The standard advice that investors get has them diluting their stock returns by balancing with bonds. We may want go the other way instead, to double down on our stock returns.
Very few investors think all that much about what they invest in. They often will rely on professional advice, whether this be from a sales person at their financial institution, a financial advisor, or even personal financial management if they have a big enough portfolio. They may simply choose on their own, being guided by advice from the industry that doesn’t differ much from the personal advice they could get.
For those investing for the future, especially those who are looking to build up a big enough nest egg to retire comfortably, how well they choose matters a great deal, and a great deal more than they realize.
At the very least, they need to be aware of what the options are, what the plusses and minuses are of each, and then choose based upon the proper consideration of these options. We don’t want to just line up like people do in a soup kitchen and let them load our plate with whatever they are serving everyone else. It is not even that the soup we get may be suitable enough for us, it may not be suitable for anyone and the soup might be terrible but no one may know the difference.
We’ll use the idea of going half in the S&P 500 and half in a bond fund as the soup kitchen soup, and although investors will mix up the ratio here, 60 stocks 40 bonds for instance, it’s basically the same bowl of soup, with one being spiced up a little more.
Some, those who are older, may choose a half serving, putting all of their money in bonds for the purposes of earning income. This is the same soup basically, you just get fed less of it, and folks who are older often see their appetites reduced and are happy enough with half a bowl.
Before we start to look at what they are serving at better eateries, we want to look at why people may choose the soup kitchen instead. Aside from being told this is where they should be getting their meals, they are told that they should be frightened of eating anywhere else, because while the food may be better, there’s a chance that they may end up going hungry in the end, and not having enough to eat later in life is a scary prospect.
They could go to the diner down the road instead, putting all of their money in the S&P 500, but they are told that they never know how that’s going to go, and they could get left with less in the end if they do that, at least that’s how the story is told anyway, whether it is true or not.
We’re going to start by looking at these three scenarios, the half serving at the soup kitchen, the full serving, and the better but still pretty bland fare at the S&P Diner. We’ll then move on to a much better restaurant, the Nasdaq 100, and then take you to the best one in town, the QLD, to examine how they all stack up to one another and if this better dining is really all that scary, and whether we should not be choosing to eat at better places.
While there are other options and other combinations, such as funds that specialize in all sorts of stock types and sectors, actively managed funds, these funds mostly lag the S&P 500 and the ones that beat it don’t really beat it by much, and none of them contend with the restaurant up from here, the Nasdaq 100, and especially not the QLD. It is more than enough that we just look at these main types.
Investing is always a balance between risk and return. There always is a line that involves taking on too much risk that we don’t want to cross, and paying attention to risk always is important. We would not want to be putting all of our investment savings in a 1000:1 leveraged forex trade for instance, even though we could become a lot wealthier doing this if we get lucky. Catching a just a 1% move would multiply our investment by ten times, and you could do this in just a single day, but a tenth of a percent against us would wipe us out, and that can happen in mere minutes.
In between this and burying your money in the back yard will lie the right amount, but the goal here isn’t to minimize our risk, and if that were the case, burying our money would be ideal, and even though you can’t eliminate risk altogether, as someone may find our stash and steal it.
There’s also the risk of hyperinflation that we take on when holding currency, or any asset denominated in hard currency, or the entire economy collapsing due to a world war or a pandemic that wipes out most of the world’s population. There are always risks in other words, and what we need to do is seek to understand and manage them alongside what we are looking to achieve, in this case, investment returns.
Whenever we invest in anything, we take on risk, in order to pursue returns, and risk and return always want to be viewed together. Just hiding our cash is low risk but no return, and that’s why that plan does not make sense. Putting our money in a savings account is also low risk, but very low return, and even though we may be able to get by on this, it can make more sense to seek out better returns whether we need to or not, if we can achieve them safely enough.
Safely enough is the key concept here, as once again, the goal isn’t to minimize risk, it is to keep it acceptable. Risk here is not subjective, even though it may be felt that way, for instance among people who see investing in stocks instead of bonds as too scary of a prospect because their personal appetite for risk is so low.
This is a lot like saying a child has a reduced appetite for doing mathematics so they shouldn’t bother with it, and while the kid may end up not liking the subject very much after sufficient exposure to it, we still want to say that he or she should, because it is to their benefit. Far too often, we give in to these subjective fears with clients, and while there may be cases where they just cannot bring themselves to do the right thing, there is a right thing to do and they need to at least be encouraged to pursue it.
