Do you want a portfolio that’s vulnerable to wild swings in value? Likely not. In fact less volatile portfolios are both easier on the stomach and they help you achieve better long-term returns.
For example, a portfolio that declines 10% this year requires an increase of 12% next year to recover its losses. If your portfolio drops by 50%, it must rebound by 100% just to break even! Clearly, minimizing the downside of your portfolio will allow it to reach positive net returns more quickly.
A portfolio that is accumulated a few investments each year, year after year is often just a collection of investments versus a diversified portfolio. Ask yourself this: if, over many years you acquired all the parts you thought you needed to build a car and you piled them up in your garage, would it be a car? Or would it be a pile of car parts? Do you end up with the right pieces, or do you have too many of some parts and too few of others? Why would a portfolio be any different?
Our best technique for protecting portfolios is called Modern Portfolio Theory. This Nobel Prize winning idea said it is insufficient to look at investments in isolation. Instead, rational investors should seek out “efficient portfolios” offering the highest expected return for each level of risk.
In our next article, A Diversified Portfolio vs. a Collection of Investments, The Only Two Things You Need to Know About Modern Portfolio Theory, we discuss the two simple things that will help you build less volatile portfolios.
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The Index House is a division of Polaris Financial Inc.