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Our Retirement is the Last Frontier
By Stephen J. Butler |
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Jim Carey, in the movie "Dumb and Dumber" is told that he has one chance in a million of ever getting together with the object of his desire. He is ecstatic as he exclaims, "I have a CHANCE!" Sometimes, we approach our future investment hopes with the same level of optimism only to be crushed when we don't experience the results we had projected. Of course, the probability of success was undoubtedly in the ballpark with that of a large lottery winning or the successful outcome of a personal injury suit.
When it comes to projecting investment returns, we don't have to be shooting in the dark. Investment managers and financial planners have it all figured out for us in the form of an investment concept called the "Efficient Frontier." Unfortunately, no frontier has looked very efficient over the past two years, but it helps to know what, on paper, is supposed to constitute the most profitable investment mix that falls within an individual's propensity to take risks.
Simply put, the efficient frontier is a point on a graph that represents the highest expected rate of return for a given acceptable amount of volatility. Volatility is deviation from what would otherwise have been a straight line of results. The more volatility, the more risk. A technology fund that doubles in a year or loses 50% of its value presents a lot more risk than an S&P 500 Index that can be up 30% in a year or lose 20%.
The efficient frontier offers an investment IQ test of sorts. It can tell us when we are taking risk to a degree that is pointless. In other words, there is a different mix of investments that, for less risk, would generate the same expected rate of return. The basic underpinning of the Efficient Frontier is diversification. However, the diversification needs to include investments that are inversely correlated or basically different from each other. If all your investments exhibited the same characteristics, they wouldn't offer any diversification.
Stocks and bonds offer about a 60% correlation to each other. If they continually moved in exactly the same direction, they would have a correlation of +1. If they were always exactly opposite, the correlation factor would be -1. Because movement of both investments is only similar about 60% of the time, statistical studies show that adding bonds to a mix of stocks will increase returns without adding to risk. Basically, bonds pay interest every year, and they don't fluctuate as much as stocks. The combination of steady earnings and less volatility leads to an increase in returns over long periods of time.
Of course, from the early eighties until two years ago, this argument would have fallen on the deaf ears of most investors. But that was then and this is now. We may be moving into a period many feel will include much backing and filling before markets begin to rise substantially again. If so, a determination of our efficient frontiers should illustrate the contribution that other investment types might offer.
The actual research and statistical analysis can be hopelessly complex. However, we can "eyeball" the past annual returns of different types of mutual funds and see where combinations would have smoothed out our returns. As a starting point, we can just compare two mutual funds such as an S&P 500 index and a long-term corporate bond fund. The combination of the two clearly offers a greater return over the past four or five years with less volatility. This is not to say that anyone should rush out and make drastic changes in their investment allocations. The exercise is only meant to offer a reality check.
The nineties was, in statistical terms, an aberration. The next ten years may prove to be a more normal period. Let's hope so anyway. Anything other than normal would probably be bad. Determining an efficient frontier and blending in some inversely-correlated investments could lead to gratifying results. One of the best and most readable books on the subject is "Asset Allocation" by Roger C. Gibson. In the meantime, remember that only the "Dumb and Dumber" bank on the hope that a one-in-a-thousand chance will somehow work out.
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