Video Posted: July 3, 2024
Hello, it’s John Smallwood. I recently was down in Florida visiting my mother and was going through some of my old business partner’s stuff—my father, John P. Smallwood—and stumbled across a bunch of charts that are about 10 years old. They had a lot more data than what I was doing in the last one, and I thought it would be really powerful to share some of that information.
But before I do, I kind of want to talk about some things that go on in financial services—in the wealth management space, in wealth accumulation, and in financial planning—that are really interesting to me. Some people embrace long-term planning and strategies very quickly. Some people never even think about getting started. And other people have tremendous fear about getting started.
Everything that we do in Smallwood Wealth and in the Wealth Curve Blueprinting is really designed to get rid of those fears, to help you get started, and to make sure that we have fail-safes in place, backstops, and liquidity. We have all those things, but the success of a financial plan really comes down to the actions that you take today and that you repeat over and over and over again. If you don’t repeat those core strategies, then you’re probably not going to get to the destination that you want to be.
My father—cleaning out some of his old things—made me think back. It made me reflect a bit on our journey of creating this wealth management firm, and now having multiple advisers, kids in the business, partner kids in the business, and exponentially going to the next level. It made me think of something my father used to say that I didn’t really understand.
He said, “When you buy some piece of equipment, there’s typically an instruction manual that comes with it.” You could just take it out of the box and start using it. Some people are quick to adapt. Other people read the directions, and other people read the directions after they fail, but money doesn’t come with an instruction manual.” I started to think about it. I used to go, “Yeah, right.” But then you talk to some really smart people—people with incredible educations and degrees—and they say, “I wish I had a class like this when I was in my graduate program or in college.” I realize we never had any instruction.
Part of what we do, given the complexity of all the different financial factors that are hitting, touching, and pushing upon your wealth, is to try to create an instruction manual. One that would allow you to troubleshoot when things go wrong—or to recall and get you out of the trap you’re in. You could potentially be much more successful.
In one of the previous podcasts, I used some charts put out by JPMorgan Chase. I’m going to go through and show them to you. But the phenomenon has been that you get less and less data on these charts, so the true meaning behind them—and what is happening—is getting lost, in my opinion. They are working with a narrower frame of information. As you expand the lens and zoom out, you begin to see a wider picture.
So, when we’re looking at money over the long term, most people’s belief is that money accumulation is math. But money is not math, because it’s subject to erosion principles. But the goal of what I’m going to show you is to provide confidence. If something is normal, then it’s simply noise. But most people are going to tell you, “Well, it’s just noise. You need to ignore it.” Meanwhile, what I hear often from people coming into the process is, “I’m feeling a lot of pain in the moment.”
The idea of a really well-designed financial future—and a financial plan—is that there are structural elements and components in the plan designed to not participate in up or down markets, and to simply make small rates of return. It’s that foundation. What I am going to be talking about today is above the foundation. This is building the engine, the business, the structure that’s going to make this financial plan sing and win.
S&P intra-year declines vs. calendar year returns
Source: FactSet, J.P. Morgan Asset Management
This chart is basically 44 years of financial data. The black represents the ending market close, and the red dots represent intra-year volatility—an inflection point where the market hit its lowest during the year. If we focus on 1980 for a second, the market at some point during that year was down 17%, and it ended the year up 26%. When you look at 2008, the market was down 49% and ended the year down 38%. If you focus on the following year, 2009—March 9th (I know that date is burned into my brain)—the market was down another 28%, but it finished the year up 23%. What I see in the chart is despite average intra-year drops of 14.2%, annual returns were positive 33 out of 40 years, and somehow this is supposed to make you feel good.
Years ago, one of my first clients that was very successful said, “John, yes, I want to work with you,” and really embraced what I said. We were managing a portfolio for him during the Asian contagion in the early ’90s when the markets were down like 30-something percent over that time frame. We had a portfolio that was well-diversified, and we were down, let’s say, 23%. The market was down 26–27%. He said, “John, I get it, but is that supposed to make me feel good?” I said, “Yeah, it is.” But it doesn’t, right?
That was something where we start to take a look at this—being down 33 out of 40 years. But every single year, if you look at every single year, there’s a red dot—there’s a spot where it was negative. It was negative every single year. If negative happens every single year, I need to develop a plan and a structure that’s going to smooth that out, because emotionally, I can either take it or I can’t.
Source: Capital Group
But what’s interesting is I uncovered this piece from the Capital Group (American Funds) digging through my father’s stuff. If you look at the side of it, it’s data through 2013. It happens to be the S&P 500—same type of thing. It’s entitled Long-Term Investors Can Weather Market Declines. Intra-year declines in the S&P since 1946 have averaged 14%, yet annual price returns have been positive in 47 of those 67 calendar years.
Then when you look at the size of the downturn, there were 172 downturns of 5% or more, 55 of 10% or more, 21 of 15% or more—once every three years—and then 12 of 20% or more—once every five and a half years. But this goes back to 1946. Now, instead of looking at it from 1980 to now, this is going from 1946 through 2012. When you look at this chart, the blue represents the intra-year gain or return—whether it was positive or negative—and the gray represents the intra-year decline. During those 67 calendar years, there wasn’t a year where there wasn’t a negative.
