If you want your investments to do more for you, you have to be able to answer the simple question: "More of what?" At the core, I think most investors have three main goals. First, we want to preserve our capital instead of lose it. Second, we want a return each year that will achieve our financial objectives. And third, we want performance relative to the market...usually we want to do better than the market. I suspect all investors would be happy if they achieved all three. But if you’re going to invest efficiently, you need to know which one of these three is the most important to you.

Is your top priority to preserve your capital? You can certainly do it. Is it to get a specific return, say 8 percent or 10 percent, each year? You can do that, too. Or is your fondest wish to beat the market? There’s no guarantee on this one, but you can certainly try for it.

However, you can’t have all three of these at once. No highway will take you north and east and south all at the same time. You can choose one or two of those directions. But if you try to do more, you’ll end up going in circles. The same is true of investing. If you want to meet or beat the market, you’ve got to put your capital at risk, and you can’t be too concerned about getting a fixed return every year.

IS LOSING 5 PERCENT GREAT?
IS MAKING 20 PERCENT A BUMMER?

Imagine a year in which the market drops 20 percent and your portfolio falls "only" 5 percent. If preservation of capital is your priority, you’re not happy. If a steady return is your priority, you’re not happy. But if you’re mainly interested in beating the market, you should be in heaven. (However, not many investors would brag much about losing 5 percent, and that makes me suspicious of folks who say all they want is to beat the market.)

Now imagine a year in which the market is up 30 percent and your portfolio is up 20 percent. Are you happy or crabby? It all depends on your priority. You preserved capital. You met and probably exceeded your need for a return. But if you are focused exclusively on beating the market, this 20 percent year could be a downer.

I’m not suggesting that one of these objectives is better than the others. Your priorities and your needs are up to you. But if you don’t make a conscious choice, you can experience anxiety no matter what results you get. To investors, anxiety is more than just an emotional drain. It’s a powerful force that can tempt you to switch strategies when you shouldn’t do so. And if you’re constantly changing your strategy, you’ll never give any strategy enough time to work properly for you.

There’s no right answer for everybody. The only wrong answer is to have no answer or to believe that you can and should achieve every possible financial goal at the same time. Investing is no different from most other things in life. You can’t have everything, and you have to make choices. The trick is to make them well.

Here are my recommendations. First, identify your overriding priority and make a commitment to strive for it. Second, find or develop a good strategy for achieving your goal, then stick to that strategy. Third, recognize that you won’t meet your target every year. So take the longer view, and invest a little patience along with your money. You will be rewarded.

MORE SPECIFIC ADVICE

If you’re going to shoot for high returns, statistics show that the higher your target benchmark, the less often you will achieve it. And the higher your goal, the more important it is that you allow for "slippage," or a margin of error. As a general rule, give yourself a 20 percent slippage factor. That means if you need 4 percent, invest as if you needed 5; if you need 8 percent, shoot for 10, etc.

Often, your chance of success will improve if you diversify your holdings. And that leads us to another interesting topic.

WHY DIVERSIFY?

One of the first lessons savvy investors learn is diversification, spreading your eggs among more than one basket. It’s an easy lesson to forget, however. Over the past two years, large U.S. stocks have seemed to be a sure thing. Why mess around with foreign stocks, bonds or any other investments, you might ask, when you can just put your money "in the market" and watch it grow at 20 percent or more every year?

If the only experience you have is the past two years, when the Standard & Poor’s 500 Index rose 37.1 percent in 1995 and 22.3 percent in 1996, that might seem like a valid strategy. But it’s naive to think the past two years are "normal" and that the future will give us more of the same. We certainly got a taste of this in March! Investors who make decisions based on seeing the future through rose colored glasses are certain to wind up with disappointment, grief and probably financial loss. I hope this month’s discussion will help you avoid those unpleasant fates.

WHAT IS "THE MARKET?"

When most people think of "the market," they think of either the Dow Jones Industrial Average of 30 stocks or the Standard & Poor’s 500 Index. While the S&P represents about 75 percent of the value of all stocks traded on exchanges in the United States, it’s only 500 stocks. The universe of all securities available to investors is much broader than that. There are many thousands of domestic and international stocks, bonds and mutual funds, and in most years, these investment types perform quite independently of one other.

