Money Talks: Reduce risk, increase gains
Investors here in paradise certainly are familiar with the dichotomy of summer in the tropics. The beauty of reduced traffic congestion combined with the risk of severe tropical weather goes hand in hand. A similar dichotomy exists with investing and money management.
By now, the concept of risk reduction for the average retired investor certainly takes a front seat as it pertains to big picture planning. There is great appeal with the concept of risk reduction, or safety, while at the same time there is the concern about the perceived lack of gains associated with the addition of a risk reducing component within the portfolio. However, this is an attainable goal with a proven track record behind the research.
It is easy for most to digest the concept of winning by not losing, as in avoiding market losses. Of course this concept loses value with each passing month and year that this unprecedented stock market run continues to defy the odds. This is why now may be a good time to refresh our collective memories as to the potential for enhanced investing success by embracing risk reducing asset classes as a percentage of any given portfolio.
A closer look reveals that there is proven research quantifying the reality that the judicious addition of risk reducing asset classes can, in fact, increase long tern performance. A recent report revealed the value of achieving only a percentage of the market’s overall return while avoiding any and all market based losses. The chart tracked a $100,000 investment from 2000 through the end of 2016. Portfolio A invested 100 percent in the S&P 500 over the entire 16 year period grew to roughly $145,000. Portfolio B capturing only a 45 percent participation rate from the same S&P 500, while avoiding market losses during the same sixteen year period grew to roughly $175,000. This powerful single page chart shows the power of avoiding market risk while at the same time accepting considerably less return. This is a textbook example of reducing risk while increasing gains.
Another strategy for retired investors to embrace is the addition of the alternative asset class of managed futures. Yes, as misunderstood and mysterious as they may seem on the surface, the reality is that commodity trading has been around longer that stocks. The beauty of managed futures lies within their ability to capitalize on computer driven trading systems versus their ”identity crisis…with open pit trading and fortunes being made and lost on beans and oil”, according to ThinkAdvisor.com. The Noble Prize winning research known as modern portfolio theory illustrates clearly and concisely that the prudent addition of managed futures can, in fact, reduce risk to the portfolio, while at the same time increase returns.
The cornerstone of the research illustrates the effect of reallocating 20 percent of a combined stock and bond portfolio to Manage Futures based on a 60 percent stock, 40 percent bond allocation. From 2000 to the end of 2015, portfolio A, the stock, bond only portfolio, grew $1,000 to roughly $7,000. Then, portfolio B reallocated 20 percent of the same 60/40 stock and bond allocation into managed futures. The results over the same period grew to roughly $10,000 for a whopping 50 percent increase in overall portfolio returns during a 25 year time frame.
The report goes on to compare the worst losses based on particular market indices. Dating back to 1990, the worst corrections with both The Dow Jones as well as the S&P 500 were roughly 50 percent market losses. The Futures index is based on the Barclays Top 50 CTA index, which represents the audited performance of the index’s commodity trading advisors. The worst correction, or draw down losses, was roughly 10 percent; 10 percent losses versus 43 percent losses tell the story of reducing risk while increasing gains.
In fact, managed futures significantly outperformed US stocks from 1980 through 2015; with less risk. Now it is critical here to understand that either of these strategies should be taken in the proper context as to representing only a percentage of the overall portfolio. Reducing risk while increasing gains can lead to the life of a SWAN, Sleep Well A Night.
William F. Hague is a managing partner of Hague Wealth Management; 239-389-1999 or WFHague@earthlink.net. The opinions and observations stated above are those of the columnist.