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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Thursday, April 7, 2011

Higher Returns with Lower Risk?

Note: We published this article in the Oakland Press back in 2007. The concepts detailed here are a key element of our client investment strategy. We updated it to reflect changes we’ve made since then. We felt a reminder about the role diversification plays in your investment strategy would be appreciated by our readers.

A basic principle of investing is that the higher return an investment pays, the higher the risk of the investment. And, if you want low risk, you must expect lower returns. We all expect stocks to return more than bonds over the long run but nearly everyone knows that higher returns bring higher volatility. Fixed income investments, with their lower returns than stocks are less volatile, hence less risky.

Whenever a client calls touting some great new investment that promises to pay 12%-14% or more, “guaranteed”, we are immediately suspicious. In every such situation we’ve experienced, there has been a significant risk associated with the investment.

The more risk you take on, the greater the chance of losing money. Warren Buffet, considered by many to be the greatest investor of all times, abhors losing money. His Rule # 1 is “Never lose money”. His rule # 2 is “Never Forget Rule # 1.” Consider that if you lose 50% of your principle, you must achieve a 100% return to recover your losses.

So how do you go about lowering risk and reducing the chances of losing money? And, is there a way to lower risk and increase returns at the same time, contrary to the basic principle discussed above? Fortunately, the answer is yes! It’s called diversification. Proper diversification of your portfolio can boost your portfolio’s returns and at the same time lower the risk (volatility) of the portfolio.

Clients often come to us with a portfolio made up of a large number of stocks and mutual funds and believe that they are well diversified. Often their portfolios may contain some cash, one or two bond funds, maybe one or two international funds and a number of large domestic stock funds. More often than not, the stock mutual funds overlap, (i.e. they each invest in many of the same individual stocks). It’s not unusual for clients to have 60%-80% of their total portfolio invested in large company U.S. stocks. That’s not what we consider proper diversification.

To be properly diversified, you need to be invested in several distinctly different asset classes. We include eleven different asset classes in our clients’ portfolios. These include cash or cash equivalents, short-term bonds, Treasury Inflation Protected Securities (TIPS), high-quality intermediate-term bonds, high yield bonds, international bonds, large domestic stocks, small domestic stocks, international stocks, commodities and real estate equities. We utilize broadly diversified no-load (no commission) mutual funds, Exchange Traded Funds (ETFs) and index funds.

You may be wondering: “Why does diversification increase returns and lower risk?” Warren Buffett might say that it’s due in part to the fact that diversification reduces investment losses (Remember Warren’s Rule #1?). The distinctly different asset classes noted above experience different up and down cycles. Thus, real estate equities may be in their up cycle while other stocks are in their down cycle. Bonds may be doing poorly while stocks are rallying. International stocks may be up while U.S. stocks are down. The returns of these various asset classes are not strongly correlated, meaning that they move somewhat independently of each other.

The next logical question is: How much of an effect does diversification have? Well known speaker and investment manager, Roger Gibson, in his book “Asset Allocation: Balancing Financial Risk”, Dow Jones-Irwin, Homewood, Illinois 1990, cites a study of the performance of what he describes as a “traditional portfolio” versus the performance of what he calls a “broadly diversified portfolio”. The “traditional portfolio” includes only Treasury Bills, corporate bonds and S&P 500 stocks. The “broadly diversified portfolio” includes the same asset classes as the “traditional portfolio” plus international bonds, small company stocks, international stocks and real estate equities.

During a 10-year period ending 1988, the ‘traditional portfolio” returned 13.9% versus 15.3% for the “broadly diversified portfolio”. And, the higher return of the more diversified portfolio was accompanied by 0.8% lower risk as measured by the portfolios’ standard deviations (a statistical measurement generally equated to investment risk). Over 16 years ending 1988, the “broadly diversified portfolio” returned 12.3% versus 9.9% for the “traditional portfolio” with 0.9% lower risk.

So, if you want to pursue Warren Buffet’s Rule # 1, make sure your portfolio is broadly diversified. You can improve your portfolio’s return and at the same time lower your risk!


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