When people decide to invest in the stock market, there’s almost always an aversion to losing money. There’s a risk that investors will receive less in the future than what they contribute in the present, and that’s often enough to scare people away indefinitely. When others invest, they conceptualize risk as an opportunity cost of missing out on the next big IPO or private equity success story. To them, the risk of bad timing and missing large returns on their capital drives their investing behavior. And this “opportunity cost” risk must be mitigated for these high-return-seeking investors when allocating money in search of returns above and beyond what an index fund can deliver. After all, there has not been a single billionaire who made it big off matching the market with an index fund. Not one.

Great investors have taken chances to invest in businesses that have benefited millions of people, and they’ve been rewarded handsomely for those efforts. This includes entrepreneurs who have invested their time, money, and effort to create value for others. Instead of allocating their money in the stock market, they chose to take a risk and invest in their idea in hopes of earning a higher return than what the market was offering at that particular point in time.

Contrary to this relative aggressive style of investing, is a passive strategy of buying and holding index funds for the long term. And with time on your side, you’re almost guaranteed to earn an average return of 5-7% over several decades, just by buying and holding a basic S&P 500 fund; by no means a bad way to go when considering the compounding effects of those returns over longer periods of time. To highlight the concept of compound investment returns, if you earned a return of 6% per year, on average, you would double your investment every 12 years. For example, if you invest $50,000 and earn 6% in the first year, you’ll earn $3,000 after year one. Starting year two with $53,000 and earning another 6% will net you $3,180 instead of the initial $3,000. In the 20th year, your balance in this hypothetical example will have increased more than 200%.2 Staying the course and investing for the long term can be a lucrative endeavor.

Time is on your side

Based on historical statistics, the chances of losing money in the stock market after one year are greater than 25%. But, if you invest for 10 years–based on what has happened in past years–that number would drop to about a 4% chance of loss. After 20 years, historically, that number goes to zero.1 Zero chance of losing in the stock market after 20 years can be a selling point for investors, or it can be a great deterrent for those who want their money to work for them in a much more impactful way. Some would no doubt say that breaking even after 20 years in the stock market is an awful way to invest; and they wouldn’t be wrong. Skeptics would also point out that past statistics are by no means guaranteed to repeat, and they wouldn’t be wrong either.

There are many more ways to invest than by simply buying stocks and bonds, and although many of these investments might carry higher risks, the rewards could potentially outweigh any realized losses. And this is where diversifying over several asset classes with the intention of seeking negative correlation with the stock market can truly pay off over various time periods.

Think differently

In order to properly diversify, one has to minimize the risks associated with the overall stock market. In other words, if the entire stock market is in free fall like it was in October of 1987, the chances of investors somehow avoiding massive losses are very improbable. But, if an investor decides to allocate financial resources to create a business that is in high demand over that very same time period, chances are it is less likely that the losses will be exactly correlated with that of a loss in the stock market. Of course, those losses could be more severe, but they could also yield positive returns precisely as everyone else is losing their shirts.

Burton Malkiel, author of the perennial best-selling book A Random Walk Down Wall Street was correct when he wrote: “risk, and risk alone, determines the degree to which returns will be above or below average.” Investing in your own business, or allocating capital with someone running a promising startup are ways in which investors can attempt to mitigate the systemic risks associated with investing in the stock market. Real estate investments, limited partnership interests, and even certain alternative investments like hedge funds may provide much needed diversification when markets head south. It must be noted, however, that these asset classes are not always negatively correlated with the stock market and often carry more risk and higher costs. Nonetheless, prudent investors consider these asset classes in conjunction with a portfolio consisting of equities and bonds to optimize risk-adjusted returns.

Risk and return are inseparable. You cannot earn large returns without taking on large risks. But the greatest risk of all comes from overconfidence in one’s ability to outsmart everyone else they’re trading with, since there must be a buyer and a seller on each side of a trade. Warren Buffett said it best when he said “we don’t have to be smarter than the rest. We have to be more disciplined that the rest.”

Disciplined investors remain diversified in both bull and bear markets, maximize risk-adjusted returns, and recognize their limitations when it comes to earning a return on their hard-earned capital.

1. Based on calendar-year returns of the specified indexes, stocks have had a negative 1-year return 28% of the time, a negative 10-year return 4% of the time, and a negative 20-year return 0% of the time. Data covers the period 1926–2014 and uses the Standard & Poor's 90 from 1926 to March 3, 1957; the S&P 500 Index from March 4, 1957, to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, to June 2, 2013; and the CRSP US Total Market Index thereafter.

