Your Portfolio Numbers Are Sending You a Powerful Message. Are You Listening?

Investors are sickened by the plunge in value of their portfolios. There is a message in the numbers. Let me tell you why you should listen to it.

I divide investors into three basic groups:

Conservative risk investors: These investors have 60%-85% of their assets in bonds and the balance in stocks.

Moderate risk investors: These investors have 35%-55% of their assets in bonds and the balance in stocks.

Aggressive risk investors: These investors have 0%-30% of their assets in bonds and the balance in stocks.

I am going to assume that the stock and bond portions of all of these portfolios are invested in a globally diversified portfolio of low cost index funds.

Here is a range of returns for each risk type, as of the close of business on October 10.

Conservative investors had losses ranging from 5%-15%.

Moderate investors had losses ranging from 17%-25%.

Aggressive investors had losses ranging from 27%-39%.

What are these numbers telling you?

First: The higher the expected returns, the greater the risk. Investors who seek these returns must have the time horizon (and stomach!) to wait out the bad times in order to achieve the long term superior returns which are the reward for the risk they have taken.

Second: If your losses are greater than the range of losses in your risk category, you need to reevaluate your portfolio. Many investors had no idea of the risk of their portfolios. The chances are very good that the additional risk in your portfolio is "uncompensated", which means that you could obtain the same expected returns with less risk, by holding a more diversified portfolio.

Very few investors know the risk of their portfolio. When I give talks to groups, I ask for a show of hands for those investors who can tell me the risk of their portfolio as measured by standard deviation. Less than 1% respond.

I tell every investor to go back to their broker or advisor and find out their standard deviation. Most report back to me that the broker has no idea what they are talking about, much less how to compute it.

Bill Bernstein, the author of The Intelligent Asset Allocator, wrote: "If your broker is not familiar with the concept of standard deviation of returns, get a new one."

To which I would add: If you have uncompensated risk in your portfolio and don't know your risk, why are you using a broker?

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[Unrepentantliberal]

Dan, I've wondered, "In your opinion, does the fact that we now have all these monstrously enormous, exotic, unregulated, confusing debt instruments spread throughout financial institutions worldwide for the first time in our financial history change in any way your thoughts about investing?"

I am just "joe-small-investor" and not a professional, but it seems that all the so called experts have no idea what impact these instruments will have except as even Ray Charles could see, it seems to have been historically bad. And I know how you feel about the 'experts.'

Are we in truly in uncharted economic waters and do you foresee any modification of your 'invest in and hold a portfolio of globally diversified index funds consistent with your capacity for risk,' approach under these circumstances?' ; or is this just another 'the market will go up and the market will go down and if you ride things out and not panic you will be alright in the long run' situation? Thanks.

[Dan Solin - Huffpost Blogger]

I agree with Warren Buffett on this issue. No one knows what will happen in the future. All we know is that, over time, investors are well-rewarded for the risk they take by investing in stocks. In sharp contrast, risk free investments practically guarantee a loss given the ravages of inflation and taxes.

My advice remains unchanged. An important part of my advice is to be sure you have the right asset allocation so that you can hold during the inevitable bear markets, like the one we are currently experiencing.

[Unrepentantliberal]

Thank you for your reply. I have followed your advice and am in a much better position than if I would of kept to my previous all-over-the-map approach. I

[Minotaurus]

Investing in the Stock Market today would make sense if you are investing in new age sound durable products from real companies or Banks.
I understand lots of people are afraid and are cashing out,and I don't understand why the Banks are keep doing the same old investing procedure?They must be thinking there will be a fast recovery from this downturn.
I think time will adjust the market and the economy with better products and better solutions,meanwhile cash will talk as good as credit.

[BillZBubb]

My portfolio numbers are telling me I was right earlier this year when I advised people to get into cash. People that advised them to stay in stocks because selling was just "trying to time the market" were totally wrong. What were you advising back then?

[Unrepentantliberal]

Actually Bill, you did follow Dan's principles which include the phrase, "consistent with your capacity for risk." You simply felt that you had no capacity for risk at that point and acted accordingly. I on the other hand have, at this point, a greater capacity for risk and have made less dramatic changes in my portfolio composition.

In the short run, you have benefited more. In the long run, who knows? Dan's a smart guy, read his books. As Louis Rukheiser used to say, "Economists have predicted 24 of the last 7 bear markets successfully." This time you guessed right. Next time?

[worldtraveller]

Dan,
Glad to see you. Overall I like your message but several months ago I wrote a moderate post explaining to you somewhat mathematically the failure of Random Walk. A few weeks later you brought up price movement as a random walk once again. If the market exists inside of something it must hold true at all times. So how does essentially a binomial distribution explain a 1,000 point move in an hour. You are talking a movement so outside of any permissable standard deviation movement that a random walk would ever permit. That move should never happen in thousands of years. It would be flipping a coin and having it come out heads 100's of times in a row which is exactly what a random walk says is not occurring. Well some people like making up their minds and others are intellectually curious, your choice. Otherwise diversify, don't think you can time the mkt, and keep your expense low. Good message!

[lapoutlander]

More recently the Adaptive market hypothesis's reply to random walk points out that the relationship between risk and reward is unlikely to be stable over time (i.e. past performance not being a guaranty to future gain). Consequently some adaptation of an investment strategy is advisable to deal with changes in the market etc.

[cylindar]

Even the more conservative loss of 5% to 15% is big enough if you can never recoup that loss.