Base Hits Beat Home Runs

Submitted by Tom Orecchio on Tuesday, April 24, 2012 - 9:00am
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When explaining the impact of volatility and portfolio risk, I often tell clients that that it’s better to aim for singles and doubles rather than swing for home runs.

Prior to the economic downturn of 2008, clients were eager to take investment risks.  They wanted double-digit returns and appeared relatively unfazed by short-term fluctuations in their portfolio. 

When I was illustrating a sample portfolio with 5%, 6% or 7% net return, clients wondered if they should take on additional risk to generate a higher return, even when their financial plan suggested that a lower return was more than sufficient to achieve their objectives.

 

Year 1

Year 2

Year 3

Year 4

Year 5

Average

Return

Compound Return

End Value Year 5

Portfolio A:

10%

10%

10%

10%

10%

10%

10%

$161,051

 

Portfolio B:

40%

-20%

50%

-30%

10%

10%

5.28%

$129,338

 

At annual review meetings, I often reminded clients to focus on compound rather than average rate of return and that, to achieve a higher compound return, they needed to reduce portfolio volatility. Even something as simple as using a basic chart to compare a $100,000 portfolio with huge yearly swings (a.k.a. home runs and strike outs) to one with more consistent returns over time (a.k.a. base hits) seemed to hit home with many clients and helped illustrate the point.

However, since the market bottom of 2009, the game seems to have changed.  The concern is less about convincing investors to go for base hits and more about persuading them to participate in the game at all.

U.S. stocks in this year’s first three months, as represented by the Standard & Poor’s 500 index, had their best quarterly performance period since 1998. Yet net outflows from stock mutual funds continued during the equity price upturn. JP Morgan reports that bond flows exceeded equity flows by $35 billion during February and U.S stock mutual funds are still suffering from net redemptions.

Although market contrarians view recent trends as a positive indicator of future stock market potential, the stock fund outflows may be signs that fear of volatility, stemming from the 2008 drawdown, is playing a role in investor behavior. 

The problem that exists with “safe” investing through bonds is that yields are so low that they often represent a negative return after taking inflation into account. This has resulted in a broad search for yield, especially among retirees, which actually may run the risk of making a portfolio more volatile and less diverse as investors extend maturities and take greater credit risk seeking to obtain higher current yields.

Another yield-seeking approach of late is to acquire dividend-paying stocks through the popular high-dividend exchange-traded funds. But this may also compromise the diversification of one’s portfolio by overly concentrating equity holdings in a few stock positions.   

So while the baseball analogy still holds true when explaining volatility, perhaps a caveat needs to be added: While it’s better to aim for base hits rather than swing for home runs, it’s also important to stay in the game.

Sitting in the dugout with a portfolio that includes too large a concentration in cash, bonds or dividend-paying stocks is also risky and may dilute the effectiveness of your investment strategy over the long run.

Tom Orecchio, CFA, CFP, ChFC, CLU, AIF, is a principal and wealth manager of Modera Wealth Management, LLC in Westwood, N.J.

Nothing contained in this article should be construed as personalized investment, financial planning, legal, tax, accounting or other advice, and there is no guarantee that the views and opinions expressed herein will come to pass.  Investing involves gains and losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be construed as a solicitation to buy or sell any security or engage in any particular investment strategy.

For more information about Modera, including our registration status, fees and services and/or a copy of our Form ADV Disclosure Brochure, please refer to the Investment Adviser Public Disclosure web site at www.adviserinfo.sec.gov, visit our web site at www.ModeraWealth.com or contact us at (201) 768-4600.  A full description of the firm’s business operations and service offerings is contained in our Disclosure Brochure which appears as Part 2A of Form ADV.

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