Whole news channels come out with reasons why the market did something on a daily basis. Why is this? I’m going to joke about this for a second, but most of it is somebody saying, “Oh, that’s the reason why the market went up or down today.” But often, it’s not. It’s a soundbite—it’s part of a bigger story.
Ultimately, what the chart really reveals is: it doesn’t really matter. What matters is that I was participating in that strategy, and it matters whether or not I had the guts and the ability to get in. But more importantly, was my plan structured properly so that when this event happened, I had two opportunities? Either to ride through it or reposition a portion of the portfolio to do something everybody talks about—buy low and sell high. Those things are emotional. It’s a whole aspect of the emotional investor.
But I wanted to share this because I felt that if I compound this information now another 10 years, it’s 77 years. When you combine the JP Morgan chart and this American Funds chart of negatives every single year. It’s 100% normal and I should just expect it to be part of the plan. And when I expect it to be part of the plan, I’m not focused on short-term or intermediate moves. I’m focused on my strategy and my long-term plan.
We have to realize this: we’re all in what we call the “rate of return Olympics,” meaning “What have you done for me lately?” Why have you performed or underperformed? When you read all the studies, most actively managed mutual funds don’t outperform the S&P on a consistent basis or their benchmark. Some do, some don’t. This is not about promoting indexing or not promoting indexing. I’m just saying there’s a lot of information out there.
One of the biggest things is that when you look at the large endowments, pension funds, and the large, successfully managed organizations—they have a different time horizon. They manage their money as if it’s 100-year-plus money. Most individuals do not. They look at it in time frames, and they look at it as shorter time frames. In reality, good strategy is long-term.
As human beings, we make an investment in something, and our emotions—if it goes positive or negative—start reacting. If it goes positive, I look at my other investments and say, “Well, that’s bad. I’m going to put everything in this.” Then the cycles and the volatility change. Then it’s like, “Oh, I should have had this,” and I go chase yields.
Based on findings from that DALBAR study, if the index performed at some level, and then they take the top mutual funds and ETFs over the last 20-year period, what did the average individual receive over that time frame? The result is a spread—that’s usually a 4% to 5% difference in return—because of when people come in, when they leave, how they chase funds, and how they move from Fund A to Fund B, from asset class to asset class. It’s because they don’t have a core strategy.
Source: J.P. Morgan Asset Management
The chart, in this case, looks at average returns from 2000 to 2013. Large cap core—basically the S&P 500—had the best-performing asset class during that time frame. Commodities had a negative return during that time. If you follow the green through the chart, you see in 2008–2009 (after the crisis), different things performed differently. Emerging markets in 2008 were the number one performer, and cash was the laggard. If you held only cash in 2008, you’d have a different story. Then you have real estate investment trusts (REITs). What you see is that large cap core has been at the top of this for a very long time. Cash, commodities, and emerging equities have been down near the bottom. People make decisions saying, “I don’t want those asset classes in my plan. I want to follow this trend.” We all know how those trends end up—trees do not grow to the sky. Just because I am taking risk doesn’t mean I am going to get a return.
I found a much longer and older chart put out by MFS Funds. This is dated February 2015. What I wanted to go through is this: when you look at this chart, it breaks it down between large cap value and large cap growth. It does not include the S&P, but the S&P is basically 50% large cap growth and 50% large cap value. From 1995 through 2014, small and mid-cap stocks had the highest average return. REITs were number two. Large cap value was number three. Large cap growth was number four. Cash was at the bottom. What you tend to see over a larger viewing scale is that an asset class might be a winner two to three years in a row, then it’s not. Then something else is better. Then that fades, and another comes back. It’s a constantly moving cycle, and the power of what we’re talking about here in the charts is that the diversified strategy that puts everything together in a specific asset allocation, a diversified portfolio, is giving you a better, more solid foundation with a decent rate of return and less risk over time.
Source: Massachusetts Financial Services Company
That’s what you’re seeing here: that diversified portfolio had about an 8.5% rate of return over that time frame, which is a big variance from the 10.3% during that time frame. This is not putting in the risk metrics, right? When you look at the JP Morgan chart with the volatility, you’re seeing the return for the asset allocation is middle of the road, but the risk level is near the bottom.
The thing I want to focus on is all of this. All of these charts are really, really nice, they’re beautiful and brought back some really good memories for me to dig into my father’s stuff and find these were the sets that he felt were valuable. But what we want to focus on is that the average rate of return is not how your plan is going to work. You’re going to get the actual rate of return. You’re going to get that volatility-adjusted return. And the greater the standard deviation, the volatility, the risk measure, the greater that gap is going to be.
