Someone famous (I can’t remember who, and could not find the exact quote) once said that return of principal was more important than return on principal. The obvious implication is that efforts to earn high rates of return, when ultimately unsuccessful, are more hurtful than the safer pursuit of more moderate returns where return of your original investment, plus a modest profit, is preferable to sustaining a big loss which needs to be recovered.
The problem with the instruments we all think of when trying to maximize the return of principal (money market funds, certificates of deposit, etc.) is that the reward, or return on principal is generally very low over time. Investments that offer the higher rates of return (stocks, corporate bonds, real estate) go through cycles where they look great for a few years and then lousy for the next period of time, of course with most investors buying and selling at the wrong time.
I recently had the opportunity to review a report from a large investment firm, which highlighted the concept of diversification in a different way than I have employed in the past. Their thesis was that just placing one-eighth of your portfolio in each of eight common asset classes would produce a low volatility portfolio which provided a higher chance of return of principal, and did not, at least during the time period examined, sacrifice return potential compared to a more aggressive portfolio invested in equities.
Today, investors view commodities as hot, large stocks not. Bonds unexciting, cash a bore, real estate – nevermore? Fond feelings for international stocks fueled by the dollar’s drop, small stocks were on top – what happened?
I just mentioned eight basic asset classes we can all invest in reasonably easily using mutual funds and exchange traded funds (ETFs). The one thing they all have in common is sometimes they are on top and then sure to be a bottom performer sometime in the next few years. It is just the way of the markets.
What if I told you that, if you simply put 12.5 percent (one-eighth) of your investment portfolio in each of the eight asset classes named in my poorly contrived rhyming paragraph, you could have achieved an average annualized return of over 10.2 percent for the 15-year period ending March 31 of this year, besting the S&P 500 Index’s return of 9.5 percent during that period. Most importantly, there were no negative calendar year returns during the time period examined. Gains were tiny – less than 1 percent in both 2002 and 2002, but the stock market was down double digits in each of those years, as you probably remember.
Most importantly, the volatility of this hypothetical portfolio was virtually half of the average stock market volatility for that period. Better return potential for less risk, sounds like a plan we could all use as a basis for building our portfolio and then customizing for our personal situations as necessary.
A big part of the success of the eight asset class hypothetical portfolio is the discipline to rebalance back to the target weighting for each segment after market forces cause the allocation to be out of balance. Obviously, picking the right investment vehicles to gain exposure to the asset classes is important as well.
This review was, for me, a huge reinforcement in the importance of a disciplined portfolio plan and the commitment to stay with the plan, even when tough times like we face now come along.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.