The Three Little Pigs
Even though my kids are in or fast approaching their teenage years, we still read together every night. While the stories themselves have morphed from fairytales to solidly young-adult material, the purpose is the same – to connect and to learn.
Those stories naturally got me thinking about investing and how stories we learned as children are still helpful in navigating the wild world of stocks and bonds. Last week we explored how the Tortoise and the Hare demonstrates the value of consistency and time (spoiler alert: be the Tortoise). So too can three charming little pigs show the importance of a diversified portfolio.
A Straw House
Too often, investors may be like the first pig: eager to get started, quickly building a house or portfolio from whatever is laying nearby. That pig was quick and efficient, proud of being the first of his siblings to complete his new abode. But it wasn’t long before the Big Bad Wolf arrived, threatening to blow the new house down. Sure enough, with just a little huffing and puffing, down came the rapidly built house.
The straw approach to portfolio building can be tempting. After all, who wouldn’t want to grow their investments overnight? Why can’t we just buy some bitcoin and retire? The challenge is that the faster a house or portfolio goes up, often the easier it is to come down. And there is always a Big, Bad Wolf lurking around the corner.
In 2021, for instance, the cryptocurrency rose by 66%. During that year, the number of users of crypto-exchange apps doubled. But the following year, bitcoin dropped by 65%. For anyone who had held for those two years, they would have lost over 40% of their investment. In fact, one study suggests that “around three-quarters of users have lost money on their bitcoin investments.”
With his straw house blown down, the first pig couldn’t double down and simply build another house, he had been wiped out with no choice but to take refuge at his sister’s place.
A Twig House
Just as some investors seek the quick path to riches, others prefer to hide and avoid any losses, much like the second pig. Keenly aware of the Big, Bad Wolf’s destructive power, she had tightly bound her twigs together and kept the house small, with wads of cash stuck under her little mattress. She wasn’t going to take the risk of a flimsily built structure. Alone in her twig house, the second pig slept easily, even after her houseless brother arrived.
Then the Big, Bad Wolf showed up. But this time, the wolf didn’t huff and puff. He simply waited. As time ticked by, those carefully stored wads of cash became less valuable and the second pig’s sense of security dwindled away.
Taking too little risk can be just as detrimental to a portfolio as taking too much risk. For instance, in the US, from 1900 to 2021, inflation averaged about 2% per year, a modest-sounding amount. But compound that rate year after year, and that bucket of cash would have lost 97% of its buying power.
Keeping your hard-earned money in cash means that you won’t suffer the big drawdowns that a bear market can bring, but it pretty much guarantees that your assets will lose value over time.
A Brick House
No surprise that the first and second pigs eventually ended up at their brother’s place. His house had taken so long to put up that he was just putting the finishing touches on it when they arrived. He had carefully selected his materials with small amounts of straw and twigs interspersed with his hefty bricks to form a commanding structure. It was the very diversity of materials that allowed the house to stand even as the Big, Bad Wolf howled outside.
If you’ve read articles published by the financial industry, including here, you’ve probably seen something to the effect of “past performance does not guarantee future returns.” In looking at the annual performance of various asset classes, it becomes clear that rarely is one asset class in the top slot from one year to the next. The figure below is often called the “quilt chart” because it looks much like a grandmother’s blanket crafted from a variety of fabric scraps.
In 2008, for instance, fixed income outperformed other asset classes as the global financial crisis drove large cap stocks down 37% and emerging market equities down over 50%. The following year, however, results were almost the complete opposite as stocks soared – emerging market equities up almost 80% – while fixed income lagged, rising a mere 6%.
The unsung hero of the quilt chart is the white box showing a diversified portfolio, the investment equivalent of a brick house, bumping along the middle – never first, never last. After a fifteen-year period, the diversified portfolio earned an impressive 6% return, despite two bear markets, and importantly did so with one of the lowest levels of risk.
Quilt Chart: Asset Class Returns by Year, Ranked
All the performance data shown represents past performance. Past performance is not an indicator of future results. Source: J.P. Morgan Asset Management, Guide to the Markets.
The most important takeaway from the pigs’ experience is that the Big, Bad Wolf will always come knocking, so it’s best to prepare ahead of time. Not by relying on the high-risk straw investments nor by hiding in the no-risk, no-reward twig portfolio. Drawing on a full spectrum of investments, an investor can build a portfolio that can much more easily weather the Wolf’s tantrums. And avoid having to bunk up with your brother.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by any entity for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Kestra Advisor Services Holdings C, Inc., d/b/a Kestra Holdings, and its subsidiaries, including, but not limited to, Kestra Advisory Services, LLC, Kestra Investment Services, LLC, Bluespring Wealth Partners, LLC, and Grove Point Financial, LLC. Does not offer tax or legal advice.