A TABLE OF RESULTS

You can see this plainly if you look at the following table of annual equity investment returns (calculated without market timing). For the sake of simplicity, we’ve divided all stocks into only four categories, U.S. and international, large and small. A sophisticated diversification program will divide stocks many more ways. But these four groups are enough for this discussion. We have highlighted the best return from each year, so you can see at a glance that the annual "winners" come from many places.

The fifth column in the table shows the results of a portfolio that started each year with 25 percent of its assets in each of the four categories. That’s a pretty good model of diversification.

It’s easy to see that geography matters. In 1979, U.S. stocks were the place to be, while international issues barely kept their heads above water. In 1987, the opposite was true, with international stocks generating hefty returns while the U.S. was unable to recover from the sudden, legendary crash. In 1992, some people might say that "the market" was up 7.31 percent. While that is true of the Standard & Poor’s 500 Index, it hardly describes a year in which domestic small-cap stocks rose more than 23 percent and all sizes of international stocks lost money.

In the 27 years shown in this chart, I cannot find any consistent pattern that would point the way to either ruin or riches. With the benefit of hindsight, it’s easy to see that international small companies had the greatest compound annual return over the whole period. But imagine somebody had told you that in 1970, and you decided to invest exclusively in international small-cap stocks. You would have had to endure six years in which your friends make money in U.S. large-cap stocks while you either lost money or barely kept your head above water.

Even if you remained a diehard believer in international small-cap stocks, imagine how you would have felt at the end of the last two years, when you had made only $40 on a $1,000 investment at the start of 1995 while your friends with money in the Standard & Poor’s 500 Index made $680. Would you have stuck with your belief long enough to enjoy international stocks’ superior performance in the first quarter of 1997?

THE RISING TIDE SOMETIMES LIFTS ALL BOATS

The table shows that in some years, a rising tide in fact lifts all boats and an ebbing tide lowers all boats. Every column showed double-digit gains in 1971, 1975, 1980, 1983, 1985, 1988 and 1989. And there was no place to hide from the losses in 1973, 1974 and 1990 (and almost no place to hide in 1981).

However, I notice that year after year the fifth column, representing global diversification, provided an above-average compound rate of return with below-average volatility (measured by standard deviation). That diversified strategy gave you as many winning years (22) as any other column.

Another obvious lesson from this table is that it’s very dangerous to take short-term trends from only a few years and project them out over longer time periods. If I had only the first five years of data, for 1970 through 1974, I could logically conclude that large-cap domestic stocks are far better than small-cap domestic stocks. (That may seem like a strange conclusion since in both cases an investor would have lost money. But the losses were much more severe in small-cap stocks.)

But had I decided to ditch small-cap stocks at the end of 1974, I would have bitterly regretted it over the next five years, when U.S. small stocks left their larger counterparts far behind in the dust.

In order to achieve higher returns over the long run, you must take the risk of lower returns in the short run. To get your reward for taking above-average risks, you’ll have to wait for the long-term trend to play out. This, by the way, applies equally to buy-and-hold investors and market timers.

DO YOU DESERVE TO HAVE YOUR EXPECTATIONS MET?

Many people have the mistaken notion that if they take higher risks, they deserve to be rewarded with higher returns. Some investors think that higher risks should not cost them any penalty during the "good times," only in the really bad times. But in reality, the market doesn’t care what you deserve or what you want or what you need. If you take higher risks, you should expect to underperform in the short and intermediate term.

A REBALANCING ACT

The last column in our table assumes the portfolio was rebalanced annually so that it started each year equally divided among the four stock classifications. You don’t have to do this, of course, but your results could be quite different if you simply leave your portfolio alone from year to year. As each asset class grows progressively smaller or larger over time, you get farther and farther out of balance, and the whims of past performance gradually start dictating your asset allocation.

Because there’s no good way to predict which asset classes will do better or worse than others in a given period, I think it’s best to rebalance your portfolio once a year. This is easier in a tax-deferred account, since you won’t have to worry about calculating capital gains and losses and reporting them on your tax return. But it is a valid practice for taxable accounts, too, as long as you are willing to pay the taxes as you go.

 

 

Discover how professional money management can help you.  Get a Free Consultation from a Merriman financial advisor.