Equities as measured by the S&P 500 ended virtually unchanged for the calendar year 2011.  Were it not for dividends the year would have been a complete washout.  What 2011 did not lack was volatility.  Given the year’s performance one could argue that it was filled with a great deal of “excess volatility” or volatility that takes the markets nowhere.

You would think that in such a year the so-called smart money would thrive.  You would be wrong.  In 2011 some 60% of hedge funds actually lost money.  In fact a comparison of a pretty simple strategy, the Vanguard Balanced Fund, against long-short equity hedge funds shows the superior performance of simplicity and low fees versus complexity and high fees.

Most people recognize that volatility is not risk.  By that we mean the true financial and economic risk of an asset is not well-captured by a measure like volatility.  So volatility, and in the case of 2011 high volatility, works on us in a very real emotional sense.  James Surowiecki writing at the New Yorker writes:

It isn’t just that volatility costs ordinary investors money. It also makes them more likely to give up on the stock market entirely: over the past three years, investors have pulled almost two hundred and fifty billion dollars out of equity funds, even though stock prices have almost doubled since the lowest point of the crash. And, while some of that money has gone into exchange-traded funds, most of it has just left the market. This flight from stocks is probably not a good thing for people’s retirement accounts—after all, in a capitalist country owning some capital is usually a smart way to make money. But it may well be a good thing for investors’ psychological well-being. In effect, they’ve decided that, in a market as volatile as this one, the only way to win the game is simply not to play.

It’s the giving up on the stock market that is going to cost investors.  Some will stay out altogether.  The more likely situation is that those investors scared out of the market will return at the most inopportune time, i.e when the market has already risen a great deal.  The challenge for most investors is to try and create a portfolio whose volatility they can live with over time.

For most investors this means following a strategy that is broadly diversified across a range of assets so that the volatility of the stock market will not be the overriding force driving portfolio decision making.  Rob Arnott quoted at WSJ states:

Mr. Arnott doesn’t believe that stocks are inherently better than other investments. Indeed, he believes too much attention was paid to equities in the past. People need to look at the “whole spectrum of investments available to them,” he says, not just stocks and bonds.

“The cult of equities did a lot of damage,” Mr. Arnott says. “People are expecting the markets to do their saving for them by delivering a high return. That’s just not realistic. Ratchet down your return expectations,” he adds, “broaden the tool kit, and recognize that real returns are what matters.”

James Picerno at Capital Spectator goes even farther in advocating an equal-weight approach to asset allocation. He writes:

An equally weighted portfolio of all the major asset classes returned roughly 4.3% a year over the last five years, by my calculation. That’s hardly spectacular, although it’s probably competitive in the grand scheme of clever managers trying to outsmart the markets. Naïve strategies that deliver decent returns sounds counterintuitive, but this is finance and so the risk of trying too hard should be considered.

“Decent returns.”  We aren’t talking about world-beating returns that will easily fund your goals.  What we are talking about is staying in the investing game and not letting market volatility push you to the sidelines.  Because the sidelines these days is filled with money market funds yielding 0.01%.  The financial services industry in general is built on selling complexity (and high fees) to its clients.  Sometimes it is hard for individuals to believe that a naive approach to investing can yield decent returns.  For most investors decent returns is a big step up from their current attempts to “beat the market.”

Items mentioned above:

For the S&P 500, 2011 basically never happened.  (MarketBeat)

60% of hedge funds lost money in 2011.  (The Reformed Broker)

Hedge funds vs. a 60/40 balanced fund.  (ETF Replay)

Market volatility has forced many investors from the market altogether.  (James Surowiecki)

Investors should bring down their expectations for bonds (and equities).  (WSJ)

In praise of naive asset allocation strategies.  (Capital Spectator)

Is the money market mutual fund model broken?  (Barron’s)

The behavior gap illustrated.  (Abnormal Returns)

Abnormal Returns