beating the market, part 2: the right question

In last week’s post, I posited that “how do I beat the market” is the wrong question. “OK, smart guy,” you say. “What’s the right question, then?” Well, I wouldn’t call myself “smart guy”, but I’m glad you asked.

Actually, there are two right questions. One is: “Given how much risk I’m willing to take, what investment will give me the best expected return?” The other is: “Given what kind of expected return I need, what investment will give me the least risk?”

Of course, “how much risk am I willing to take?” and “what kind of expected return do I need?” are in themselves not necessarily simple questions. Obviously the answers will vary widely depending on whether you’re talking about saving for next year’s vacation or retiring thirty years from now. But once you’ve answered those questions, then really the investments you pick should largely depend on the questions above.

Let me reiterate: you are not necessarily looking for the largest possible return. If there’s a huge “upside potential”, as the investment folk like to say, but you’ve got an 80% chance of losing your shirt…well, you may as well go to Vegas. It’s more fun! Sure, you might pick a big winner this time, but how much do you want to bet on your ability to pick winners year in and year out for the rest of your life? Everybody think’s they’re above average, sure, but how much are you willing to stake on that?

No, what you want is a balance of risk v. return. Generally speaking, the riskier an investment is, the higher the expected return, but there are many cases where you can take a huge chunk out of the risk without losing too much of the return. This is why good financial planners often encourage their clients to diversify, buying mutual funds instead of individual stocks: people will tell you that it’s a good way to mitigate risk, but the crucial point they don’t often mention is that it mitigates risk much more than it mitigates return.

(As a side note: this is what people talk about when they say efficient frontier; it’s the investment where you get the best balance of risk v. return, for a given amount of either.)

So those are the questions: how to get the best return for a certain risk, or the least risk for a certain (expected) return. Now, given these questions, I’ll end with three answers you’ll often hear from good financial planners:

Limit the proportion of any one stock in your portfolio. If any individual company’s stock makes up more than a few percent of your portfolio, you’re looking for trouble. The example I hear brought up most often is Enron employees whose 401(k)’s were mostly shares of Enron stock; needless to say, their retirements vaporized when the company did. But there’s another example that’s more insidious: ESPP’s, RSU’s, and stock options. A lot of my engineer friends carry a ton of their company’s stock around, simply because these programs make it easy to acquire company stock. If this is you, please: consider diversifying. I’m sure your company is great, but there’s better return to be had for the risk.

Limit the proportion of commodities, especially gold, in your portfolio. I’ve already mentioned this in a previous post, and I’ll say it again: gold buyers beware. Historically — and I mean over the past hundred years, not the past five — gold has been extremely volatile, and the returns have not been enough to compensate for the risk. Commodities in general have their place, but all the same, limit the amount you have in your portfolio.

Don’t buy long-term bonds. Now, there are admittedly differing opinions on this, but the majority fall in the camp of Larry Swedroe, William Bernstein, and others: long-term bonds have obviously higher returns than short-term bonds, but the added risk doesn’t compensate. (Long-term bonds fluctuate dramatically with interest rates, much more so than short-term bonds do.) Historically speaking, over the long term, stocks will give you better returns for your risk. That said, if you have a very specific need at a very specific time (like, say, pension funds do), long-term bonds can give you the certainty you need (especially if they’re U.S. Treasuries).

So: how about your investments? Are they answering the right questions?