2. Vanguard Research, How Risk, Reward, and Time are Related.

Almost anyone can come within a dollar or two of estimating what it costs for certain household items, whether it’s a gallon of milk or a roll of paper towel. We know what it costs because we buy them so often and the price is in plain view for us to see. We also have a tendency to look for deals and discounts to decrease that price even further. Unfortunately, the price of investing isn’t so transparent, and we often don’t do our due diligence to find out what we should be paying, let alone what we might be paying.

After all, does the average investor really know—down to the dollar—how much they’re paying their advisor in the form of commissions or fees, or both? Do they know how much it’s costing to buy and sell certain securities? Do they know the dollar amount of the expense ratios these funds carry, or the tax costs that they incur when they recognize gains? The reason that these figures are probably unknown is because we don’t buy securities as often as we buy things like household goods, and oftentimes these financial instruments and services lack even the most basic price transparency.

Dr. William Sharpe, Nobel Prize winner and creator of the Sharpe Ratio, has a good estimate of what it costs us to do business with the investment industry. He estimates that “a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments.” The numbers don’t lie.

A 2012 Demos study assumes a dual-income household at the median income level of approximately $35,000 to $45,000 over a 40-year period from 1965 to 2005. Furthermore, the study assumes contributions of 5-8% of their household income. Based on these assumptions and typical 401(k) fees, this household would stand to lose 30% of their savings, or $154,794.1 And if you think that’s high, households that earn more than three-quarters of other American households—in keeping with the same assumptions as above—would pay about $278,000 in fees. The irony is that 401(k) plans are classified as a benefit by companies offering these plans, but there’s nothing beneficial about losing this much to fees and other unnecessary costs, especially when many times employees don’t have the option to select low-cost investments in the plan.

Active costs vs. passive savings

Mutual funds or Exchange Traded Funds (ETFs) that are actively managed by investment professionals are more costly precisely because there is someone behind the desk making decisions on how best to manage the fund. This isn’t the case with passive funds, which normally track a benchmark index such as the S&P 500, without any management whatsoever, other than perhaps making a trade when a particular security is added or eliminated from the index; an event that is not nearly as common as trading on a weekly or monthly basis.

In a 2014 publication from the CFA institute, John Bogle estimated “all-in” actively managed fund costs at 2.27%. This figure is comprised of average expense ratios of 1.12%, transaction costs of 0.50%, cash drag of 0.15%, and sales charges of 0.50%.2 Expense ratios are annual fees based on the assets under management (AUM) a client has with an institution. This percentage, deducted from an investor’s total AUM in their account, is used to pay for management, administrative, and operating costs to run the fund. Transaction costs and sales charges are self-explanatory; however, cash drag is one aspect of total all-in costs—albeit a small portion—that isn’t normally considered, as it’s not a direct cost being charged to the client.

Cash drag is the opportunity cost of not being fully invested in a fund. Most active fund managers carry about 5% of assets in cash, consequently forgoing a chance to earn a return on the money that is sitting in cash. A conservative estimate of the equity premium over cash is about 6%, translating into a 30 basis point (bp) drag on active returns. Bogle takes an even more conservative estimate when he puts that figure at 15 bp. Compare this to the all-in cost of index funds, which both Bogle and Sharpe estimate to be around 0.06% of AUM, and investors who opt for active funds are starting out with a 2.21% disadvantage; a very substantial amount to overcome. Costs definitely matter.

Behavior and its toll

Fund managers are often measured on their Time Weighted Return (TWR), which assumes a fixed dollar amount at the fund’s inception without any inflows or outflows coming into the fund. Contrast this with a Dollar Weighted Return (DWR), which accounts for how investors allocate their capital over a given time period with both contributions and distributions from the fund. The difference between these TWRs and DWRs is a gap between how the fund actually performs versus how the investor actually performs in the fund; thus, a behavioral or performance gap between the two.

One study that examined TWRs in relation to DWRs between 1991-2013 found the difference to be about 1% for funds with low expense ratios and about 4% for higher expense ratios.3 If we use the more conservative 1% estimate, this still adds up over time and is a major drag on performance. Excessive trading, especially in funds with higher fees, widens the behavioral gap, nearly always unnecessarily adding to an investor’s costs.

Investors whose goal is to maximize returns should be cognizant of both explicit costs, such as transaction fees and expense ratios, as well as those costs which are less obvious, like cash drag and behavioral costs.

1., 2012.

