Nitroglycerin is volatile. So are markets, all markets. Always have been, always will be. In 2000 the stock market took a nose dive, just as it has, on average, every 7 years since they opened the doors of the NYSE.
Spinach farmers can tell you a thing or two about volatility with the recent food poisoning scare that came out of California. And a lot of people have a lifetimes worth of experience with making and losing money on real estate.
With all of this volatility, there is only one historical certainty – markets will ultimately continue to increase. The problem is, we can’t accurately predict which ones and when.
As a result, the most prudent strategy is, as everyone knows, to have a balanced portfolio. Problem is, no one ever takes the time to define what “balanced” is. So, here is my definition:
A truly balanced portfolio includes a mix of investments which have been purposely planned to render a given yield over time with a known level of risk.
Possibly the most important aspect in financial planning involves the selection of investments based upon their correlation to one another. That’s right, in the long run it’s less important to choose the “best stocks” than it is to ensure your stocks are balanced by a non correlated investment.
Let me explain…
Let’s say you’re a wizard at picking the best stocks. You start with $100,000 and you manage to grow it by 15% annually for 3 years – then the market takes a nose dive and your portfolio drops by 1/3 in the fourth year. Here is what occurs mathematically:
| Year | Funds | Growth | Percentage |
|---|---|---|---|
| 1 | $100,000 | $15,000 | 15% |
| 2 | $115,000 | $17,250 | 15% |
| 3 | $132,250 | $19,838 | 15% |
| 4 | $152,088 | -$50,189 | -33% |
| Totals | $101,899 | $1,899 | 1.9% |
Total Growth = $1,899 or 1.9% in 4 years.
Now, lets assume we make only one change to the equation. Instead of having 100% of the money in stocks lets assume we only put 60% of the money into stocks and the other 40% into municipal bonds.
Bonds are normally inversely correlated to stocks, meaning when stocks are booming bonds stagnate, but when stocks crash bonds perform well (because people flee the stock market for the stability of bonds).
In our fictional model our bonds will earn 4% in good stock years and 8% in bad stock years:
| Year | Funds | Growth | Percentage |
|---|---|---|---|
| 1 | $40,000 | $1,600 | 4% |
| 2 | $41,600 | $1664 | 4% |
| 3 | $43,264 | $1,731 | 4% |
| 4 | $44,994 | -$3,600 | 8% |
| Totals | $48,593 | $8,593 | 21.4% |
Stocks Portion
| Year | Funds | Growth | Percentage |
|---|---|---|---|
| 1 | $60,000 | $9,000 | 15% |
| 2 | $69,000 | $10,350 | 15% |
| 3 | $79,350 | $11,903 | 15% |
| 4 | $91252.5 | -$30,113 | -33% |
| Totals | $61,139 | $1,139 | 1.9% |
Total Growth = $9,732 or over 9.7% in four years
As is clearly demonstrated, the more balanced portfolio crushes even the professional stock picker because when the stock market as a whole tanks (which we know it does routinely) everyone is along for the downward ride.
Now, having mutual funds or many stocks might help you perform like an expert stock picker, but when an entire market collapses no one is immune. And although one might get lucky and be better off in a given year, such as the previous years with the stock only portfolio, it absolutely is going to come to an end and noone can predict when to pull money out before a crash.
The real purpose of the balanced portfolio is to even out the peaks and valleys because timing is important when it comes to investments. Think of all the people who decided to quit their job and retire in 2000 because they were loaded up on stocks and the market was doing great. That was bad timing… and after the crash many people lost everything and were unemployed as well.
So, find yourself a good investment advisor and put some effort into planning a truly balanced portfolio. When retirement time comes you’ll thank me.
