I was reading an investor forum recently where a commenter said that he was contemplating a purchase of shares in Vanguard’s legendary Wellington Fund that has a track record of delivering 8.5% annual returns to investors dating back to 1929, making it one of, if not the, oldest balanced fund in the nation.
He said that he wasn’t going to buy shares because it had trailed the S&P 500 over the past three and five years. For reference, the Vanguard Wellington Fund has returned 12.32% over the past three years and 13.95% annually over the past five, while the S&P 500 has returned 16.58% and 18.83% over those same time periods, respectively.
While it’s always true that you should never make an investment based on past performance alone but you can use it to inform yourself about future performance (for instance, the history of labor problems at Hostess can help explain why Hostess has gone from bankruptcy to bankruptcy while Kraft has built wealth at a 12.5% clip annually for a century. Looking at Little Debbie’s and Oreos in a grocery story aisle may not make the wildly different experience of owning the shares apparent, and a look at history can explain a lot about the future in that situation), you should not rely on performance metrics alone when the economy and the stock market has been rising for five years straight.
Even I would always prefer longer data (ten years vs. five years) over shorter data, it is especially short-sighted to rely on five-year returns right now because it only captures half a business cycle, rather than a full one. Typically, one years out of three will result in stock price declines. But because the 2008-2009 experience was so extreme, it has created conditions that have allowed for prolonged positive stock market performance as stocks have generally moved from undervaluation back to fair valuation and then the slightly modest overvaluation that we see today.
If you are contemplating any potential investment, you have to take the bad years into account as well. If you look back ten years, the S&P 500 has returned 7.78% while the Vanguard Wellington Fund has returned 8.53%. Viewed in that light, it’s easier to understand the purpose of the Vanguard Wellington Fund: it’s not supposed to be a high-flyer that steals the spotlight in good times, but it holds up in poor times and also does satisfactory in good times.
How is this possible?
When you look at its composition, you can see that it consists of 35% high-quality bonds. The purpose of this is to limit the downside volatility when economic conditions worsen and stock prices decline. The bond prices don’t fluctuate as much and they keep pumping out interest to hold up the prices better than some fund that is fully invested in stocks.
Meanwhile, the Vanguard Wellington Fund is prepared for the good times as well by putting the rest of the money (aside from a small cash allocation) to the highest quality stocks in the world, with the largest bets on Wells Fargo, Chevron, Johnson & Johnson, Exxon Mobil, and JP Morgan. The growth of those firms during good times is why the fund’s returns are within hailing distance of S&P 500 funds during prolonged periods of stock price advances and improving economic conditions.
That’s the Vanguard Wellington’s formula for success—diversify, hold a basket of stocks divided among the most powerful companies in the world to provide ballast during times of economic expansion, and keep enough bonds on hand to ensure that the fall isn’t too steep when the next recession inevitably hits. That’s how you stay in business for ninety years and deliver 8-9% annual returns in the process.
None of this should be read as advocacy that you buy the Vanguard Wellington Fund, although it’s probably one of the best buy-and-forget-about-it funds out there, given its low fees of 0.26% annually, its nearly century long track record of delivering 8-9% returns, and its current collection of high-quality assets. But really, my point is more along the lines of how you think about the process. I don’t want you to make any investment decisions based on the performance of an asset over the past five years. The only thing you learn from that fact is that the asset performs well during good times. That sets you up poorly when the next recession and steep decline comes around. You should probably be looking at ten-year performance charts anyway to get an idea of a strategy is playing out, but this is especially true when reviewing the previous five years of performance because they were no bad years included in the data. The skeletons in the closet can only be found if you go back six or seven years.