We will start by looking at those who choose the half servings at the soup kitchen, those who choose to go all in with bonds. Bonds are thought to be a lot less risky than stocks, but this depends on how you define risk, and we don’t want to define it improperly. The only risk that matters is the risk of your falling short of your objectives, and this is where looking at returns as well comes in.
Let’s See How These Strategies Play Out Over Time
We’ll be looking at average annual returns over the last 5 years in our little study here, and it’s actually nice that we did get a bear market this year because this is the sort of thing that scares investors a lot and steers them away from more lucrative paths. Looking at these things in the midst of a bull market will have people wondering what would happen when we see such a big pullback as we just have, but they need wonder no more.
Bond funds have averaged 2.9% over the last 5 years, compared to the S&P 500’s 7.7%, with the pullback being accounted for with each. We have a 4.8% annual differential, which we can think of as money banked which we will use not only to enjoy later but to also serve to protect us against any additional risk that we may encounter.
People fear the pullbacks, like the one we just had, and might think that the goal here is to accumulate enough extra to protect us against such a thing, but this view is a mistaken one for investors to take in the overwhelming majority of scenarios. Unless you absolutely had to cash in at the bottom of this, where this stock index bottomed, or even had to cash in today, these things shouldn’t even matter to you, because you generally aren’t going to need the money for quite some time.
If you are that close to cashing in and you hear that we’re in the midst of a pandemic, and stocks start to tumble, selling now instead of later in the year should not be a difficult decision at all as long as you still have a working mind. This isn’t how even the oldest of investors cash out though, as they will just get disbursements to maintain their lifestyle, and even in retirement, the majority of their money will be left to ride out the many peaks and valleys that stock investing encounters in whatever investments they happen to be in.
Some years are better than others though, but we want to look at the averages, the 4.8% a year that this stock index has outperformed bonds over our lookback period. We all know stocks go up over the long run though, and this differential is therefore not only reflective of the long run but the cumulative amount builds over time.
This 4.8% includes the 2020 pullback, so we need to ask why this number would not be persuasive for investors, why they would be afraid enough of this to want to dilute it, as is very typical. Sure, we could halve it to 2.4% per year by going half stocks half bonds, but why?
It turns out that while people invest for the long term, they aren’t thinking long term when it comes to risk, and instead are afraid of bumps in the road that are just part of their journey there. Sitting in the back of a car, you will feel the bumps in the road twice as much if you are travelling twice as fast, but if you are able to stay on the road and travel twice as far, the harder bump might give you butterflies in your stomach but really isn’t something that you should want to slow down over.
The part that people tend not to understand very well is that all this extra money in the bank does protect us a lot from these bumps, and all we need to do is take a starting point and then add up all of these extra gains to see how this in itself builds in a lot more tolerance for risk, which is especially the case when we move to higher returning investments where the differential is larger.
While the waves are higher with the S&P 500 than with bond funds, the level of the ocean rises faster, and if the bigger dips of stocks along the way still have us well above the more calm waters of bonds, we need to ask why this strategy would ever make sense.
While we may wonder why investors ever prefer bonds over stocks unless we are in a long bear market, we also need to wonder why they would prefer investing in the S&P 500 when they could be investing in the Nasdaq 100 instead. Aside from not really being very aware of the difference, people tend to be more afraid of the Nasdaq for whatever reason, thinking that it is riskier but not bothering to even check out the validity of their assumptions.
As it turns out, the amount our boat drops with the Nasdaq are similar to the S&P 500, but the amount that this ocean rises over time is considerably greater. In contrast to the S&P 500’s 7.7% average annual return over the last 5 years, the Nasdaq has grown by 21.4% over this time, bettering the S&P 500 by 13.7%. We’re now banking much more money each year, with a similar nominal risk profile, but one that is dramatically improved over time by these much higher returns.
Both of these indexes fell by similar amounts during the 2020 crash as well as the 2008 one, and the only real difference is this extra 13.7% per year, which really adds up over time. The S&P 500 is still down by 9% for the year even after the huge rally it had, but the Nasdaq 100 has already made everything back and is up by 6% instead. The Nasdaq has not had to tap into the huge lead it built up over the big index, it has actually increased it during these more dire times.
If we project this difference out 30 years and start with $100,000 put into all four of the approaches that we’ve looked at so far, the bond fund would have us sitting with $185,000, the half stocks half bonds would provide $257,800, all in with the S&P 500 would give us $331,000, and going all in with the Nasdaq would see us with $742,000.
