Wealth creation: a process that I hope ends in a sun-drenched haven filled with leisure and fulfillment. But without careful financial planning, this idyllic picture can quickly fade into a stressful reality. 

The key is understanding the rates of return on various investments, and how to leverage each of them to make the most of your time in the market across the boom-and-bust-and-boom cycle

Before we delve into strategies, let’s dispel any unrealistic expectations. 

J.P. Morgan’s investment data paints a clear picture of the landscape:

• Stocks: While offering the highest potential returns (small-cap stocks averaging 13.2% over 10 years), they also come with the highest fluctuation (growth stocks experiencing a -52.92% 12-month return). This risk/reward trade-off is inherent in stocks.
• Bonds: These provide stability and steady income (average annual return of 2.9%). Their return often lags behind inflation, which can erode their purchasing power over time.
• Gold and Oil: While offering diversification benefits (7.75% and 7% historical returns respectively), their returns fall short of the stock market.

Fidelity’s data confirms the trend:

• Conservative and Balanced Portfolios: These offer lower returns (5.75% and 7.74% respectively) but also lower risk (worst 20-year returns: 2.92% and 3.43% respectively). This demonstrates the risk reduction achieved through diversification.
• Growth and Aggressive Growth Portfolios: Though offering higher potential rewards (8.75% and 9.45% respectively), they also come with significantly higher risk (worst 20-year returns: 3.1% and 2.66% respectively). This shows the importance of aligning your risk tolerance with your investment strategy.

That’s it. If you’re terrified of a bad year, you’re a prisoner of bonds. Even commodities can be volatile.

Bonds mean you’re probably going to earn about 3% a year for the rest of your life. If you’re a billionaire already, that’s all right.

If you want to reach for more than 3% across the long cycle, you need to take on at least a bit of short-term risk. Diversification helps to smooth the ride but there will always be twists along the way.

And across longer periods, statistics always wins. Extreme outcomes rarely happen and usually balance out over time. Instead, history favors the “mean,” where most of the data points are clustered somewhere in the middle.

That’s where we spend most of our time and where most of the outcomes add up. It’s actually pretty good, as JPM’s numbers suggest.

The “mean” is in our favor, as long as you’re willing to experience some of the negative extremes in order to capture the good ones along the way. We had a tiny stock in the IPO Edge that gave us all the agony and the ecstasy in a matter of hours.

Obscure company that just went public a few months ago, lost in the noise. So new and so small that a lot of trading platforms still have trouble dealing with it.

But I liked it around $11. This morning, it crashed to $6. Apocalyptic, right?

We held on. I even suggested buying back in at any level below $8.

The stock recovered and closed a few pennies from $16. We pivoted from a 50% loss to a 40% gain. Those shares people bought below $8 have doubled in value.

Surely some of this gain is transitory, an artifact of a volatile world. We might cash out on Monday. It remains to be seen.

But if we were afraid of the 50% loss, we would never have hung on for the 40% win. And to reach for that 40% win, we need to accept the possibility of ending up with a 50% loss.

Pick your spots according to your return appetite and your risk tolerance. Others might prefer a nice “steady” index fund that stumbles around in a seemingly random walk but delivers  8-11% a year historically.

We made 4-5X that much in a minuscule fraction of the time. The next trade might not be so lucky. But we trade enough that the numbers stack the right way.