ON THE MONEY: Reducing your strikeouts

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Stock market investors are aware of the possibility that one or more stocks or funds within one’s portfolio may decrease in value within a given time frame. The susceptibility of an investment to a drop-in value is usually based on the degree of risk in that class of investment or attendant to the specific security itself. The correlation is usually stated as the greater the risk, the great the likelihood that the investment will perform better over a specific time frame than will less risky choices.

One reality of investing is that negative returns inflict significant damage to one’s portfolio. Consider the case in which your mix of investments are worth $1 million on Jan. 1 of the year, but at the end of the year, the value of your holdings diminishes by 10% to $900,000. During the succeeding year, your gain will have to be at least 11.1% for you to break even over the two-year period. If the drop-in year one is 20%, then your rate of return must be at least 25% in the second year to get back to the $1 million starting value.

As a result, one of the most important tenets for an investor to remember is to avoid large losses, and this axiom is of paramount importance if you are withdrawing money from your account each year. Obviously, the greater our returns, the better off we will be, but balancing return potential with less volatility is also important for the reasons we have seen.

Volatility can be measured statistically by the standard deviation of investment results over time. In other words, the greater the variation in investment returns over a period, the greater the standard deviation of those returns.

If your investment portfolio earns 20% in year one, -10% in year 2, 15% in year 3, 30% in year 4 and -5% in year 15, the average return is 10%, but the standard deviation is 15.16.

The risk to return ratio of a portfolio is simply the average volatility (think standard deviation) divided by the average returns from the investment mix. In our example, the risk to return measure was 15.16/10 or 1.516.

The lower the risk to return ratio, the better, and a one-to-one ratio is excellent but very difficult to attain year in and year out.

In an insightful article several years ago, Dr. Craig Israelson a principal at Target Data Analytics, compared the risk to return ratios of three different investment portfolios over every 10-year period from 1970 through 2014.

The first portfolio consisted of all Large Cap U.S. stocks, and the second was a traditional mix of 60% Large Cap Stocks and 40% U.S. Bonds. The final investment mix was made up of an equal portion of Large Cap U.S. Stocks, Small Cap U.S. Stocks, non-U.S. stocks from developed countries, real estate, commodities, U.S. Bonds and U.S. Money Market funds.

The large cap mix had the highest average 10-year rolling return at 11.21%; the diversified mix followed closely at 10.88%, and the 60/40 blend of stocks and bonds returned 10.35%.

The large cap mix was the most volatile investment mix, while the 7-asset mix was the least volatile.

Earlier, I stated that a risk to return ratio of 1:1 was difficult to maintain consistently, but the 7-asset mix had the lowest risk-to-return average 10 year rolling return ratio of 1.08, while the 60/40 blend had an average score of 1.42 and the U.S. Large Cap mix had a 3.05 ratio.

Since there are several top-rated ETFs in the 7 investment classes that Israelson studied, it is simple to build such a portfolio that will approximate the one that was studied.

As Israelson stated in his excellent article, “a diversified approach means that you will hit singles and doubles – not home runs. But it is worth remembering that home-run hitters strike out a lot.”