Since the real risk with saving for retirement is not having enough, and the great majority of investors fall well short of what they need, having a lot more in retirement is pretty important and makes a huge difference in the end.
Let’s Now See What This Looks Like at Over Twice the Speed
There’s one more strategy that we want to look at though which is the centerpiece of this analysis, the ProShares Ultra QQQ (QLD). If the Nasdaq 100 is so much better than the S&P 500, not only banking a lot more money for our retirement but allowing this much higher amount built up to buffer and reduce risk so much, doubling this advantage should be doubly good.
Before we look at this fund, we need to understand how this leveraged fund works. The first concern someone will have when they consider leveraging by two times is their being subject to losing all of their money if the Nasdaq drops by 50%. That’s not quite how it works though, as this uses futures contracts which are settled daily and that actually represents a meaningful advantage over something that just borrowed the extra money and bought more stock like what happens when we leverage stock ourselves, where a 50% loss could indeed take us out.
The QLD has been around long enough to have gone through the 2008 crash, where the Nasdaq did lose more than 50% at its worst. The QLD didn’t go to zero though, and the reason is that each day that the fund declines, since it trades in futures only, it settles and then re-enters at a lower amount. This is similar to what traders do, where as their account balance declines, they take smaller positions, and this keeps them from going broke no matter how bad things get.
This is like the opposite of compounding, and as the price goes down, the amount of stock owned goes down in turn so to speak, even though futures don’t involve ever owning stock. It is not that it goes down all that much, and we wouldn’t want it to because this will make it harder to recover, but just enough to ensure that the fund doesn’t ever go broke.
Just like you can’t lose everything with unleveraged investments, as stocks don’t all go to zero, they don’t do so in a single day either, and the resetting of this fund daily will always leave a positive value to be reproportioned the next day. This is an ingenious way to keep the fund and you from ever going broke and to always be kept in the game to capture the recovery no matter how bad things get.
While it may not be all that wise to hang on to anything declining this much, and especially when leveraged, we don’t want to limit this to those who are even the least bit inclined to exit even in the face of such catastrophic drops. Investors can take a buy and hold approach to even something like this without worrying about losing it all, and sit back and just let the long-term capital accumulation that stocks have always enjoyed happen all on its own without any intervention if they choose, as inadvisable as that may be in terms of optimization.
As tempting as it might be to stand by and do nothing when panic runs wild, when even your kids know that stocks are getting hammered, it simply is not smart to hold on to stocks during the worst of these times, but we also want to take into account those who insist on this anyway and may worry that a leveraged ETF like this can take them out. Like investing in stocks without leverage, you can just ride these things out if you prefer, and be way up in the end, much further up than the S&P 500 or even the Nasdaq.
To get a better feel for this, we’ll look at how the S&P 500, the Nasdaq 100, and the QLD have fared since October 10, 2007, before the mighty crash, to see what sort of return each has provided since. The S&P 500 is up 87.5% over this time, the Nasdaq has gained 326.9%, and the QLD has moved ahead by 741.1%. This was achieved just by holding the funds, no action required at all, even running for your life when you clearly should. Stocks indeed go up over time, but some approaches return much, much more, and we at least need to be aware of this, whichever we end up choosing.
This daily settling also helps us on the way up, as we can see our gains compounded the same way that traders can. Every day is a new trade with this fund, and as the price moves up and this ETF is settled each day, they take a little bigger position and this has the fund growing faster than just owning the regular index fund.
Over the last 5 years, including the recent fall, the QLD has averaged a whopping 51.7% return per year over the last 5 years, versus the Nasdaq 100’s 21.4%. This shows how nice this settling every day and compounding can be, as this is 2.4 times the return, not just 2 times. When your losses get pared a little on the way down and your gains get increased on the way up, that’s pretty nice and not anything you could achieve outside a daily settled fund.
Projected over 30 years, this will turn our initial $100,000 into $1.65 million, something you could actually retire on pretty comfortably. While the last 5 years isn’t necessarily what you’d get over 30 years, as you could get more or less depending on how the market plays out, the idea here is to show how these advantages can play out over time based upon this 5 year performance, and when you average so much more per year, it all adds up to a lot more.
It is only when we are able to free our minds of all of the mundane thinking that we normally encounter and actually have a look at the real differences between approaches that we can even pretend to be minimally enlightened to be able to decide. We still are the ones that will be doing the choosing ultimately, but knowing what the choices really are and how they really stack up against one another will at the very least allow us to make more informed decisions, instead of just sticking our plates out and be served whatever slop they want to give us.