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Benchmarks and Bitcoins

As 2017 comes to a close, investors have much to be thankful for. At the time of this writing, US stocks are up more than 20%, international and emerging markets stocks up even more in the 25% to 30% range, and bond funds are also in positive territory with low to mid-single digits returns year-to-date.

As a result, some investors may think: The S&P 500 is up 20% this year, so why is my portfolio only up—fill in your number—%? The S&P 500 may seem like a reasonable performance benchmark. After all, it is the most widely discussed proxy for U.S. stock market returns. In addition, some of your acquaintances are already bragging about how much money they made in stocks (or in bitcoins—more on that later), and the pressure naturally mounts to do something about it. We urge you not to listen to this siren’s song.

First, while the S&P 500 index is a standard benchmark, it is typically not the right benchmark for investors whose portfolios tend to be diversified between stocks and bonds. In 2017, a performance comparison with an all-stock index is bound to disappoint as bond returns were much lower. A proper benchmark for such a portfolio should incorporate a blend of equity and fixed income indices.

Second, increasing a portfolio’s allocation to stocks following a 20% increase is akin to driving a car looking only in the rear-view mirror. Stock returns are mean reverting, i.e. over time they converge towards the (very) long-term average range of about 9% to 10%. However, as shown in the table below, since 1930, 10-year returns only fell within that range once—during the forties. All other decades saw average returns below 9% or above 10%, mostly by wide margins.

Looking forward, it is important to remember that starting valuations for stocks (we use the Shiller cyclically adjusted PE or CAPE) are a key determinant of which 10-year average returns investors are more likely to earn. Intuitively, it makes sense: the more you pay for a stream of cash flows, the lower the expected return. Logically, stocks are more likely to experience a decade of lower returns following high valuation levels. The same table illustrates this point: low starting valuation levels (1950s and 1980s) lead to 10-year average annual returns in the 17% to 20% range, while high valuation levels (1930s, 1960s, and 2000s) yielded much lower 10-year average annual returns. The latter might provide a better indication for what to expect from the S&P 500 during the next 10 years as the starting PE today is about 32.5 versus an average of 16.8.


Finally, and more importantly, the S&P 500 index (or any other single benchmark for that matter), should not drive your investment process nor provide you with the marker by which to judge success. A better alternative should be your required rate of return (RRR), which is derived from your investment plan. The appropriate RRR is based on your financial goals, risk tolerance, tax circumstances, and expected spending or savings. It is essentially the average return necessary to meet your most important objectives such as being able to retire without outliving your assets. The RRR drives the asset allocation that balances your risk tolerance and return objectives.

For most people, the RRR should also be below the 10% or so historic average annual return delivered by the S&P 500 over the past 80 years. To illustrate, if your portfolio needs to beat the market to be able to retire securely, you are on thin ice and very unlikely to succeed. Our recommendation would be to save more, spend less, work longer or any combination thereof to increase the odds.

Keeping your eye on your personal required rate of return will keep you on track and motivated to stick with your long-term plan, while measuring your portfolio against the S&P 500 or the Jones’ will land you in troubled waters.

Talking about sirens and troubled waters, not a day goes by without the surge in the price of bitcoin and other cryptocurrencies being mentioned in the news.

But first, what is it? Cryptocurrencies are digital currencies created through complex computer algorithms and stored on a network of servers. Unlike the US dollar or any sovereign currency, they are not issued or guaranteed by a central bank and therefore fall outside the purview of regulators. They are secured against hacking through encryption (hence the name) and can be converted into real-world money anonymously. This has attracted some criminal elements, a point emphasized by regulators and critics.

Why are prices up so dramatically? Scarcity, enthusiasm and—a big driver of such speculative manias—the fear of missing out are all contributing factors. Only a finite number of bitcoins can be created or “mined”, and the closer we get to the finite number, the more computing power is required. Consequently, the cost of mining new coins is rising rapidly: according to this article in Mother Jones, “just one transaction can use as much energy as an entire household does in a week, and there are about 300,000 transactions every day.”

Should you care? Bitcoins, like gold, art, or tulips, have no intrinsic value because they do not generate any cash flows unlike stocks, bonds, or real estate. As such, there is no standard by which to estimate the value of what one is buying. Consequently, it is a vehicle for speculation rather than investing, and today’s buyer can only hope that someone in the future will be willing to pay a higher price. Eventually, like all manias before, it will end badly for a lot of people. We just don’t know when.

As its price keeps spiraling higher though, we believe that bitcoin’s success might unfortunately reflect an increasing lack of trust in fiat currencies, especially following a decade of loose monetary policies around the world.  It might also signal a lack of faith in government in general as cryptocurrencies are created outside of a central bank. It is very possible though that some of the technologies behind cryptocurrencies such as blockchain, a digital ledger, will remain and thrive in a world where securely tracking financial transactions is increasingly challenging.

Happy Hanukkah and Merry Christmas.