either.
During this almost 19-year period from July 2002 through March 2021, the S&P 500 had a 10.32% average annual return and took 4.87 years to recover to its previous high-water mark after the big drop of 55.19% in 2008-09.
The much more conservative portfolio with only 40% exposed to risk (SPY) and 60% in the safer Aggregate Bond Index ETF AGG, had a 6.59% average annual return, but only took 1.94 years to recover from its more moderate 22.14% maximum loss.
The Panic Portfolio where the investor switched from 100% S&P 500 exposure to 40% S&P 500 exposure before the market bottomed in March 2009 saw the worst 6.15% average annual return, and their portfolio took a whopping 7.10 years to recover to its previous high after dropping 48.66%!
There is some good news that most investors don’t know and probably won’t figure out for a very long time. Investing for good returns doesn’t have to be this way.
You can make better or almost as good returns as the S&P500 by taking much less risk, and I’ll show you how below.
It’s simple, but it took years of research to figure it out.
If an investor combines corporate risk assets (stocks) and corporate safety assets (corporate bonds) in a portfolio, the resultant portfolio combines in a linear way where the average of 1 and 3 = 2. This is shown in the graph below where the resultant portfolio falls halfway in between the two corporate asset classes.
In the two graphs below, the vertical (Y) axis shows the Compound Annual Growth Rate (CAGR) over the 15-year period ending on March 13, 2020 while the horizontal (X) axis shows the maximum loss incurred during that same timeframe. The size of each bubble represents the percentage of each component and the Portfolio = 100% so it is the largest bubble. In these types of graphs, up and to the left is good, while down and to the right is bad.
If instead of using corporate bonds for the safety portion of their portfolio, they use U.S. Government Treasuries for the safety portion, the resultant portfolio performs better than either of the two components as shown below. The average of 1 and 3 = 3 or 4, sort of.
If we look at the typical investor allocations using the ETF SPY for the S&P 500 (risk) and the ETF AGG for the Aggregate Bond Index (safety) we end up with the following table and graph showing the returns and the maximum losses.
The reality is that AGG contains some non-linear U.S. Government Treasuries, but not enough to give a strong non-linear effect.
All the results that follow are for the more recent 15-year period prior to November 31, 2021.
Now let’s look at the same allocations, but this time let's replace AGG with U.S. Government Treasury ETFs, to create non-linear diversification in our model portfolios.
Notice above the non-linear diversification using SPY and Treasury ETFs outperforms the more linear portfolios using SPY and AGG both in terms of Compound Annual Growth Rates, and in terms of maximum loss characteristics. In fact the Moderate allocation of 60% SPY and 40% Treasury ETFs returns almost as much as the 10.41% S&P 500 alone over this timeframe, but with a little more than half the maximum loss (29.92% vs. 55.19% for SPY)!
If instead of the ETF SPY for the risk portion, we replace it with a combination of the DIA ETF for the Dow Jones Industrial Average and the QQQ ETF for the NASDAQ100, we end up with even better performance as shown below.
Note the ratio of DIA to QQQ is about 2:1 in all the allocations.
Now the Moderate portfolio above handily beats the 100% S&P 500 (SPY) portfolio both in terms of return and maximum loss.
If these maximum losses surprise you as being more risk than you’re willing to take, it’s because no one ever (or rarely) discusses them in the context of the allocations they recommend to you as an investor.
The good news is you can get better results by following a few simple rules when you invest your money:
1. Don’t take more risk than your comfort level will tolerate and don't let anyone tell you to take more risk because you are a certain age. Ask yourself some questions:
a. What percent loss am I comfortable taking?
b. How many dollars am I comfortable losing? Do this at portfolio sizes of $10,000, $50,000, $100,000 $500,000, $1,000,000, $5,000,000, and $10,000,000, then calculate the percent losses from those dollar losses in each case
c. If the percentage loss from a. and calculated percentage losses from b. above don’t lineup, make sure you adjust your portfolio to the more conservative result, so you’re not tempted to sell at or near the market bottom
2. Don’t be tempted to reach for return on the safety side of your portfolio - it's a fool's errand. The value of the safety side of your portfolio is to provide safety first, and to provide return second. Make your portfolio non-linear using U.S. Government Treasuries (through ETFs or direct investment in Treasuries) and you’ll get much better long-term (10-years+) results
3. Take the very long view and be patient! I can’t emphasize this point enough. As an investor you must have a multi-year view and the patience (and confidence) to stay the course. Gamblers want to see returns the minute they pull the handle, but investors understand the value of long-term compound returns that will happen if they are allocated to their comfort level and don’t make changes to their portfolios when the markets tank (which will happen again, and again over the next 20 years or more).
If you would like to learn more about how you can achieve even better return and maximum loss characteristics in your portfolio(s), please click the Contact button above and set up some time to talk to us about your current situation and future goals. We'll help you figure out your comfort zone and show you additional ways to get better returns with better maximum loss characteristics.
1. Matthew Frankel, CFP, November 1, 2015, updated October 2, 2018. The Average American’s Investment Returns – and How You Can Do Better. Dalbar’s 2015 Quantitative Analysis published by the Motley Fool,
2. Calvin Rose. October 25, 2021, What Is Wrong with My Portfolio?, a case study.
3. Calvin Rose. November 17, 2021, Are Women Better Investors than Men?
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