The Holy Grail Of Investing

05/25/2011 12:15 pm ET
  • Dan Solin Author of the Smartest series of books

Asset allocation and "holding period" are critical to all investors. They are far more important than stock picking and market-timing.

Unfortunately, most investors still do not focus on either.

Historically, large stocks have returned on average over 10% a year; small stocks over 12%. In contrast, long term government bonds have returned slightly more than 5%, which is pretty dismal given the historical inflation rate of 3%.

Why not just load up on stocks, especially small stocks? Because of short term volatility. A small stock portfolio would have lost almost 50% of its value in 1973-1974.

But what if you could minimize the volatility of a risky stock portfolio and make it almost equivalent to a conservative bond portfolio? The best of both worlds. Superior returns. Low volatility. The holy grail of investing.

There is a way to do this. Most brokers and financial advisors will not tell you about it. Not because they have a sinister motive. They just don't understand the relationship between holding period and risk.

Even a broadly diversified stock portfolio is extremely risky if your holding period is one year. The volatility of this portfolio, as measured by standard deviation ("SD"), is almost 20%. In contrast, a portfolio consisting of mostly bonds is almost risk free, with an SD of less than 2%.

However, you can reduce the volatility of the all stock portfolio from an SD of 20% to less than 6%, if you know you can hold it for seven years. The risk is now almost equivalent to the one year risk of a very conservative portfolio.

So what's the bottom line?

Depending on your holding period, you may be able to achieve the higher returns of stocks over bonds, without significantly increasing your risk.

The next time your broker or advisor blathers on about a great stock or a "hot" mutual fund, cut the conversation short. Tell him that you want to talk about your holding period.

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