By: Richard Feldman, CFP®, MBA, AIF®
Picking the next hot stock or hot mutual fund has practically no bearing on building up a substantial investment portfolio. Most retail investors and even some professional financial advisors focus on the wrong factors when trying to maximize total portfolio wealth. They tend to focus on maximizing investment return by trying to find the next hot stock or mutual fund instead of focusing on the incremental risk of the portfolio. Risk is inherent when you invest in the capital markets. The recent market correction that started towards the end of October 2007 when the S& P 500 approached being down 20% from peak to trough and the 2000 to 2003 time period has shown us that the market has significant up and down years in terms of total returns. The total return of the S&P 500, which enjoyed one of the worst stretches of performance in its history from 2000 to 2002, was down 43.09% (-9.11%, -11.88%, -22.10%) and the following year, in 2004 when it eventually recovered, the snapback was significant to the tune of 28.69%. The successful investor needs to be able to control the volatility in their portfolio rather than trying to maximize average total return. It may seem counterintuitive but more wealth can be created by reducing the volatility of a portfolio than by focusing on obtaining marginally higher rates of return.
The difference between the average return and compound total return of an investment can have a dramatic effect on the total ending value of a portfolio. For example, assume that you were offered a chance to invest in a stock that had a 29% average annual return over the time period from 1997 to 2003. Most investors would probably jump at the chance to invest in this scenario. How about if I offered you the chance to invest in one of the technology boom darlings – Lucent Technologies in 1997? Most investors knowing what they know now would not jump at that chance. The reason individuals would avoid Lucent is that we know how the Lucent story turned out for investors, very badly. Lucent lost more than 60% of its total value for the time period from 1997 to 2003. (See the following sequence of returns.)
|Annual Return (%)||74%||176%||37%||-81%||-53%||-75%||125%|
|Ending Value of $100K||$174,000||$480,200||$658,000||$125,000||$59,000||$15,000||$33,000|
The average annual return over the period: 29%
Compound total return over the period: -14.64%
The difference between the average return of 29% and a compound return of -15% is owed to the distribution of returns or the volatility of the returns of the investment. The more volatile the returns the lower the compound annual return. The reason behind the difference is that when an investment losses principle the portfolio has to work doubly hard to offset that loss. If a portfolio loses 50% one year, the next year the portfolio would need to earn 100% just to get back to even.
Another way to visualize volatility is to take a look at two different portfolios with a starting value of $100. The first portfolio has a return of 10% in the first year and -10% in the second year for an average return of zero. The second portfolio has a return of 30% in the first year and -30% in the second year, again for an average return of zero. Which portfolio would you rather have? The first portfolio is much more optimal because the ending value of the portfolio is $99 versus an ending value for the second portfolio of $91. The compound rate of return for the first portfolio is -0.5% and the compound rate of return of the second portfolio is -4.61% .
If you have two portfolios that have the same average return, the more diversified portfolio will have a greater terminal value because of the lower volatility of returns.
The most efficient way to control volatility is by diversification or using modern portfolio theory. In order to combat volatility, an investor needs to think of diversification beyond a single market or a single asset class such as the S&P 500. Diversification can be achieved by combining multiple asset classes that have low correlations and high expected returns. Returns can be smoothed out by selecting asset classes that have low correlations to domestic indices like domestic real estate, international real estate, commodities, bonds, and international equities both large and small. The benefit of selecting asset classes that have low correlations to one another is that losses will be mitigated because when one asset class is fairing poorly the other may be doing well.
The greatest way to build portfolio value is to construct a portfolio that attains a high percentage of global equity like returns but minimizes the volatility of the returns or variance of the returns. If you are a fan of baseball the analogy would be to try and hit singles and doubles rather than taking the chance of trying to hit a home run and end up striking out. My next article will detail how adding non correlated assets can maximize terminal wealth accumulation.