The conventional wisdom is that placing your life savings with a money manager is a good idea because these are the people with extensive investing experience. If the name on the firm’s door is a recognizable worldwide brand that has been in operation for decades, one would think that this means the firm’s investing acumen in low-risk stocks must be pretty solid.
The sad truth is that these money managers have not been trained in how to construct a portfolio or how to measure its risk. Instead, they and their superiors, all the way up to the top, are only concerned with “compliance.”
The securities industry is heavily regulated and heavily self-policed about everything under the sun … except the one thing that matters the most: How to measure risk in a portfolio. Compliance exists for one reason: to cover the rear-ends of the investment firms so they don’t get sued.
The Securities and Exchange Commission regulates Registered Investment Advisors under the Investment Advisers Act of 1940. That’s a piece of legislation passed by Congress that grew out of the creation of the SEC in 1934, itself rising from the 1929 crash and Great Depression.
Now, in addition to this federal law, there are scores of regulations that originated in the SEC, and “interpretive guidance” in the form of scores of letters and releases to interpret all the gobbledygook.
You will not believe how many rules and regulations there are — many of which are quite important — yet none of them relate to proper investment of your money. Regulators do just about everything, except the most important thing, which is how to measure risk in a portfolio. If they don’t understand it, why would the managers that they regulate understand it?
Nobody Is Looking Out for You. What Can You Do?
You need to have a long-term diversified portfolio, one that balances higher volatility investments with lower volatility investments. I’m not just talking about stocks and bonds. I’m talking about targeted investments across all asset classes.
The Liberty Portfolio, my stock advisory newsletter, is building a long-term diversified portfolio, that aims to deliver a real rate of return that beats a weighted average of the benchmarks, with less risk, using these principles.
I’ll give you some examples of low-risk stocks that you may want to consider as part of your overall strategy. One of the metrics you want to look at with exchange-traded funds is the Sharpe Ratio. It is not supposed to be used in the absence of other metrics, but at its core it is a guide toward risk-adjusted returns. A higher Sharpe Ratio means a higher return for that investment in relation to risk.
Let’s look at the popular benchmark index, the S&P 500. The go-to ETF is the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). So if you purchase the ETF, you get a basket of market-cap-weighted stocks that reflect the index.
That may seem like ideal diversification, but you can actually do better. The reason is the SPY has rather high relative volatility because the stocks are cap-weighted, and those stocks move the entire index more than if they were skewed towards lower volatility stocks.
The PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) is the lower volatility companion ETF, which takes a certain number of the stocks in the index that have had the lowest volatility over the a certain period.
The SPY has a Sharpe Ratio of 1.00, but SPLV has a ratio of 1.40. Over the index’s five-year history, it captures 80% of the S&P 500’s upside, but only 64% of the downside. So you don’t enjoy all the gains, but isn’t it better to only grab 80% but only 64% of the downside? You bet it is.
Many major indices have low-risk, low-volatility peers. You should consider replacing cap-weighted indices with those.
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].