Investments that are Good on Paper, Bad In Practice

A buy-and-hold strategy

Good on Paper. Whether it involves holding an index fund that tracks the S&P 500 or one that represents a specific factor like growth or value, this approach looks good on paper because of its simplicity. You buy, you hold, and maybe you rebalance periodically or stepdown equity exposure every five years. Even one of the most sophisticated versions of this strategy, a target-date fund, is still something clients will readily understand.

But… While on paper the U.S. equity market has recovered from all major declines, asking clients to ride through several 50% or greater drawdowns is a hard pill to swallow. The “hold” can quickly turn into HODL (hold on for dear life!). Catastrophic drawdowns take years to recover from, which might be OK for some clients, but often has devastating effects for those nearing retirement.

REITs

Good on Paper. Real estate is often a favorite of advisors seeking to protect their clients’ portfolios by diversifying away from any one asset class becoming dominate. The reasoning is easy to understand: diversification reduces exposure to individual asset risk, and as a hard asset, real estate has a fundamental value that’s tangible and easy for clients to understand.

But… Upon further inspection, real estate is highly correlated to stocks and therefore offers fewer diversifying characteristics than first meets the eye. We saw this in 2021, when real estate was a top performer in a year where the market was up well above average.

The consequences of correlation can be particularly difficult during market drawdowns. For example, since 2000, the Wilshire US REIT Index experienced a more severe maximum drawdown (over 75%) than several other traditional diversification strategies, including Treasuries, corporate bonds, or the value factor.

Amazon.com (AMZN)

Good on Paper. Little explanation is needed here because an investment doesn’t get much better looking on paper than a 31.1% annualized return over the past 30 years, diversified business lines, and a foothold in areas of the market that show tremendous growth potential.

But… There’s no such thing as a free lunch, and the “price” paid for such a good-on-paper return is volatility – which comes with its own emotional toll.

Investors who have captured this exceptional return have also had to ride through three separate occasions when Amazon lost over half of its value, plus a 94% decline during the tech bubble. Reminder: a 1,567% return is needed to breakeven after a 94% decline.

That’s an enormous psychological price. It takes a lot of intestinal fortitude to hang on.

Gold

Good on Paper. Gold has long been used as a hedge strategy because it usually demonstrates “safe haven” attributes during periods of market crisis or inflation.

As a risk-management strategy, it performs well, offering enhanced risk-adjusted and cumulative returns over full market cycles that include at least one bull and bear. Since performance is correlated to an asset rather than stocks, gold can provide portfolio diversification in a way that’s not possible in direct equity investments.

But… The attributes that can make gold attractive during times of market volatility may mean it’s equally unappealing when the stock market is strong and calm. Often there’s a negative carry during these times, when the cost of holding the hedge exceeds its benefit.

Clients may compare gold’s performance to their preferred benchmark – be it the S&P, Dow, or Nasdaq (even though we all know these aren’t fair benchmarks for all investment products…I digress) – conclude gold offers paltry returns with no yield, and become impatient. Due to the optics of underperforming during strong markets, advisors must continually remind clients of the role gold plays in achieving long-term financial goals. But, the potential lack of investor commitment can lead to abandoning the plan at precisely the time risk management is needed most.