Forget individual investment returns, REAL gains come from considering your investment returns collectively

Posted In Financial Planning | Investments | Wealth Building
22 May 2017
REAL gains come from considering your investment returns collectively

People exercise to get healthier in the same way people invest to get wealthier.

I have no idea whether there’s a way to achieve more from my workouts, such as spending less time exercising or benefiting more from the time I spend exercising, but I have learned the equivalent efficiencies that can be achieved when investing.

exercise returns vs. investment returns

Note: Efficient investing will not lead to a better beach body, but it may result in you spending more time at the beach… or exercising!

To clarify, efficient investing is not achieving better returns from less time investing, I’m referring to improving returns while lowering investment risk.

How do you achieve higher investment returns with lower levels of risk?

Welcome to the science of risk-efficient investment portfolios

harry markowitz Nobel prize winner
Harry M. Markowitz receiving the Nobel Prize for his pioneering work in the theory of financial economics.

Back in ‘52 Harry Markowitz published a paper that changed the way investments were selected and grouped. Harry explained that performance can be improved without increasing risk by combining investments in a very selective way…

What did he mean by investing in a very ‘selective way’? Simply put, finding a selection of higher growth, higher risk investments where the fluctuations cancel each other out.

i.e. Aligning investments where the best years of one happens during the worst years of another – Imagine if Harry was a personal trainer.

Selective investing in action

To illustrate risk-efficient investing, consider all the different companies where the temperature has a significant impact on sales performance; and out of these companies – separate the ones who experience stronger sales performance during warmer years, from the ones who experience stronger sales during cooler years.

For the example below, we use an air conditioning company and a heating company.

Our air conditioning company returns 20% during warmer years and nothing during cooler years, with an average return of 10% p.a. across a 10-year period (illustrated below), though a few additional cooler years would see this average drop.

Average 10 year investment returns for air conditioning company

Our heating company also returns 20%, but during cooler years and nothing during warmer years, with average investment returns of 10% p.a. across a 10-year period (illustrated below), though a few additional warmer years would see this average drop.

Average 10 year investment returns for heating company

Because some years deliver great returns and other years no return, we are weathering a lot of volatility to achieve an average return of 10% (and there is no guarantee that warm/cool years would be sequential as per our example).

When combining these two companies, average returns are maintained during both the warmer years and the cooler years (as illustrated below).

Average combined 10 year investment returns for both companies

The outcome of holding both these companies in a portfolio of investments is an average return of 10% p.a. without increasing the overall risk in the portfolio, even if a string of warmer or cooler years were experienced.

Average combined 10 year investment returns for both companies

“Successful investing is about managing risk, not avoiding it” – Benjamin Graham

These days, risk can be measured mathematically, and with the speed of information technology, any stock that is underpriced relative to its risk is snapped up instantaneously – immediately bringing the stock back to its risk-weighted value.

– Excerpt from The Top 10 Investment Mistakes Made by Mum and Dad Investors

Many investors get caught out searching for underpriced opportunities, chasing the latest investment trends or following investment tips – or generally relying on the merits of individual stocks rather than considering investment returns as a collective.

With the right investment structure and approach, it is possible to mathematically reduce your investment portfolio’s risk or conversely, increase your investment returns without increasing the portfolio’s risk-weighting.

Stephen Vick

Written by  Stephen Vick

Stephen holds a Bachelor of Business majoring in Banking/Finance & Accounting, a Diploma of Financial Planning, a Diploma of Finance & Mortgage Broking Management, Specialist SMSF accreditation, a Real Estate Agency License, and is a member of the REIQ. He has spent 20 years in the finance industry and has held State Manager Roles with Australian Finance Group (AFG), Australian Unity, and Lawfund Australia. His last institutional role was with MLC as an advisor to financial planners.

Leave a Reply

Your email address will not be published. Required fields are marked *