Risk and Reward are Related
August 19, 2019
Like with anything in life, when creating an investment portfolio, it is imperative that you be responsible. But what does being responsible with your portfolio mean? Well, properly understanding the importance of asset allocation is one way to practice responsibility. Understanding the best way to balance your assets is a complex problem that depends on your personal financial goals and the amount of risk you are willing to take. Fortunately, the fundamentals of asset allocation aren’t rocket science, and with a basic understanding you may be able to create an Investment Policy that balances your lifetime financial needs with a level of risk that is acceptable to you. Think of this as a breakdown of how your portfolio is divided in a mix of various asset classes that historically delivered the return you need with the lowest possible risk.
High Risk – Opportunity for High Reward: The S&P 500 is comprised of the largest, and best companies in the United States – the cream of the crop! Over very long periods of time going back to 1926, history tells us that the average return has been slightly less than 10% a year. But, beware – there have been times when returns have been very low. For example, during the first 10 years of this century the return was close to zero. Thus, the coining of the name for this period as “the lost decade.” I believe it is best to tilt your portfolio toward small and value companies as well as diversify internationally. To be responsible about this, it would be prudent to develop a mathematical model that illustrates up and down years and annual volatility. If you are not willing to do all this work, then find a trustworthy adviser to do it for you. This is no time to be “shooting from the hip.”
Low Risk – Low Reward: A low risk approach can be quite appealing, especially when you’re approaching your “Golden Years.” No one likes the idea of having their life savings go down the drain. While minimizing risk in general is a good idea, being too cautious can stunt the growth of your investments. Let’s use U.S. Government 30-day Treasury Bills as an example of a low risk asset. These are considered to be essentially “risk free” because they are backed by the full faith and credit of the United States! We have never defaulted on our debt. This makes them safe during times of market instability. You may be thinking: “Then what’s the catch?” Well unfortunately the rate of return on treasury bills, while practically guaranteed, has only averaged about 3.3% annually from 1926 to 2016. For comparison, the rate of inflation over that same period was about 2.9%. While utilizing this low risk option technically still out paces inflation, it’s the equivalent of filling a zeppelin with a straw. You may not crash but you’re hardly getting airborne.
Finding the Balance: Now you may have noticed that both examples I’ve mentioned above fail to abide by one simple rule. Don’t put all your eggs in one basket. This saying is straightforward and it clearly outlines the flaws in those strategies. They lack diversification, and in the financial world, diversification is the key to mitigating risk and maximizing growth. Again, tune your portfolio for the results you need.
Your Investment Policy Statement: This document sets forth the mix of asset classes you have chosen to stick with in good times and bad. Let’s assume you have done your homework and are crystal clear about your investment plan moving forward. With clarity comes a sense of inner peace about the future. If you are like me, you believe in the system of capitalism. I believe it will always work and this gives me comfort. I hope you share this belief with me unconditionally.