BALANCING RISK AND RETURN THROUGH DIVERSIFICATION

Most people know that diversification means not to put all your eggs in one basket. But it means much more than that. Portfolio diversification is a balancing act that considers risk, return, and the expectations for each. With an investment philosophy that was successful even in the bear market of 2000-2002, Rubino & McGeehin's affiliated entity, R&M Wealth Management Services, LLC, works with clients to understand portfolio allocation and create and implement plans for effective diversification.

To properly diversify a portfolio, each asset class must have a low correlation to the other asset classes. Correlation is the calculated tendency for market securities to react (rise and fall in price) proportionate to each other given the market conditions. This is the one way to reduce the risk of the portfolio, and this is a major reason to diversify. By commingling asset classes that do not react the same way to market conditions, an investor smoothes out the volatility (systematic risk) of the portfolio as well as the rate of return.

All portfolios are subject to systematic or market risk, the risk common to all securities resulting from economic changes and business cycles. Diversifying a portfolio with low-correlated asset classes allows an investor to expect a certain rate of return based on the level of risk he/she is willing to undertake. Most investors will choose the portfolio with the highest return and the lowest risk. If investors want higher returns, they must also expect higher risk. Portfolio diversification is the means by which the investor can steer their portfolio towards the risk/return desired.

Here is a general example of risk reduction, but first a little background. The S&P 500 has a historical standard deviation of approximately 17% and a historical average rate of return of approximately 11%, over the last 30 years. Standard deviation is a measurement of risk or the percentage spread of a securities price from its mean price. Higher standard deviation means higher risk to the investment. S&P 500 type portfolios are very popular because the S&P represents 500 large-cap corporations and typically serves as an indicator of the entire market. R&M Wealth Management analyzes hundreds of portfolios every year. Most of the portfolios the firm analyzes have the risk characteristics of an S&P 500 portfolio. The standard deviation is approximately 17% and the rate of return is 8% to 12% over the last 10 years.

Now the example: If a publicly traded REIT (real estate investment trust) is added to the portfolio, and the domestic equities are weighted toward a value style of management as opposed to a more aggressive growth weighting, and we incorporate a commodities position (petroleum, precious and industrial metals, etc) the standard deviation of the portfolio can be reduced to 11% to 12%, without sacrificing the 8%-12% rate of return. The increased diversification of low-correlated asset classes reduced the portfolios systematic risk by 30%, just by restructuring the types of equities in the portfolio.

The next step would be to add fixed income (high-grade government or corporate bonds, high yield and international bonds) investments thereby further reducing risk with the introduction of those assets. A good rule of thumb for investors is to use their age as the percentage of fixed income in the investment portfolio. Increasing the percentage of fixed income over the course of one's investment life helps reduce unwanted risk in the portfolio and helps preserve accumulated wealth. Introducing bonds into the portfolio will further reduce the standard deviation from 11 – 12% to 8% or 9% or even lower.

While there are many advantages of a diversified portfolio, there are also some disadvantages. First, a portfolio with four or five different asset classes (domestic stocks, real estate, commodities, etc.) will always have one asset class that is the ‘loser' that year. For example, Investors should not panic and sell out of their real estate position when it is negative 6% and everything else appreciated nicely. Second, by diversifying, the portfolio's rate of return will lag behind an all equity portfolio's rate of return in an appreciating market. Because the portfolio is so well diversified, it cannot compete with the S&P when it earns 20% or 30% in a given year.

Over the years, R&M Wealth Management has come to understand what investors want. They do not want outlandish returns with 50% gains, as in 1999, and 50% losses, as in 2000 through 2002. They want a portfolio that is managed to reduce risk as much as possible while achieving their expected long-term rate of return. An investment philosophy that seems to work well is: Expect 70% to 80% of the market return during a bull market, and in a bear market expect returns to be relatively flat. This balanced approach and the adage about all eggs in one basket provide the foundation for an effective long-term investment strategy.

Steve Moore may be reached directly at 301.564.3636. For more information about Rubino & McGeehin, please visit www.rubino.com.