How can an investor allocate their portfolio for the greatest return and minimize the related risk? The answer is it depends.
How can an investor allocate their portfolio for the greatest return and minimize the related risk? The answer is it depends. With any investment, there is inherent risk to be taken for a given expected return. Even risk-adverse investors soon learn keeping cash in a savings or money market account is subject to inflation risk and subsequent purchasing loss risk.
Risk vs. Return
Deciding on when and what to buy or sell presents an enigma to many who partake in the investing process. Determining when the market is ripe for buying low and selling high remains a bit of a challenge. Research has shown time and time again this may be a fool's game of chance. However, some look to a professional money or market manager thinking this individual possesses the wherewithal to beat the market and earn superior returns vs. the correlated benchmark.
Unfortunately, available data indicate this may well not be the result. However, that's not to say in any given year a professional manager cannot obtain a superior return for managing a portfolio of investments. The question that presents is, can professional management consistently repeat superior returns? Regrettably, the statistics indicates the answer is no. Only about 25% of active managers in any given year beat their relative benchmark. Ask them to do it again and less than 1% can repeat beating the benchmark in the consecutive year. Moreover, “Active managers outperform the index by 0.12% before fees, but charge more in fees than the value they create.”
Case in point, “Barras, Scaillet and Wermers tracked 2,076 actively managed U.S. domestic equity mutual funds between 1976 and 2006. They found that after fees, three-quarters of the funds exhibited zero ‘alpha,’ a fund’s excess return over a benchmark index. And 24% of the funds were run by unskilled managers (who had negative alpha, or value subtraction).” Additionally, “Only 0.6% showed any true skill at beating the market consistently.”
More recently the S&P Dow Jones Indices 2014 year-end report showed, “Looking at the numbers, you can’t tell whether there is skill involved in what they [managers] do or whether their performance is just a matter of luck ... based on how they’ve done in the past you really can’t predict how they will perform in the future … It’s possible that any one of these funds will beat the market over the long term. Some of them will do that. But the problem is that we don’t know which of them will do that in advance.”
Conversely, passive investing can be as simple as buying a mutual fund (you cannot buy the index) which correlates directly to an associated benchmark index and involves no active management. “Passive funds simply track an index (like the S&P 500) or a basket of companies. It's akin to ordering the pre-fix menu at a restaurant. You get whatever is on offer, and it's often not as exciting, but it comes with a cheaper price tag — sometimes as low as 0.2%.”
What is Your Investment Style?
An investor has choices when deciding to invest in different asset classes, i.e., stocks, bonds, mutual funds, precious metals, real estate, ETFs, etc. There is the ongoing feud between passive vs. active management styles. Can an individual be content by investing passively and allowing the market to find its own price equilibrium and rate of return for risk taken or utilize an active approach and attempt to beat the market return? Moreover, smart beta recently entered the investing fray by combining passive investing with active management by attempting to harness market volatility hoping to yield a positive alpha thereby beating the market return.
Ultimately and with whichever investment style selected, “Comparing your results against the correct benchmark gives you a more accurate statement of how your fund is performing. And comparing different indexes is a good indication of how different market segments are performing.”
An innovative investing and asset allocation approach uses evidence-based research, asset allocation models with asset correlation diversification and lowering the costs associated with active management. “Quality passive advisors offer valuable services, such as rebalancing, tax loss harvesting, a glide path strategy, and other wealth management tools that are rarely properly applied by do-it-yourself investors.”
When to Start, What Investments to Choose, and Who to Consult
Being aware of market movements is realistic, but trying to understand the reasons why may be an act in futility. Whether to participate in any financial market is a personal as well as financial dilemma which only you can answer. Prior to investing, you should be crystal clear with personal and financial goals. Know your time frame, whether short- or long-term, and how prepared you are to deal with the inevitable bumps in the road before you attain your anticipated end result. The answers to those questions may be as simple as knowing when you need the money, what asset classes are you most comfortable investing in and remaining in sync with your financial philosophy and objectives. How will you ensure your plans meet your projected goals? If you cannot answer these upfront questions perhaps asking for help may be your best first decision.
There are always choices to be made with every potential decision. Whether your financial mantra is aggressive or conservative, the ultimate return on your investment should be aligned with your personal financial philosophy and realistic expectations. Bull and bear financial market gyrations are inevitable and should be anticipated. Ask yourself if you are comfortable engaging the financial tussle alone or consulting with a knowledgeable fiduciary financial advisor (i.e., Certified Financial Planner)? A CFP professional understands the financial maze of available products with associated risk-return projections and how it relates to your goals and planned requirements. The results of charting your course and decisions made — good or bad – may determine how comfortably you sleep at night and if you adequately answered the “When, What, and Who” scenario.
About the Author
H. William Wolfson, DC, FICC, MS, MPASSM, is a financial consultant and advisor. After passing the rigorous Certified Financial Planner™ examination, Dr. Wolfson obtained a Master of Science in Personal Financial Planning from the College for Financial Planning. He was subsequently awarded by the College a Master Planner Advanced Studies. Dr. Wolfson is a member of the Financial Planning Association (FPA). Dr. Wolfson retired after 27 years of practice and remains active volunteering his time to the continued education and success of professionals. Dr. Wolfson may be contacted for consultation at firstname.lastname@example.org and view all his published articles at https://www.linkedin.com/pub/h-william-bill-wolfson/14/a55/226.