If you’re like many investors, your account statements list a bunch of investments, but don’t resemble a portfolio.  What does this mean?

The basic idea of an investment portfolio is that the different investments you own are selected in relation to your other investments.  The primary consequence is that investors will diversify their investments to limit their risks.  For example, an aggressive investor may have most of his money in stocks.  But he should still want to spread out his bets among many different types of stocks, both by industry and country.  Disaster can strike when an investor has too much exposure to one industry, such as technology stocks a decade ago or financial stocks three years ago.

The investor may also want to reduce his risk by holding assets other than stocks.  For example, U.S. Treasury bonds are considered a good complement to stocks, because they may perform well when an economy is weakening, at the same time that stocks may be doing poorly.  Diversification gives the investor a chance to have some part of his portfolio doing well at any time.

A lot of investors don’t assess their portfolio in this way.  They look at each investment in isolation and decide whether they like it or not.  Over time, they can end up with a lot of individually selected “it seemed good at the time” investments, but no overall strategy as to how to utilize the investments to manage risk and pursue their financial goals.

In our view, it is the portfolio structure that matters most; the individual investments are just building blocks that we use to create a strategy that matches a client’s risk and desired return goals.  It does require a different way of thinking, but the potential benefits to risk management are worth thinking about.

A simple example will illustrate the point.  Let’s assume an aggressive investor chooses all of his investments in isolation and wants to produce a high expected return over the long run.  He would have been highly unlikely to have purchased long-term U.S. Treasury bond in recent years.  The reason is that, for most of the past 5 years, such bonds have yielded between 4-5%.  Compared to his expectations for long-term stock returns (historically close to 10% total returns per year), he would never want to buy a bond with half the expected return.  Thus, the volatility of his overall portfolio is likely to be similar to that of the stock market.

Now let’s look at an investor who makes decisions on his investments by looking at the overall portfolio, and not just by picking one security at a time.  This investor recognizes that, even if stocks do have higher potential long-term returns, there will be periods where stocks fare poorly and he does not want to be fully exposed to the losses when this happens.  His research has shown him that, historically, long-term Treasury bonds have acted as a good diversifier in many periods where stocks have declined (particularly when inflation concerns are limited).  Not only do the bonds pay interest, but their prices may also rise significantly if interest rates fall.  So despite the lower long-term potential return, he is willing to make an investment in U.S. Treasury bonds because of the expectation that it will reduce the overall risk of his portfolio.  This has been a beneficial strategy in recent years.  For example, in 2008 when the S&P 500 Index of U.S. stocks plunged -37%, Long-Term U.S. Treasury Bonds¹ had a total return (income plus price change) of +24%.  So not only could he have reduced his losses in the worst year for stocks in eight decades, he also had the opportunity to sell some of those appreciating U.S. Treasury bonds to buy stocks at cheaper prices.  A similar, though less dramatic, situation has been playing out so far in 2010 as investors have bid up U.S. Treasury bonds as safe-haven assets while worries about European government debts have rattled stock markets across the globe.

While you could argue that an aggressive investor should only be concerned about maximizing long-term returns, there are several points to counter this.  1) The higher risk investment may not achieve the higher expected returns, even in the long run.  If stocks were guaranteed to outperform other assets, then there would be no risk to stock investing.  But the reason that stocks offer high potential returns is the very fact that they are quite risky!  2) Few investors are comfortable seeing their investment portfolios decline substantially during bear markets in stocks.  The worst time to find this out is when you have already had a large portfolio drop substantially, when you will be tempted to sell stocks to reduce your risk.  There certainly are some investors out there that can tolerate heavy losses without flinching, but the odds are that you are not one of them.

In our view, there are clear advantages to looking at your assets from a portfolio perspective, particularly so if your goal is to manage risk in different economic environments.  U.S. Treasury Bonds are just one example of an investment that can offset some of the risks of investing in stocks.  Modus Advisors builds investment portfolios that have the potential to limit losses in a variety of adverse scenarios.  With the ongoing uncertainty in the global economy, you need a portfolio perspective to pursue your financial objectives.

¹Long-Term U.S. Treasury Bonds returns as measured by Barclay’s Capital Long-Term Treasury Index

* Past performance is not a guarantee of future results.
* The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.   It is not possible to invest directly in an index.
*Barclay’s Capital Long-Term Treasury Index tracks the total return of fixed-rate coupon bonds with 10+ years to maturity that were issued by the U.S. Treasury
* Investing in stocks is subject to fluctuation such that, upon sale, units may be worth more or less than the original cost.
* Bonds are subject to market and interest rate risk if sold prior to maturity.  Bond values will decline as interest rates rise and are subject to availability and change in price.
* There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.  Diversification does not ensure against market risk.