2. The Arithmetic of “All-In” Investment Expenses, John C. Bogle. Financial Analysts Journal, Volume 70 Number CFA Institute 2014.

3. Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies. Hsu, Myers, and Whitby, 2015.

There has probably been a time where you’ve heard someone discussing a stock or mutual fund that has had big returns, or perhaps an advisor who has outperformed the market over a given year or so. Naturally, we’d like to flock to that expert advisor, or that superior stock or mutual fund to realize some of those gains as well. There would probably be something wrong if we didn’t feel compelled to jump in and make some money right then and there. Unfortunately, chasing investment returns can be one of the worst mistakes an investor can make. And too often this impulse occurs when an investor has not established a plan of some sort from the outset, making decisions willy-nilly as though allocating one’s hard-earned money in the markets was not an important matter.

Asset allocation is one of the most important aspects to investing, and for good reason as it’s directly derived from an investment plan and a risk tolerance profile. Risk and return are inseparable; the more risk one takes in the market, the more return one should expect to receive. This is axiomatic for most things in life as well. There has not been a single entrepreneur who has had an aversion for risk, unless of course they stood to lose no money along the way. The same risk/return trade-off holds true when determining the asset mix of your portfolio.

All things in moderation

Big returns over a long period of time will most likely not come from holding an entire portfolio of treasury bonds. Nor will an all-bond portfolio result in crippling losses, as the average loss over the 88-year period ending in 2014 was just a mere 5.4%. Compare this to an average loss over the same period of an all-equity portfolio of 9.7%. Averages, however, can be misleading especially over such a long period of time.

Figure 1 highlights how devastating one-year losses can be when a portfolio consists of all stocks.1 Incurring a loss of 43.5% would undoubtedly impact both the short- and long-term investment goals of someone trying to save for a new house in the next couple years, or even retire ten or fifteen years down the road. On the other end of the spectrum, an all-bond portfolio has only lost about 8% over its worst one-year period during that time period.

Figure 1. Asset allocations and spectrum of returns

Of course, these are two extremes, so a more likely asset allocation mix probably lies somewhere in the middle. For example, with respect to a couple in their 30s, a good rule of thumb is to allocate your age in bonds—or 30% of their total capital—plus or minus a few percentage points depending on their time horizon and risk tolerance. Therefore, as we can see from the diagram, a 70/30 equity-bond mix would average around 9% on any given year; however, the roughly 72% range of returns could mean a substantial loss of about 31%, or a big gain of around 41%, for any given year. The key question is: how much can you stand to lose before you have to sell out? In other words, if you can’t stomach losing 31% of your capital, you shouldn’t allocate 70% of your money toward equities. On the flip side of this, perhaps the notion that if you’re looking to be in the market for the next 15 to 20 years, and a decline of this sort might offer you a chance to buy even more securities at a cheaper price, you would be able to reduce the average cost per security and end up buying at lower price points than if you had not bought at those lows.

Sell down to the sleeping point

There’s an old adage that says you should sell down to the sleeping point. Stated another way, this just means that if losing 30% will keep you up at night, it would be more prudent to pare down the equity holdings and replace them with bonds. This doesn’t guarantee a less-than-30% loss, but historically, it does mean that there’s probably less of a chance that it would happen.

Similar to sustaining market losses, many investors can’t handle missing out on big market runs, particularly when it appears as if everyone else is profiting from it. And this is when most people start chasing past performance, altering investment plans, and ultimately selling low after buying high; a recipe for disaster. Standard & Poor’s publishes the S&P Persistence Scorecard twice each year, which tracks performance of actively managed mutual funds over several years.2 Of the 1,421 domestic equity funds in September of 2009, only 6.47% remained in the top half just five years later. Random expectations would suggest a repeat rate of about 6.25%. So, you could literally throw darts at the mutual fund section of the newspaper and expect to do just as well as the “expert” fund managers. For shorter time periods, the result isn’t much better. Of the 692 funds that were in the top quartile in September 2011, just two years later only 7.23% remained in that top spot. Chasing past performance does not pay off.

In short, a more viable plan is to determine an appropriate asset allocation mix that is in line with the risk of loss you’re willing to accept, modifying the plan to account for investment-related goals, and buying more (or selling more) during market decreases (increases). Nothing is worse than repeatedly buying high and selling low. It’s the exact opposite of attempting to buy at low prices and sell at higher ones along the way, which is a winning strategy over any timeframe.

1. Vanguard Research, Best Practices for Portfolio Rebalancing, November 2015

2. S&P Dow Jones Indices Persistence Score, December 2013