The Perfect Portfolio

The ideal portfolio may be different for every investor, but that doesn’t mean there are 150 million perfect variations.

Nevertheless, based on the Model Portfolios on our Web site and the strategies we manage for clients, there are probably at least 60,000 combinations that could qualify.

How can an investor choose the right one?

In this article, I’ll walk through the steps I use when I’m meeting for the first time with a client. I hope this will give you some good ideas on how to put together a combination that’s just right for you.

The first conversation I have with any new client is about risk. It’s the most basic part of investing, the topic that most of the industry (and most investors) would be happy to avoid altogether.

Let me be blunt about this: Investors who don’t understand risk can’t understand the decisions and choices they must make.

I ask the client to imagine that he (or she) is in a bank applying for a loan. Soon you realize that at the next desk, Bill Gates is also applying for a loan. Which borrower is likely to be more attractive to the bank? Bill, of course.

The bank would always rather lend its money to him than lend it to you, because there is simply no question about his ability to pay the money back. He’s as close to a risk-free borrower as the bank could have.

But Bill Gates is not the sort of person who would hesitate to take advantage of his position. If he told the bank he wouldn’t pay more than 3 percent interest, and you were willing to pay 5 percent, what would the bank do?

In this case, the bank is in the same position as an investor. It can lend money to Bill Gates and earn 3 percent in a risk-free transaction. Or it can lend money to you and collect 5 percent in a transaction that has some risk.

The bank has to decide whether the extra return is worth the extra risk.

This is exactly the challenge that smart investors face, over the whole spectrum of investment choices.

In a bond, there are two main risks: maturity and credit. Maturity refers to the fact that rising interest rates tend to depress the prices of longer term bonds more than shorter-term bonds. This makes long-term bonds riskier than short-term bonds.

Credit risk refers to the fact that repayment from a blue-chip company is more reliable than repayment from a company struggling to find enough customers to meet its obligations.

In a stock, there are many risks. But in the aggregate, smaller companies are more risky than bigger ones, and “value” companies are more risky than growth companies.

Because these risks are well known, over long periods of time value stocks and small-company stocks offer higher returns than growth stocks and large-company stocks.

At this point in the conversation, I show the client a graph called “Theoretical Balance of Risk and Return.” You’ll see it in Figure 1A, below.

This is pretty simple, but you’ll need to understand this graph in order to follow the upcoming discussion.

The top end of the dotted line in Figure 1A represents the risk and return level of the Standard & Poor's 500 Index from 1973 through 2002, while the bottom end represents the risk and return of Treasury notes.

The area on the right side of this graph represents higher risks; the area on the left represents lower risks. Similarly, the area at the top represents higher returns, the bottom represents lower returns.

Once you understand this, you’ll see that the perfect investment strategy would wind up in the upper left corner of this graph, where risk is lowest and return is highest.

We’ll be looking at a series of graphs laid out this same way, always looking for combinations of assets that have more return (closer to the top) and less risk (closer to the left).

By looking at the ends of the dotted line in Figure 1A, you can easily see that, just as you would expect, T-notes have much less risk (on the left side of the graph) but also have lower return (lower on the graph) than the Standard & Poor's 500 Index.

The point in the middle of that line shows what you might expect from a 50/50 combination of T-notes and the S&P 500 Index. This represents the halfway point of both risk and return between T-notes and the index.

However, it doesn’t work out that way in real life. You’ll see that in Figure 1B below, which shows a solid line based on actual combinations of these two assets.

The solid line in Figure 1B is bent toward the left and toward the top of the graph. You can see that a 50/50 combination of the S&P 500 Index and T-notes produced more than the average of the two returns, at less than the average risk of these two assets.

In Figure 1C below, you’ll see where various combinations of these two assets land on the graph. Every intermediate combination is higher than – and to the left of – where it would fall on the straight dotted line we saw in Figures 1A and 1B.

You can think of the bend in the solid line as a benefit of diversification. As we will see, this phenomenon is not limited to these two particular assets. In fact, these three graphs illustrate a fundamental point that investors need to understand: Smart diversification lets you mix two assets together and achieve a higher return at less risk than the average of those two assets.

 

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