Investment Problem: Trading Safety for Higher Returns?

Investment Problem: Trading Safety for Higher Returns?

The core dilemma for long-term investors, particularly those planning for retirement, centers on the trade-off between portfolio safety and potential return. While broad diversification is universally hailed as a necessary key to safety, it often comes at the cost of sacrificing a portion of long-term weighted returns. This is because not all asset classes share the same outlook or probability of long-term returns.

The Security of Diversification

Diversification is essentially the strategy of "not putting all your eggs in one basket." By spreading investments across different asset classes—such as stocks and bonds—an investor reduces their exposure to any single, catastrophic event.

The primary benefit of this approach is risk mitigation. When one asset class performs poorly (e.g., stocks during an economic downturn), another asset class (e.g., government bonds) may hold its value or even appreciate. For a retirement-focused investor, preserving capital is often as crucial as growing it.

The Cost to Weighted Returns

The negative side of this risk-mitigation strategy is the dampening effect it has on a portfolio's overall expected returns. High-growth assets, primarily equities (stocks), historically offer the highest long-term returns—often cited around 10% annually. However, they also carry the highest volatility and short-term risk.

When an investor diversifies, they intentionally include lower-risk, lower-return assets, such as bonds, which might offer a long-term return closer to 5%.

Consider the example:

• Stocks: Expected long-term return of 10%

• Bonds: Expected long-term return of 5%

A common, moderately diversified portfolio employing a 50/50 mix of the two assets results in an expected weighted return calculated as:

(0.50×10%)+(0.50×5%)=5%+2.5%=7.5%

In this scenario, the investor forgoes a potential 2.5% return (the difference between 10% and 7.5%) in exchange for the safety and stability provided by the bonds. This lower expected return is the cost of diversification.

Ultimately, while an undiversified portfolio of pure stocks might yield the highest long-term return, the risk of loss is significantly higher.

For an individual dependent on their savings, the goal shifts from simply maximizing returns to maximizing the probability of achieving their financial goals without catastrophic failure. The reduction in risk purchased through diversification is for most investors, a cost they must endure.

The challenge for every investor is the same: How do you build a portfolio that offers safety and higher income without diluting the growth potential of stocks?

The solution, something other than the traditional portfolio mix will be found in an innovative income and growth strategy.

[Find out about: Nerat Capital’s Income & Growth Strategy]