Aim For The Middle

Includes: DIA, SPY, TLH
by: David Merkel, CFA

“Ya gotta take more risk to get more return.” That’s the street language version of what is commonly trotted out, but it is only half true.

The truth is that moderate risk taking outperforms taking no risk or taking high risks. This is true in bonds. BBB bonds return best of all — they are the middle of credit risk. There is no native group that wants to own them exclusively. Higher-rated bonds do next best, and junk bonds do worse still on average.

Think of it this way: Those that invest in cash get a low return. But those that invest in high-risk growth companies also get a low return, on average. Those that take moderate risk have the best potential of making money. That is why I focus on investors that take moderate risk relative to their peers.

Moderate risk taking does best on average, at least as far as public capital goes. Private capital may have more control and expertise, and can take more risk as a result. In general, the less control and expertise, the less risk should be taken. With private equity, this is one of the tough truths: Private capital can change matters if it is large enough. Then it has to deal with changing the management of the business. Public equity does not get there, except in rare cases.

That is a major reason why moderate risk-taking wins on average. In one sense, it is why low volatility investing and value investing work. You are putting your money at risk, but you are doing so with a margin of safety. Part of making money is survival; if you don’t survive round one, you won’t make money in round two and the rounds that follow.

That’s why swinging for the fences with stocks doesn’t work. You get too many strikeouts, and few home runs. Personally, I try to be a singles hitter in investing. It’s doable, both intellectually and financially.

This applies to asset allocation as well. 60/40 stocks/bonds does as well as 100% stocks, and with less volatility. 80/20 stocks/bonds did best the last time I tested — perhaps the true ratio is 70/30 given the outperformance of bonds over stocks over the last decade, but I am reluctant to think so because over the long haul, the best a bond can do is pay its coupon and return the principal. Even in the case of premium calls, you get your principal back at what is typically an unfavorable time to reinvest.

Another reason to aim for the middle is that you will not get jolted hard during downdrafts, and be tempted to trade out at the maximum point of pain, or, buy in near the peak when the bulls are running their last lap. A lot of money gets lost that way.

It’s also a reason to hang onto some slack cash or other safe assets, like high-quality noncallable bonds lacking weird features. It may diminish returns in the short run, but it allows you to stay in the game of investing. Too many people give up at the wrong time — many friends that I had that gave up on stocks in late 2002 – early 2003, deciding to focus on “what they knew”: residential real estate. Another group gave up on stocks late 2008 – early 2009, with no place to go with their cash.

Realistic expectations are needed as well. If you earn more than the growth rate of GDP plus a few percent, count yourself blessed and realize that it is very hard to do that consistently over the long-term.

So aim for the middle: take moderate risks, diversify, be realistic, and adjust your portfolio slowly as conditions change. Then you can stay in the game, and compound your returns.