The S&P 500 had a banner year in 2019, returning over 31%! While you might believe most investors would be happy by their investment portfolio returns, they often are not. Diversified investment portfolios are a common source of investor disappoint during years of unusually high returns and likewise losses.
When stock markets make strong advances up, investors become completely focused on returns. If investors compared their diversified portfolios to the S&P 500 after last year’s 31% return, many noticed they produced returns often less than half the returns of the S&P 500, which made them very unhappy. During times of economic turbulence like in 2008 and 2009, investors no longer focused on returns and became completely focused on risk as they watched in dismay as their diversified portfolio, believed to be moderate to low risk, lost potentially more than 35%, which also made them very unhappy.
Investors are not entirely to blame for being discontent with the performance of their diversified investment portfolios. The investment management industry carries much of the blame for investor dissatisfaction by leading investors to have unrealistic expectations of their portfolio’s return potential and ability to protect against large losses, especially during market extremes. However, there are ways to reduce the disappointment you may feel about your diversified portfolio by improving performance and mitigating large losses during extreme market environments.
The Jack of All Trades and Master of None
When investors are asked what their primary investment objectives are, most say they want both high returns and to protect their portfolio from large losses. The problem is that these two objectives are in opposition to one another and both objectives cannot be effectively achieved with a single investment strategy.
Everyone loves a solution that gives them everything they want and nothing they don’t, therefore the investment management industry is skilled at selling diversified portfolios that are represented as being capable of producing both high returns while also protecting investors from large losses. I call these “swiss army” portfolios because they are sold as no-compromise investment solutions. These portfolios often are sold as growth or aggressive portfolios. The problem with swiss army portfolios is they cannot possibly deliver on their promise because the primary impediment to generating outsized returns is too much diversification and the primary impediment to preventing large losses is too little diversification.
The reason I label industry standard, all-in-one portfolios, swiss army portfolios is because they function much like a Swiss Army knife. A Swiss Army knife can be used to cut through a steak as well as open a can of beans, but these unrelated tasks are not completed easily or particularly well by a Swiss Army knife. Simple tools have been designed to efficiently accomplish each of these tasks individually. For example, you could use a chef’s knife to cut a steak and a can opener to open a can of beans.
We do not stock our kitchens with just a single Swiss Army knife, but instead an array of purpose-built kitchen tools because each task can be performed with less effort and better results. Similarly, your investment portfolio should not depend on a single investment strategy to accomplish multiple unrelated investment objectives, but instead you should seek to achieve each unique objective with the best investment strategy for the specific objective.
It is possible to achieve higher returns and also protect from large losses?
The good news is that it is possible to achieve aggressive return goals while at the same time mitigating the risk of large losses in your investment portfolio that may permanently reduce your wealth. One way we manage competing investment objectives at 3Summit is to “partition” investment accounts, which simply means splitting a single investment account into multiple segments and managing each partition like it is a separate investment account. This way each partition can have its own investment objective and we can implement the investment strategy with the highest probability of achieving each partition’s unique goals.
For example, to achieve the competing investment objectives of producing high returns and limiting the size of your potential investment losses, a portfolio can be split into two separate partitions. The first and smallest partition of the investment account can implement the best investment strategies for generating potentially very high returns. Quantitative investment strategies like trend-following and picking a concentrated portfolio of stocks are strategies that give investors best odds of producing very high returns but of course are riskier than a conventional diversified portfolio.
The second and larger partition can then seek to achieve better returns than a swiss army portfolio but with much lower risk of sustaining large losses. The best investment strategy to accomplish this objective is to invest in a low-risk diversified portfolio that uses modern portfolio design techniques, making it much more likely over the long-term to produce higher levels of wealth with much lower levels of risk than you would with a swiss army portfolio.
The different investment strategies of each partition are not only purpose-built to meet the investment objective, but combined both partitions complement each other, therefore lowering the total portfolio risk while increasing the portfolio’s potential return and the probability of achieving both of your investment objectives over the long-term.
Your discontent with your diversified portfolio may be reduced and your long-term investing results dramatically enhanced by simply improving the design of your investment portfolio. But most importantly, taking a long-term view and sticking with your investment strategy is what is most likely to lead to your ultimate investing success. The biggest investing mistakes are made during market extremes, have patience and you will reap the long-term rewards for your behavioral discipline.
If you would like professional assistance in evaluating your investment strategy and portfolio or making a financial plan, please call (571) 565-2161 or email us, we are always happy to help. Also, consider learning more about this topic and gaining unique investing insights by listening to our popular podcast or viewing our investing video series.