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June 20, 2020

How Much Could You Gain or Lose in One Year?

For many investors, the decision about how to allocate occurs haphazardly—if done in a conscious manner at all. Investments are chosen based on their perceived attractiveness, suggestions from others or—in the case of employer-sponsored retirement plans—because they are the default option.

Yet, how you allocate will significantly affect your ability to reach your goals. It will also greatly influence your ability to stick with a given strategy. Follow an allocation with too much volatility and you may abandon it during a market downturn. Favor investments less prone to bigger price swings and you may end with too little growth to achieve your long-term goals.

This is why we started the project we’ve code-named “The AAII Way” by asking you to list your goals and assess your tolerance for risk. Without defining these two first, determining the right asset allocation is a guessing game. If you haven’t filled out the first two worksheets, do so.

Let’s say you have filled out those worksheets or you just want to read more about allocation first. Determining the right allocation for you starts with understanding risk and return. Specifically, if you invest in a certain type of investment, what are the odds you’ll either suffer a big loss or end up not being able to afford things you really want to? History can provide some insights.

Since World War II, large-cap stocks have realized an annualized total return (capital gain plus dividend income) of 12.4%. During an average year, a person investing $1,000 in a broadly diversified portfolio of large-cap stocks at the start of a calendar year could anticipate their investment to grow to $1,124 by year’s end.

Most years aren’t average, so the actual result may have been far different. The standard deviation of returns was 17.0%. This means the typical range of year-end values you could have expected was $830 to $1,170. We can extend the range by looking at the highest and lowest calendar-year returns. Those resulted in year-end values of $630 and $1,526.

Earning $526 on a $1,000 investment over a period of 12 months would put a smile on your face. Losing $370 on a $1,000 investment wouldn’t. While these are extremes, it’s reasonable to expect your $1,000 investment in large-cap stocks to be up or down by as much as $170 on any given year. Any changes beyond this range should be viewed as outliers.

We can repeat the analysis with other categories of stocks and other asset classes. Small-cap stocks have realized an annualized return of 15.1% since World War II but with even greater volatility. (The typical calendar-year outcome for a $1,000 investment has ranged between $760 and $1,240.) Intermediate-term government bonds have been far less volatile ($939 to $1,061) but have also realized a lower annualized return of 6.3%. Treasury bills, which are a proxy for cash, have fluctuated very little but their annual average return of 4.0% won’t likely be reached for quite some time given the current levels of and forecasts for interest rates.

As you can see, there is a trade-off for risk and return. Money you need to spend over the short term should be allocated to conservative investments given the possibility of a short-term loss. Money you don’t need to spend for many years should be allocated to riskier investments to realize growth. Put another way, the longer your time horizon is, the more you should be willing to tolerate shorter-term fluctuations in prices in order to achieve greater wealth. The shorter your time horizon is, the more you should seek to limit volatility to prevent a loss of wealth.

In between is a balance. We’re going to delve more into striking this balance as we continue to explain how The AAII Way can help you determine the appropriate allocation for you.

Change in $1,000 Invested for One Year

The Week Ahead

Six members of the S&P 500 will report quarterly earnings: IHS Markit Ltd. (INFO) on Tuesday; Paychex Inc. (PAYX) on Wednesday; and Accenture Plc (ACN), Darden Restaurants Inc. (DRI), McCormick & Company Inc. (MKC) and Dow Jones industrial average component Nike Inc. (NKE) on Thursday.

The week’s first economic report of note will be May existing home sales, released on Monday. Tuesday will feature May new home sales. The second revision to first-quarter gross domestic product (GDP), May durable goods orders and May trade data will be released on Thursday. On Friday, May personal income and spending and the University of Michigan’s final June consumer sentiment survey will be released.

The Treasury will auction $46 billion of two-year notes on Tuesday, $47 billion of five-year notes on Wednesday and $41 billion of seven-year notes on Thursday

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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