Five Secrets of High Performance Investing – Secret 1

Every investor has almost certainly heard the common investing wisdom that goes something like this, the more risk you take the higher the potential returns you can expect to earn.  Or Higher the risk, Higher the return. In fact, the entire investment industry is built around this common investing wisdom. Whether you are an individual investor or an institutional investor, if you have ever talked to an investment advisor about managing the investments of your organization or your personal investments, you undoubtedly spent a decent amount of time talking about your risk tolerance, and more specifically your tolerance to handle losses. The intention behind this exercise is good, the idea is that the advisor wants to put you in an investment portfolio that has the highest amount of risk that they believe you or your organization can tolerate with the well intention-ed goal of trying to earn you higher returns overtime. This approach to managing risk is based entirely on the common investing wisdom that an investor must maximize their risk in order to maximize their potential returns. The common investing wisdom is so universally believed among investors, most never question the wisdom behind this investing philosophy.  In this video we are going to question the wisdom behind this investing philosophy and that brings us to the first investing secret. The first investing secret that we are going to share with you flips the common investing wisdom upside down. We believe that this first investing secret is the most important piece of investing knowledge you will ever learn if you’re your objective is to maximize the amount of wealth you generate from your investments. The investing secret is that low-risk portfolios are capable of generating much more wealth over the long term than high-risk portfolios. In the remainder of this video we are going to demonstrate for you that the amount of risk you take in your investment portfolio dramatically impacts the amount of wealth you accumulate from your investments over the long-run. Let’s start with an example. Most investors (even professional investors) whether they would admit it or not, weigh past returns heavily when deciding on the investments that they’re going to put in the portfolios they manage. Let’s Say you have 2 investment portfolios to choose from, both the investment portfolios invest 100 percentage in US stocks. Portfolio one has earned historical average annual returns of 10.7 percent and portfolio 2 has earned historical average annual returns of 12.4 percent. Given this limited information, I think the choice is pretty clear, as an investor my objective is always to generate as much wealth from my investments as possible so I would choose portfolio 2 which had higher average annual returns then portfolio one. Now let’s see if I made a good decision. This chart shows how much wealth I would have accumulated if I invested 100 dollars in each of the portfolios beginning in January of 1929 and let that 100 dollars grow through December of 2017. Now remember, I chose portfolio 2 because it had higher average annual returns, but looking at this chart I’m instantly regretting my decision. What we see is that portfolio 1 with the lower average annual returns grew my 100 dollar investment into 613,488. While the portfolio that I chose, portfolio 2 grew my 100 dollar investment into just 25,655 dollars over the time period. I would say this is a shocking result given portfolio 2 had higher average annual returns, but unfortunately this is the outcome that many investors experience without realizing it. Let’s take a closer look at some of the differences between the two portfolios in this example. As I mentioned earlier, both portfolios held 100% in U.S. stocks over the entire time period. The only difference between the portfolios is the types of stocks each held. Portfolio 1, which generated more wealth but had lower average annual returns held all the lowest risk stocks in the U.S. stock market.  Low-risk stocks are not sexy. and no one at work or on the news is talking about them. They include companies in the consumer staples and utilities industries and the portfolio is heavily invested in companies you might find in “Value” oriented mutual funds. On the other hand, portfolio 2 with the higher average annual returns invested heavily in the well-known sexy stocks, the companies everyone is talking about.. The portfolio was heavily weighted towards tech and bio tech companies and it’s holding more closely resembled those of a “Growth” oriented mutual fund. This portfolio, portfolio number 2, more closely resembles most investor’s stock portfolios. What we have learned about these two portfolios is that the primary difference between the two is the RISK of the investments in the portfolio. Now that we better understand the differences between these two portfolios we can look back at their investment results. The results are very confusing. How did portfolio 1 with lower average annual returns generate 24 times more wealth than portfolio 2, which had higher average annual returns? Most investors expect the returns a portfolio generates to equate directly to the value of their portfolio. In other words, higher average annual returns should mean a higher portfolio value.right? This is where the details investors miss emerge when it comes to their overall investment strategy. The results of this example seem to confirm the common investing wisdom, Portfolios 2 took more risk and generated higher average returns than portfolio 1. But, when given the choice between owning a portfolio that generates higher average annual returns and a portfolio that will produce 24 times more wealth for you over your investing time horizon. the decision is easy. Obviously, the primary reason anyone invests is they want to grow their assets as much as possible.  At the end of the day all I care about is the value of my portfolio as that is the only number that matters when it comes to meeting my future financial objectives. What we demonstrated for you in this two-portfolio example is often referred to as the low-risk investing paradox. The definition of a paradox according to Webster Dictionary is a statement that is seemingly contradictory or opposed to common sense, yet perhaps is true. The low-risk investing paradox simply acknowledges that contrary to the common investing wisdom, lowering risk in a portfolio can dramatically increase the long-term returns, in terms of wealth that a portfolio can generate. The two-portfolio example we have been looking at certainly appears to contradict the common wisdom and fits the definition of a paradox perfectly. Because the common investing wisdom is so ingrained in all of us, when talking about investing, when we hear the words low-risk, we immediately think low returns. We have demonstrated here, that maybe when we hear low-risk we should instead think more wealth. You may be wondering if we are playing a trick on you, or if We manipulated the results of this example. Let me assure you the calculations We presented to you are accurate. The low-risk investing paradox is not just present when investing in stocks, but can be observed across almost all asset classes including bonds and commodities and within international markets. The bottom line is, the investing secret that low-risk investment portfolios can generate much higher returns over the long-term than higher risk portfolios, shows just how underappreciated risk management is as a major driver of investment returns. What investors fail time and time again to take into account, is the risk they had to take to earn their returns. Risk is not accounted for in the average annual return calculation, but risk has a direct impact on your portfolio value and therefore your wealth. What is the value of a simple return calculation, or the common investing wisdom if they do not reflect your true investing results in terms of what matters, the wealth you accumulate from your investments? The reason the low-risk stock portfolio generated so much more wealth for the investor is quite simple actually, it is because of the math behind how investment returns work. I appreciate that for those of you who might not enjoy math, this might seem like an anticlimactic conclusion. But the fact that math explains the outstanding results of the low-risk stock portfolio is actually great news. Uncertainty and un-provable assumptions are at the heart of investing, which is why investing is so hard. Investors make assumptions about how the markets will perform, the advantages that certain companies have over others, and they prescribe causes to market events, when in reality, the true underlying causes are likely a combination of factors which could never be identified, much less proven. But in the case of the low-risk stock portfolio we can clearly define the reason for its success and prove that reason out with math. In the next video we are going to explain the reason why the low-risk stock portfolio generated superior results compared to the high-risk stock portfolio. In this video we have shown you how the conventional investing wisdom that maximizing your risk, maximizes your potential returns can actually result in your portfolio earning only a small fraction of its potential. The key point we want you to take away form this discussion is this: To maximize your long-term returns, in terms of the wealth your investments accumulate for you, your focus should be on minimizing risk, as opposed to following the common investing wisdom of maximizing your risk.