Bluefield Daily Telegraph, Bluefield, WV

August 7, 2012

Investment strategy involves weighing risks


CNHI

— Let’s take a look at what may be considered a reasonable expectation of investment returns. We hear that the long-term average annual return of the stock market since 1930 is somewhere between 9 percent and 11 percent.

One of the challenges in managing any portfolio is setting realistic expectations. When we were in a

secular bull market from 1982 to 2000, it was easier to achieve higher returns. However, in a secular bear market like we’ve been in since 2000, it’s much harder.

Can you achieve higher returns in today’s market, perhaps 10 percent, 15 percent or 20 percent? Of course you can. But doing it will require much higher levels of risk and active trading. What if it doesn’t work out? Can you stand the volatility or afford the loss?

As investors, we cannot afford to turn a blind eye to risks. Understanding your potential reward is worthwhile. Understanding your potential risk is everything.

So let’s look at investment performance from a real world view. If you were to measure your performance against the S&P 500, which is up about 9 percent year to date, you might not have done as well if you had been quite conservative with your investments. What if you were conservative and made only 4 percent? Is that bad? Well, if you compare it to the overall stock market, yes. But how many people would actually have their entire investment portfolio in the stock market? Very few.

However, if you compare it to the risk-free rate of return, that was pretty good if you didn’t take a lot of risk doing it.

If you could make 4 percent on a risk-free investment (and were happy with that), but instead you invested in a diversified portfolio of stocks and bonds and earned 5 percent — well, that’s not too impressive.

Today, however, the risk-free rate of return in T-bills, money market funds and CDs is almost zero. Given that scenario, if you managed to earn 4 percent in your portfolio and you took a minimal amount of risk doing it, then you might consider that fairly significant excess performance.

Bill Gross of Pimco Funds coined the term “new normal” a few years ago. Perhaps we should call it the new abnormal instead. For reasons I have talked about extensively, I believe we are likely stuck in the new abnormal, i.e. lower average returns, for the remainder of this decade.

Let’s consider what it might take to achieve something like a 7.5 percent return in a given year. Assume that you could achieve a total return of 4 percent in the fixed income portion. That would be pretty generous in today’s market, but bear with me. If you did, you would then need to earn a total return of 12.75 percent on the equity side to get the entire portfolio to a 7.5 percent return.

What if you decide to get more aggressive than a 60/40 mix, say 40/60? Then the equity side would have to earn 10.5 percent, but you would have a bigger portion of the portfolio exposed to more risk if anything goes wrong.

Whatever mix you decide, try averaging that for 10 years or more to meet the actuarial assumptions, or your personal target return, and you now see the difficulty you are facing in today’s world. In my opinion, that type of total return is not going to happen for most people without taking on tremendous risk

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Nick Massey is a financial columnist for The Edmond (Okla.) Sun. Contact him at nickmassey.com.