Suppose you visit two retirement portfolio managers. The first is Joe Schmoe, CFP. The second is me. Well, not officially since I’m not a CFP, but I did create and run The Liberty Portfolio stock advisory newsletter.
Joe Schmoe says he can construct a portfolio for you that has a 95% chance of returning between -20% and +40% over the long term.
I tell you that I can construct a portfolio for you that has a 95% chance of returning between +6% and +14% over the long term.
Which would you choose, and why?
I would choose me every single time. (Well, of course I would.) But if it weren’t me, and instead was another manager who used that strategy, I go with him. I would rather have a very high probability that, in my worst year, I still make some money (6%), and in my very best year beat the historical average of 10% by earning 14%. That’s because there is a very low probability (only 5%) that I would do worse, or even lose money.
I would gladly give up any chance of earning 40% if that came along with the same risk that I would lose 20%.
A Closer Look at Portfolio Numbers
Let me give you another example using these same numbers. Say you have a $1 million portfolio. This year, the first manager does great. He earns 40% on your portfolio. You have $1,400,000 at the end of the year. However, next year he loses 20%. You end with $1,120,000.
This year, the second manager also does great. He earns 14% on your portfolio. You have $1,140,000 at the end of the year. However, next year he only makes 6%. You end with $1,224,000.
Which manager would you choose now? Which manager’s portfolio let you sleep better at night? And which manager’s portfolio made you more anxious on days when the market went up or down a lot?
Portfolio’s Probability of Loss
Here’s another way to think about this.
If I said that you have just as much chance of losing 20% of your entire life savings next year as you do as increasing your life savings by 40%, would you want to take that chance?
If I said that you have just as much chance of increasing your entire life savings next year by 6% as you do as increasing your life savings by 14%, would you want to take that chance?
You should be thinking about the probability of loss in the next 12 months.
Too Much Risk in Portfolio?
This all has to do with psychology. The reason risk is so important when constructing a portfolio is because it is an emotional part of our lives. When things get bad, we tend to believe those bad times will continue. We imagine what will happen if things do not improve. That’s why you see people “selling at the bottom.” They get so afraid about losing more money than they already have that they sell out in a panic.
Yet when things are going great, and the market is way up, we don’t think about protecting our gains. We don’t think about selling. We want our investments to keep running. Our emotions get the better of us. That’s always been true.
Emotion is what creates volatility, which is what creates risk. The more emotional we get, the more we are likely to buy or sell on a whim, and that creates more risk.
What this means, from an investor standpoint, is that your portfolio is very likely carrying far too much risk. That’s because your asset allocation has volatility that is too high, which leads to more risk. All that nonsense you’ve heard about having “60% stocks, 40% bonds” is, indeed, nonsense.
Lowering Portfolio’s Volatility
How do you fix this? You must find assets that are lower in volatility to balance out the investments that have high volatility, which is what The Liberty Portfolio does.
Just for starters, because risk is a big topic that I’ll be writing more about, here are some basic ETFs that you should replace with their lower-volatility counterparts.
Take the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). It obviously captures just about 100% of any up or down move in the S&P 500. However, the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), in the last 5-year period, captured 80% of the upside but only 64% of the downside. That’s because the ETF rotates in the least volatile stocks of the index.
Likewise, the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV), in the past 3 years captured 81.6% of the upside of the underlying index vs. 21% of the downside.
Next time, I’ll delve more into risk-averse moves you must make with your portfolio.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at [email protected].