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Reduce Risk—Not Returns by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc. December 6, 2007 Reprinted from the November 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. Many investors spend a lot of their time searching for the next hot stock or mutual fund. A much wiser—and perhaps more profitable—use of their time would be analyzing their portfolio risk and searching for ways to reduce it. Indeed, risk management, though a best practice for major institutional investors, is probably the single most underused wealth-boosting strategy among average investors. That's a shame because risk management can reduce the pain of sticking with your investment plan, which is key to long-term success. Reducing risk can also potentially increase your long-term returns. With a less-volatile portfolio, you're less likely to have to withdraw money when your portfolio's down. That's when a $1,000 withdrawal can cost you much more, as you'll need a higher future return to compensate for that withdrawal. And retirees take note: Investors who are withdrawing money from their portfolios can actually end up with more dollars when they lower portfolio risk. Lower portfolio risk with diversification There are two main types of portfolio risk: market (systematic) risk and security-specific (unsystematic) risk. Market risk is overarching; all investors experience it. You can see this in an S&P 500® index fund: It moves up and down despite its broad diversification. The way to reduce stock market risk is to reduce your exposure to stocks, which has the unfortunate effect of reducing your growth potential. Security-specific risk—associated with a particular stock or fund—can be lessened by diversification. Consider the simple example of a portfolio with only one stock: When the stock falls 20%, the portfolio also falls 20%. But add just one more stock that falls only 10%, and the portfolio as a whole (assuming a 50/50 split) drops just 15%. Carry this pattern forward, and you can easily see how diversification on an asset-class level can similarly reduce risk—often without hurting overall return. We compared two portfolios from 1970 to 2006: One invested in 100% bonds, the other in 15% large-cap stocks, 5% international stocks, 50% bonds and 30% cash. Guess which one had lower risk? Even though the diversified portfolio contained higher-risk asset classes like international equities, it had both lower volatility and higher returns!1 That's because the investments within the portfolio were not highly correlated—they didn't rise and fall together. Lower timing risk with careful security selection Selecting low-volatility stocks can also help reduce risk and potentially boost accumulated savings. Consider a couple in July 2004 with $100,000 each. They each owned one stock (his was Tetra Tech, and hers was SunTrust) and withdrew $1,000 a month during the next three years. The stocks had the same annualized returns (without withdrawals, both would have ended with $130,300). But SunTrust had a lower standard deviation, a measure of risk. So how did they fare? Check out the chart "Lower-Risk Stocks Can Boost Investor Wealth" below. Although the couple withdrew the same amount, because his early withdrawals occurred during down periods for Tetra Tech, he could never catch up. Thanks to her less-volatile SunTrust, she ended up with $90,948, 9% more than his $83,533.  What to do now
 Important Disclosures Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolios. 1. Bond portfolio represented by Ibbotson Intermediate-Term Government Bond Index. Diversified portfolio is 15% S&P 500 index (large-cap), 5% MSCI EAFE® net of taxes (international), 50% Lehman Aggregate Bond Index (bonds) and 30% Citigroup 3-Month U.S. Treasury Bill Index (cash). Portfolio returns and risk from January 1970 through December 2006 are: 8.2% return, 6.1% standard deviation for bonds; 8.6% return, 5.4% standard deviation for the diversified portfolio. Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976, and Ibbotson U.S. 30-day Treasury Bill Index was used for cash prior to 1978. Dividends and interest are reinvested, and the diversified portfolio is rebalanced to its target allocation annually. The S&P 500 index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Diversification strategies do not ensure a profit and do not protect against losses in declining markets. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. Examples provided are for informational purposes only and are not intended to be reflective of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. (1107-7089) Return to Top |
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