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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNER® practitioner.
Two portfolios with identical average returns but different risk levels will have different accumulations. In other words, not all 10% returns are created equal.
Most investors know that average returns are higher than compound returns. But they are not sure why, and the importance of that relationship to portfolio construction hasn't dawned on them.
Let's look at three investors. All of them have an average return of 10%.
Investor A has returns of 10%, 10%, 10%, and 10%. A dollar invested in this portfolio grows to $1.46 and has a compound return of 10%.
Investor B has returns of 20%, 0%, 20% and 0%. A dollar invested in this portfolio grows to $1.44 and has a compound return of 9.54%
Investor C has returns of 40%, -20%, 40%, and -20%. A dollar invested in this portfolio grows to $1.25 and has a compound return of 5.83%.
Investor A had a smooth trip, Investor B had a bumpy road, and Investor C had Mr. Toad's Wild Ride!
Even though the average returns were the same, as the risk in the portfolio grew, the compound return fell, and the final accumulation fell right along with it. Financial types call this behavior "variance drain" and have a formula to approximate it: (Average return - ˝ the variance is about equal to compound return). The higher the portfolio variances (risk) the lower the compound return. And compound return is what goes in our pockets.
Modern Portfolio Theory tells us that at any particular target return level investors should opt for the one with the lowest risk. Of course, lower risk feels good. It's not as scary. But, emotions aside, it will end up with a higher accumulation. And that's the whole point of investing. To use a metaphor from my childhood, it's a variation of the old Tortoise and Hare story.
Notice that Investor C would have been better off with a steady 6% return. By shooting for the lights, he shot himself in the foot. In real life, he's the guy chases after hot returns and loaded up on tech stocks. Will they ever learn? You cannot solve the investment problem by simply opting for the highest return from last year's universe.
After having slammed poor old Investor C, it would be less than fair not to point out that Investor A's portfolio doesn't exist. There are no 10% portfolios with zero risk. But, the objective is to get as close as possible through enlightened portfolio design. We are not trying to avoid risk because that's why we get investment returns. Rather we are trying to manage risk toward some optimum point.
The obvious conclusion is that investors need to spend as much effort on the risk side of the problem as on returns. At a given target level of return, driving down the portfolio volatility will drive up the total accumulation. Of course, this implies as widely diversified portfolio as possible. That's why Capital Asset Pricing Model (CAP-M) tells us that the optimum equity portfolio is the whole market. It's the one with the highest return per unit of risk. It's not flashy, but it works.
If you think you just can't stand to have a boring portfolio, especially when everybody around you is talking about today's hot thing, just remember the Tortoise. He's the guy with the low volatility portfolio, and the eventual winner.
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