The Five Secrets to High Performance Investing – Secret 4

Up to this point in the video series we have looked at a situation where the common investing wisdom that you must take more risk to earn higher potential returns is not so wise. The two portfolio example showed us that if you have 2 similar portfolios that invest 100 percent in a diversified selection of US stocks, the stock portfolio that has the lowest risk is capable of producing much higher compounded returns. Stocks are risky investments, but are also the primary driver of returns for any portfolio. Investors who allocate 100% of their investment portfolio to stocks, often do so with the hope of hitting a home run and generating significant levels of wealth. The low-risk portfolio generated 10.3 percent average annual compounded returns in our example while the high risk portfolio, which is a better representation of most investors stock portfolios, generated just 6.4 percent average annual compounded returns. While these are both good results, they are unlikely to satisfy investors looking to get very wealthy from their investment portfolios. Most investors do not realize the extent to which even the slightest amount of diversification can significantly reduce the potential returns of their investment portfolio. The high risk and low risk portfolios held dozens of US stocks, and as a result of that stock diversification there was no chance that either of these portfolios would generate life changing wealth for the investor. In this video, we are going to discuss where the common investing wisdom can add valuable insight when making the most important investment decision that will have the greatest impact on your potential return and the amount of risk you choose to take in your investment portfolio. We don’t tell you the fourth investment secret until near the end of this video. But because we are making you wait to learn the next investing secret, we have added a bonus investing secret on how to turn a 300,000 dollars investment into 274000,000 dollars, which we will explain to you now. The greatest fortunes in the world, almost without exception have been created from extreme concentration. If you invested 300,000 dollars in Amazon in 1997 your investment would be worth 272,000,000 dollars today. All you would have had to have done to accomplish these returns, is find an obscure online book seller, then predict in the future they would expand into the largest online retailer, as a thing called eCommerce became the primary method of shopping for consumers. You would have had to weather jaw dropping losses along the way, but if you stuck with your investing thesis, you would be among the ultra-wealthy. While we would never recommend an investor try to achieve the results of this example, as the odds of success are similar to winning the lottery, the example none-the-less highlights an important point. There is wisdom to be gained from the common investing wisdom, when it comes to asset allocation. How you decide to allocate your portfolio between stocks and other types of assets will dictate the potential returns you can earn, as well as the minimum level of risk your investment portfolio will have. Because stocks are the primary driver of both potential returns and risk, it is true that the more risk you take, meaning the more you invest in stocks, the higher potential returns you will have the chance to earn. Obviously, if you invest your entire portfolio in short-term treasury bills, your portfolio will have little to no risk, however you also will not generate very high returns at all. Investing in a single stock and hoping to hit the lottery is an investment strategy for potentially generating ridiculously high returns, but more probably a great way to earn very low returns or lose your assets all together. For this reason, it is not a prudent or wise investment strategy to take insane levels of risk, just to have a minuscule chance of earning amazing returns. It is safe to say that dramatically lowering risk and reducing your potential returns is the correct decision. Investment risk is a broad spectrum and the best way to make the most important investment decision you will make, which is how much of your assets to put in stocks versus other assets, is to work backwards. First, figure out the level of returns required to meet your investment objectives, then decide how much uncertainty are you willing to accept into whether your portfolio can meet those objectives. This risk spectrum chart shows why the investment management industry considers risk management through diversification as a necessary evil. Diversification, even a little, dramatically reduces risk but also inhibits potential returns, more than most investors realize. However, once you have over 15 stocks in a portfolio each increment of diversification lowers the potential returns less.  So…now late in this video I am ready to tell you the fourth investing secret. Risk management should not be viewed as a necessary evil, but a source of additional returns. Because the investment management industries guiding principal is based on the common investing wisdom, which seeks to maximize risk, the common practice is to select the percentage of an investors portfolio to be allocated to stocks. Then, to try to maximize that investors returns from their stock portfolio the risk of the stocks selected are also maximized. At 3Summit, we view risk management as a unique source of additional returns that can be used to both increase your potential returns for any given asset allocation while at the same time increasing your probability of achieving your investment objectives. This simply means, if it is determined that to meet a client’s investment objectives they should be invested 60 percent in stocks and 40 percent in bonds then we minimize the risk of the portfolio as much as possible to increase both the potential return the portfolio will generate as well as the probability of earning that potential return. So the common investing wisdom applies to asset allocation, because stocks are risky and the primary driver of a portfolios returns. However, once the appropriate asset allocation has been established, the common investing wisdom does not apply, using specific risk management techniques the investment portfolio should be designed to minimize the risk of that allocation. This approach makes it possible to build a portfolio that is capable of generating similar returns as a much riskier portfolio, while taking on much lower levels of risk. For example, a portfolio that is 60 percent in stocks would be capable of producing similar expected returns as a portfolio with 70 percent in stocks while generating equivalent risk to a portfolio with 50 percent in stocks. In the same way that the low-risk portfolio from the two-portfolio example generated dramatically higher compounded returns than the high-risk portfolio, using special risk management techniques in the design of a portfolio can significantly reduce the risk of any asset allocation, and therefore achieve gains in the expected long-term compounded returns. Going back to the risk spectrum chart, we can give a visual of how using risk management in the design of an investment portfolio can become a unique source of additional returns, while also increasing the probability of achieving your return objective. The purple sections of the chart show how risk management can both extend the potential return expected from any given allocation, while at the same time increasing the probability of achieving your return objective. You may be wondering, what are the specific risk management techniques that are used to achieve these results? That is the topic of the upcoming videos. The key point we want you to take away from this discussion is that diversification is a prudent and necessary part of any good investment plan, and that far from being a necessary evil, risk management is a unique source of added returns for any given asset allocation that most investors do not use to their benefit.