Five Secrets of High Performance Investing – Secret 2

In the last video, we showed you that the common investing wisdom that says, you must take more risk to earn higher returns, may not be so wise, that is,  if your goal is to generate more wealth over time from your investments. In the two-portfolio example, we observed that the low-risk stock portfolio generated 24x more wealth than the high-risk stock portfolio, despite the fact that the high-risk stock portfolio had higher average annual returns. We concluded, the reason for these confusing results boils down to a common misunderstanding investors have about the math behind how investment returns are calculated and the impact of risk on an investors wealth. The second investing secret can clear up this confusion and explain exactly why the low-risk portfolio generated so much more wealth for the investor than the high-risk portfolio. The second investing secret is that risk has more impact on the wealth you accumulate from investing than the returns you generate from your individual investments. It is logical to believe that higher returning investments will produce more wealth for an investor, however, as we saw in the two-portfolio example this assumption is not necessarily correct. Let’s first look at why the low-risk stock portfolio produced lower average annual returns, yet generated orders of magnitude more wealth for the investor. The average annual returns in the example were calculated using the industry standard method of measuring and presenting returns, the return calculation is called the simple return. As its name implies, a simple return is a basic calculation. First, the monthly return of each portfolio was calculated by comparing the difference between the portfolio value at the beginning of the month to the portfolio value at the end of the month and calculating the percentage change between the two values. Then, the monthly returns are added up for the year to arrive at the annual simple return. The annual simple returns over the entire time period we looked at in the example are then averaged to arrive at the average annual simple return. The simple return is a useful performance metric because it represents the average return that an investment has produced over a given number of periods, which can be useful when comparing the returns of multiple investment opportunities to each other over different time frames to better understanding return expectations. When you look at the past returns of mutual funds or the daily percentage change of the S&P 500 on a news website or your portfolio’s daily change in value in percentage terms, you are almost certainly looking at simple returns. Over a single period like a day or a month, the simple return will match the change in your portfolio value perfectly. However, when you link many simple returns together, the return you calculate will not match the change in your account value because simple returns do not account for the impact of compounding on your portfolio value. By not accounting for compounding you are not accounting for the risk you had to take to earn your returns. To calculate how the simple returns from one time period to another impacts your portfolio value and then accurately calculate how your investing impacted the amount of wealth you gained or lost over the given time period, you must calculate the compounded return, not simple return of your portfolio. The difference between the simple return and compounded return can most easily be described in an example. Let`s say before the markets opened yesterday your portfolio had a value of $10,000 and was invested in a single S&P 500 index fund, which tracks the returns of the S&P 500. Yesterday a flash crash occurred in the markets, and the S&P 500 lost 50% by market close. Today, you see on the news that the S&P 500 bounced back 50% over the day. So yesterday the S&P 500 lost 50 percent but today it went up 50 percent…you celebrate because over the terrible two days you came out even and did not lose any money. When you follow the market from day-to-day this is the intuitive calculation you make in your mind. The simple return of a loss one day of 50 percent and a gain the next of 50 percent equals a 0 percent simple return for the two days, which matches your intuition. At the close of markets today you checked your investment portfolio and you are shocked to see that while your portfolios value was 10,000 dollars at the beginning of the day yesterday, at the end of the day today you discover your portfolio value is only 7500 dollars. You can thank compounding for that result, your compounded return for the two days is actually -25 percent. Here is why. Yesterday you started the day with a portfolio value of 10,000 dollars and the S&P 500 ended the day down 50 percent. Your portfolio value at the end of the day yesterday was cut in half to 5,000 dollars. Today the S&P 500 went up 50 percent, but 50 percent of 5,000 dollars is only 2500 dollars. This leave you with a total portfolio value at the end of today of just $7,500 not $10,000. This is a clear way to understand the math behind compounding. To recover from your 50 percent loss yesterday you would have had to generate returns of 100% today to get back to even from the flash crash. Now that we have explained the difference between a simple return and a compounded return, we can now calculate the compounded return of both the low-risk and high-risk portfolios in the two-portfolio example we have been looking at. Comparing the compounded returns of the two portfolios will clearly illustrate how it was possible for the low-risk portfolio to produce much more wealth for the investor than the high risk portfolio. Remember, the compounded return reflects the change in an investors wealth as a result of their investing activities. The results of computing the compounded returns for both portfolios shows that the low-risk investors portfolio value, in other words, their wealth, increased by an average of 10.3 percent annually compared to just 6.4 percent annually for the high-risk investor. What we see from this table is despite the fact that on average, the high-risk portfolio performed better, which we can observe from the simple returns, the high risk of those investments offset the higher returns. Remember, simple returns do not account for the risk an investor took to earn the returns of their investments. It seems counter intuitive that a portfolio that held better performing investments could produce so much less wealth, and this is why the secret that you can generate higher returns in terms of the wealth you accumulate from investing remains a well hidden secret from most investors. In this video, we demonstrated that risk has more of an impact on how much wealth your portfolio is capable of accumulating for you and that not understanding the mechanics behind different return calculations can cause investors to ignore the impact of risk on a portfolios long-term returns. It is true, that by taking more risk you can earn higher simple returns, but higher simple returns does not equate to higher levels of wealth. I hope that at this point you understand that the amount of investment risk you take can have a dramatic impact of the amount of wealth you can accumulate from investing. In the next video, we are going to tell you the secret behind why risk has such a large influence on your investing outcomes. The key point we want you to take away from this video is that a portfolio that holds lower returning investments but has less risk, is likely to generate significantly higher levels of wealth for you over time. Contradictory to the common investing wisdom, risk management is the best tool you have as an investor to improve your investing outcomes.