“Reality will pay you back in equal proportion to your delusion.” – Will Smith, actor & musician
Stanley Druckenmiller is one of the most successful investors of his generation. During his time running Duquesne Capital (1981 – 2010), he never had a losing year.
Mr. Druckenmiller investment style wasn’t for the faint of heart. He famously quipped, “I like putting all my eggs in one basket, then watching that basket very carefully.”
One would think his pristine track record would embolden him with confidence to crush the market year in, year out.
When a reporter asked Mr. Druckenmiller what a reasonable return for a hedge fund might be, he said, “I think people are typically happy with about 12% per year.”
For context, the S&P 500’s annualized return (including dividends) is ~10% per year.
One of the greatest investors of all-time thinks 2% above the S&P 500’s long-term average is acceptable.
When we compare these modest expectations with most individual investors’ return expectations, we get a much different story that probably doesn’t end well.
According to Natixis Individual Investment Survey, retail investors expect a return of ~14% (before inflation) per year over the long term.
Let’s recap…
The S&P 500’s long-term average return of 10%.
The brightest minds of the hedge fund universe would be happy with 12%.
The do-it-yourself investor expects ~14%.
In our opinion, there’s a cohort of investors that have return expectations that are unanchored from reality.
High expectations combined with a favorable market back drop (as of this writing, the S&P 500 is +12.7% year-to-date), can lead to some misallocation mistakes fueled by hubris…
- Fear of missing out (FOMO)
- Performance chasing
- Extrapolating short-term trends indefinitely into the future
- Dismissing risk management
- Over-confidence
This dynamic says nothing about the current set-up, which by any historical measure indicates the S&P 500 is quite expensive.
Howard Marks, co-chairman of Oaktree Capital Management, recently stated, “When you buy the S&P 500 at a 23x P/E, your 10-yr annualized return has always fallen between +2% and –2%, IN EVERY CASE, EVERY CASE.”
Today, the S&P 500 trades at about 25x forward earnings (see “Investors are Making a Massive Bet (and most don’t know it)”.
Does that mean we are on the precipice of a market sell-off? No. What’s expensive can stay expensive. Valuation is lousy timing tool in the short-term, however, it does “explain” equity returns over longer periods (10+ years).
Here’s what an investor can do to balance things out…
- Lower return expectations; periods of prosperity are often a precursor to more difficult market environments.
- Manage position sizing; today’s winners can easily turn into tomorrow’s losers.
- Lead with humility; no one knows what will happen next. An investor that stays flexible, can change their mind, and leads with humility can have an advantage.
- Know where your risk exposures are; folks that obsess about performance, but are blind to the land mines hiding in their portfolio, are in for a rude surprise.
- Look beyond the S&P 500. In our opinion, there are plenty of asset classes that are more attractively valued than U.S. large caps.
- It’s been said no one learned anything in a bull market. An up market can hide all sorts of warts. Prudent risk management starts before the next market event through diversification, position sizing, and building a portfolio to reflect your capacity to take risks.
In our opinion, the best return money can buy is being able to do what you want, when you want, with who want.
To learn more about how Pure Portfolios manages risk & return expectations for retirees, shoot us a note insight@pureportfolios.com