I want to demo a couple of different things here, but there was this old credential piece that goes back into, I believe, April of 2013, and this one’s talking about the sequence of returns. It was basically a table on a chart showing two $250,000 retirement portfolios where you’re going to take out a 5% withdrawal, and it runs this sequence of returns where you start off with three years of negative returns versus starting off the other way. And they’re basically just taking that return and saying year 1 through 30 happens one way, and then you flip it — the return you were getting in year 30 is now the return you’re getting in year 1, which you have no control over. The outcome you get in the future, you just simply experience it. In this structure, the $250,000 portfolio with the 5% withdrawal by 16 years into retirement is at zero, whereas if you flipped it, the $250,000 was still worth $130,000 at the end of that time frame.
I remember years ago looking at a mutual fund ad in a newspaper that said if you had put x dollars in 1973-74 range into the fund and took out a 5 or 6% withdrawal, you’d have a lot of money today. That was the essence of the chart, but when you looked at the disclosure, the inception date was actually six to seven months prior. We used to have some software that would simulate actual returns, and if you took the fund back to its inception date, you actually had a 30% down downturn in those first six or seven months of the fund, and you actually ran out of money. You have to be very, very careful with the information that you’re looking at and simulate it in different environments with different time frames, different withdrawal rates, different tax rates, and different other scenarios.
So my thinking here is: we have the wealth curve simulation tool. What I did here is I simply said, let’s take $100,000, and let’s assume we had a killer 30-year-old like this person who accumulated $100,000 outside of the 401(k), and he or she is really excited and going to put it all in the S&P 500. What I’m doing here is looking at a 20-year period from 30 to 50, and I happen to be using 1995 through 2015 to sort of mimic the MFS chart. The way this is set up and the data we pulled, utilizing the S&P 500 total return at 100% of the portfolio, the average rate of return on this way we’re viewing it is 11.023% before fees, before taxes, before anything. So when you look at this curve, what we’re seeing is that the potential of the money, that $100,000, if it didn’t have any market volatility, taxes, or financial pressure, it’s going to get to about $863,000. And that’s what people take to their spreadsheet and say, “Oh, if I just put it in this fund, I’m going to have $863,000. Life is going to be great.”
Then what happens is there are taxes being paid on the gains. For purposes of this conversation, I just put the ordinary tax rate at 37% and the capital gains rate at 20%. What’s interesting is in this model, instead of compounding the money and paying the taxes for my earned income, I’m actually pulling the tax numbers out of the account every single year. Every time I pay taxes, I get an opportunity cost — it’s money I don’t get to work for me for the rest of my life. That potential has now dropped to around $560,000. And what you don’t know is what taxes will be tomorrow. You just don’t know. But as I look at this, that same inflection point got an outcome of $566,000, and if I liquidate the portfolio, there’s another $40,000 in taxes, so I’m down to about $520,000 of output, whereas my spreadsheet said I was going to have $830,000.
Then there’s the thing called management fees. While I only have a 1% management fee in here, fees are often much higher. There are trading fees even undisclosed in some products. That has now dropped it down by $44,000 and another tax liability of $34,000. That fee drain has also cost the plan. The problem is not the fees or taxes, the problem is the strategy in which we deploy the compounding. Compound interest is extremelt powerful, but with it comes compound taxation and compound fees.
This is why I’m saying money is not math. Money is a commodity. If I now layer in volatility, only capturing whether the market was negative at the beginning of the year or the end of the year, that same 50-year inflection point has now dropped you down to $352,000. The volatility adjusted returns, the taxation, and the fees have basically taken half a million dollars of your money. Your wealth is under attack.
One of my first books — no longer being published — was called Five Ways Your Wealth Is Under Attack. The new book is It’s Your Wealth, Keep It dives really deep into this. You can get it on Amazon or on our website and request a free copy if you book one of our wealth curve conversations, and we’ll send you a nice copy — free, no obligation.
I want you to think about this for a second. The volatility adjusted return is now down to 7.7%. My expectation was 11%. You’ve got to know what I’m showing you is not the full picture because it’s calendar year, it’s not the right tax rate. If tax rates go up or fees are higher, it becomes worse. If you’re looking at this chart and you’re 34 years old and you’ve grown your $100,000 to $260,000, and you’re going through that 2000–2002 50% downturn, and you’re now eroded back down to $156,000, you just lost a third of your money. You’ve hired the worst financial advisor possible.
If you look at the chart now, you realize there is a full ride back up that many miss out on. This is the essence of the Dalbar study. Investors tend to say, “I’ll get back in when it feels good,” but market timing rarely works in their favor. The power lies in the strategy—not the market return itself, but how you minimize the effects and impacts of erosion. You could have the greatest financial products in the world, but all the market volatility and eroding factors descending upon your wealth will take it away if you do not keep an eye on minimizing taxes during the accumulation phase and focus on minimizing fees and the impact of market volatility. Learning how to weather the inevitable storms is key to your success.
If you focus on setting clear goals and building the right foundation for your financial plan, you can transform your wealth curve substantially. For example, you might have a great idea to start your own business, but feel you lack enough capital or resources. Those reasons could be holding you back, but with the right plan, you can gain the permission in your own mind to take those actions. What I want you to understand is that it’s not about chasing a particular rate of return; it’s about how you structure, nurture, and think about your money that unlocks its true power.
This is John Smallwood signing off. It was great to talk to you. Thank you.
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