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Seven strategies to reduce investment risk

By Scott Keffer

“Frankly, I want out!,” Dr. Tim Frick thought as he sat across the desk during the negotiations. “You want me to see more and more patients for essentially the same money.” More risk, more time, more stress and less money—that’s what practicing felt like anymore.

He wondered, “But can I really afford to quit at age 59?” Then his stomach tightened, “And what happens if I quit and the market keeps going down?”

As he looked back a year, it hardly seemed possible that he was the same person that had felt those things so strongly. Here he sat reading one of his favorite novels with very little stress about his future and his investments, despite the continued downturn in the market. It’s not that he didn’t think about the market, it’s just that he didn’t worry anymore. He didn’t jump on the Internet to check the market anymore, or go straight to the finance page in the newspaper, or search every financial publication looking for the “best” mutual fund or the new investment “guru.” His life had been simplified and he and Betsy were now focusing on other parts of life—like reading, golf, skiing and visiting the children and grandchildren. He could hardly believe how good it felt.

What had made the difference?

He had been introduced to the fastest growing investment strategy among institutional investors—a strategy becoming more and more known to the average individual investor. It is an academic, disciplined approach to investment decision making that has research and proof to back it up. The strategy is Modern Portfolio Theory.

Modern Portfolio Theory is an investment approach developed by University of Chicago economist Dr. Harry M. Markowitz, who won a Nobel Prize in economics in 1990. In 1952, Markowitz began asking questions. He pondered, “How can the average investor earn an attractive rate of return without undue risk?”

It was his position that a portfolio’s risk could be reduced and the expected rate of return improved if investments were combined that didn’t move together. He called it dissimilar price movements: those asset classes that move like a see saw. Markowitz further explained how to best assemble various asset classes together into an efficiently diversified portfolio. He turned to mathematics to find out what were the best combinations of asset classes in a portfolio for every reasonable level of risk, what he called “an efficient frontier.”

In 1986, a prestigious pension firm published a study that shocked many in the investment community, yet supported Markowitz’s conclusions. The study was designed to test the impact of three strategies on a portfolio’s performance. The three strategies tested were market timing, security selection and asset class investing. It concluded that market timing (the ability of a manager to consistently time the market) and security selection (the ability to pick the right securities) had an inconsequential impact on portfolio performance. Asset allocation accounted for over 90 percent of the impact on performance.

Roger G. Ibbotson and Paul D. Kaplan studied the same issue and published their results in the article, “Does Asset Allocation Policy Explain 40 Percent, 90 Percent, or 100 Percent of Performance?” It appeared in Financial Analysts Journal, in the January/February 2000 edition. Their results essentially confirmed the previous study: 88 percent of the performance of pension funds was attributable to asset allocation.

Yet, Wall Street firms spend billions of dollars to try and outguess each other and convince you that these two strategies work. Why? Because emotional investing benefits these firms, not you. Fear is a great motivator.

Here are the seven key strategies that allowed Dr. Frick to sit be so calmly while the current market seems to be falling apart.

Start with an Investment Policy Statement. An investment policy statement is a blueprint. It outlines your goals, expected returns, time frames, risk tolerances and liquidity needs. It is also your protection—it is what you can hold on to when everyone else is out of his or her mind with either excitement or fear. It takes the emotion out of the investment process. Everyone who goes to the market for excitement eventually loses; everyone who sees the market as a game eventually loses.

Utilize efficient diversification to reduce risk. We’ve all heard, “Don’t put all your eggs in one basket.” Diversification does not necessarily reduce risk. Buying more of the same asset class will not effectively reduce your risk, because similar asset classes move up together and down together. Your overall portfolio risk is not the average risk of each of the investments; it is actually less than the average if the investments do not move together. That’s using dissimilar price movements to reduce risk.

Reduce unnecessary volatility to enhance your portfolio’s performance. Everyone uses average rate of return to gauge whether one investment is better than another. If you have two portfolios with the same average rate of return, the one with less volatility will have the greater return to the investor. Let me illustrate like this: your neighbor comes over and brags that he has had an average rate of return of 11 percent over the last five years, made up of annual returns of 20 percent, 25 percent, -10 percent, -15 percent and 35 percent. Your disciplined portfolio has experienced an unexciting 10 percent, so you say nothing, yet wondering whether a disciplined approach really works. If you work the math, your neighbor’s $100,000 would have grown to around $155,000 (ignoring taxes). Your $100,000 would have grown to $161,000.

Invest in international securities. By ignoring investment opportunities outside of the United States, you are missing out on approximately half of the investable developed stock market opportunities in the world. In 2000, the total developed world stock market capitalization was $29.4 trillion, with $14.3 trillion representing international stock market capitalization. That’s almost 50 percent. In 1970, it was only 32 percent. The real benefit to you is the dissimilar price movement, or low correlation of the international asset class with the U.S. asset classes. In other words, they do not move together, offering you the opportunity to reduce risk and increase return. Therefore, adding international stocks to a portfolio, even though they are risky by themselves, can actually increase the return without assuming additional risk. Although it may appear counterintuitive, including international stocks can reduce the volatility of domestic portfolios.

Employ specialty investment managers. It takes multiple managers to execute an asset class investment program. This is so simple, it’s scary: no manager can be equally skilled in all asset classes and no one institution has all the best managers in every asset class. You must employ different managers, each specializing in a different asset class. Therefore, you must have established guidelines for manager selection to ensure that you are hiring the “best of the breed” in each asset class.

Benchmark each manager’s performance. Performance should be reported on a quarterly basis with each of the managers benchmarked against the appropriate index or peer group of similarly managed portfolios. In addition to evaluating each manager, you must also evaluate your portfolio on a consolidated basis. Performance should be easy to understand and show you exactly what’s happened to your portfolio in terms of total return, both income and capital appreciation, for the current quarter, year-to-date and inception-to-date. Be sure to get the results net of all fees.

Rebalance regularly. As one asset class outperforms the other, your portfolio’s actual asset allocation will vary from your target allocation. Therefore, it’s necessary to rebalance the asset classes in your portfolio. This should be done on a regular basis, usually when actual allocation deviates from the target allocation by some predetermined percentage.

Seven key strategies that can reduce your investment risk and increase your return. They worked for Dr. Frick and they can work for you. However, there is one more thing. Unless you want to spend your free time doing this, you’ll need a specialist to design and implement these strategies for you. Then, simplify your life and focus on what you really love—and see how good it feels.

Scott Keffer is president and founder of Wealth Transfer Solutions, Inc., a legacy planning company in Pittsburgh.

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