Investments Updates

By Selwyn Gerber:

Investments

While it is impossible to completely eliminate risk, diversifying your investments should significantly reduce the total volatility of your portfolio. In building a diversified portfolio, some general rules apply. Stocks carry more risk than bonds. That’s why stocks provide better returns than bonds over the long run. It is also true that small cap stocks are more volatile than large cap stocks, because it is more likely that smaller companies will have erratic earnings or could even go out of business. This explains the greater returns available from small cap stocks. International securities involve more risk for the U.S. investor than an investment in the U.S. markets. Changes in currency, in particular the long-term decline in the value of the U.S. dollar, can have a significant impact on the returns realized by Americans investing abroad. In emerging markets, which offer the greatest potential returns, political instability is a risk factor that can not be easily quantified. For these reasons, and others, the returns from international stocks exceed the returns from U.S. stocks over the long-term.

Stocks

“Over 90 percent of investment returns are determined by how investors allocate their assets versus security selection, market timing and other factors.”
- Brinson, Singer and Beebower, “Determinants of Portfolio performance II: An Update,” Financial Analysts Journal, May – June 1991

Dow Jones

The idea of risk and reward can be easily illustrated, as shown in Table 9-1. For this example, we use an S&P 500 index fund to represent stocks, and a long-term Government bond fund. We vary the allocations and find the returns for those portfolios over the test period which began in July 1991 and ran through Feb 2008.

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The 50/50 mix of stocks and bonds offers the best returns with the least risk. In all cases, adding some allocation to bonds decreased risk.

Combining the different risks and rewards can lead to a portfolio where the sum is greater than the parts. While it seems counterintuitive, a 50/50 mix of bonds and stocks outperformed either investment with less risk. While the increased returns were minimal, the risk reduction was dramatic.

The lowest returns are found in a 100% bond portfolio. But risk is reduced more than returns by adding a small amount of bonds to the stock portfolio. By reducing exposure to stocks by 20%, risk is lowered by more than 15% and returns fall by less than 8%. Most investors will sleep better at night with less risk, and the peace of mind is worth the price paid in foregone returns.

The idea behind diversification is that while one asset moves down, another is likely to be moving up. The biggest problem with diversification is that it requires some work to maintain the asset allocation at the right levels. While many investors initially create a diversified portfolio, over time the performance of one asset can lead to it having too much weight in the portfolio. After performing well enough to grow in size, it is likely to underperform for a time. Unless the portfolio is periodically rebalanced, you’ll miss out on the capturing the large gains by allowing them to slip away.

Over the course of a year, or even six months, a portfolio that started out as 60% stocks and 40% bonds can easily become 50/50 if stocks decline and bonds rise, or 70% stocks and 30% bonds if stocks rise and bonds decline. Rebalancing means that you will need to periodically sell the winner and buy more of the laggard to bring the allocation back to the starting point. This captures gains and increases the investment in the part of the portfolio likely to benefit from long-term shifts in the market place. Failing to rebalance will result in the portfolio failing to maintain the desired allocation and increasing in risk.

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