“The most powerful force in the universe is compound interest.” – Albert Einstein
In the 1780s, Benjamin Franklin donated $5,000 to his two favorite cities, Philadelphia and Boston, to be invested in mortgages for a term of 200 years. By the 1980s, each $5,000 gift became over $5,000,000. The funds were used to build education facilities for tradesmen. This growth was driven by a concept known as compound interest. Compound interest is compelling and the most effective way to harness it is to invest methodically over time.
That’s not to say the current economic backdrop doesn’t matter – it does. Historically, however, there has been little chance of long-term (10+ years) losses in stocks with a strong economy. At present, we have a growing economy with low inflation and almost 95 percent employment. Since the 2008 financial crisis, most buyers have continued to finance autos, pushing demand for cars and trucks close to record levels. We see mortgage underwriters easing requirements slightly, and pent-up demand for housing starting to drive higher sales, with room for expansion. In the meantime, consumer confidence is strong and spending is climbing.
What is going on with oil? It continues to be very volatile. In the last 50 years, crude has dropped by 50 percent on seven occasions. In all but one instance, World War II, global economic expansion followed. Think of it this way: If you live in India and spend 20 percent of your income on cooking oil, you just got a break. You’ll likely spend that on food and clothing, maybe even a motorcycle. Instead of enriching a few countries, lower oil prices drive a higher quality of life and a stronger global economy. One analysis, as cited on CNBC, suggests lower oil prices result in a 4308 billion boost GDP.
Recently, we reviewed 10-year forecasts from some of the world’s largest investment managers*. On average, the predictions indicate that stocks should appreciate in the 7 to 8 percent range, bonds in the 2 to 4 percent range and cash in the 1 to 2 percent range annually. You may be wondering why these percentages appear to be relatively low numbers. Didn’t the S&P 500 deliver almost 30 percent in 2013? Yes, and the point is that the price paid going into an investment is extremely important, especially for 3 to 5 year results. Good investors maintain a longer-term perspective, and in so doing, the importance of remaining diversified can hardly be overstated. According to Vanguard, almost 90 percent of investment results (performance and volatility) are attributable to asset allocation.
Even at today’s elevated valuations, stocks are still one of the best long-term bets for capital appreciation, but they will also have one of the widest range of outcomes. Historically, on average, a portfolio of U.S. Equities will decline in value approximately 28 percent of the time, however the remaining 72 percent of the time it will increase. This can make it hard to “stay the course.” Psychologically, losing $100 is double the pain relative to the pleasure from gaining $100. To minimize those nasty negative return periods, an allocation to bonds can help cushion the ride. More specifically, high quality bonds tend to appreciate when stocks take a hit. Almost every week the stock market got hammered last year, bonds were up. The number one reason to hold bonds is for diversification and downside protection. To view this from a different perspective, in the 2008 financial crisis, U.S. stocks were down 57 percent but the 10 year Treasury was up 15 percent.
Based on all of this information, it is important to pick a target allocation that aligns with your personal risk profile. Then, annually rebalance back to your target allocation forcing you to sell high, buy low and keep your risk tolerance at your desired level.
2016 is a new year. Regardless of your spending and caloric intake last year, this year is a new opportunity. Remember, the largest contributor to your portfolio’s future value is the amount you save and invest, so you have control over the most critical variable. Forget about your past and focus on the small decisions which lead you a step closer to that car, house, college education or retirement. We all have those one-time recurring expenses (tires and brakes come to mind), but save whenever you can. As Mick Jagger said, “Catch your dreams before they slip away.”
*GMO, JPMorgan, PIMCO, Blackrock, Credit Suisse, BNY Mellon, AQR, Vanguard