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Turning risky into safe

If, like most individual investors, your money is largely for the dual purpose of retirement and leaving a little something for the kids, then you need to build a portfolio of investments that makes the optimum tradeoff between high inflation-adjusted returns and predictability. Predictability is another way of saying low-risk, but I think it captures the idea better.

There is no perfect tradeoff, Each investor will make a different judgment about that. However, we can say with some confidence that certain mixes of assets are better than others. A great paradox of the investment universe is that a mix of risky assets is usually safer than a mix of safe assets.

By risky, I mean here investments whose returns over a given time period are quite uncertain. If we buy a short-term bank CD or a T-bill, our return over the holding period is quite certain. We know exactly what we are going to get. Even unexpected inflation isn’t much of a worry since our funds aren’t tied up for very long.

Alternatively, we don’t know what will be the returns on stocks, real estate or long-term bonds, especially after factoring in future inflation. Those are dumped into the “risky assets” bin. Some are riskier than others, but we would still lump them all into one general category.

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I can tell you that almost everyone who crosses my doorstep says they don’t want to take a lot of risk. The conventional approach to building a portfolio for such investors is to include a sizeable dose of bonds and cash mixed in with the stocks and maybe some real estate funds. But, do cash and bonds really make a portfolio safer?

Well, it depends on what you mean by safe. If you mean that the portfolio is comfortable and familiar and that it doesn’t expose the advisor to a lot of second-guessing then, sure, it’s safe.

If we include enough bonds and cash, the portfolio is unlikely to suffer any massive losses in any given year. For the adviser or broker, the portfolio minimizes his or her career risk.

The problem is that it is not as likely to meet the key investment objective: high inflation-adjusted returns, with a minimum of uncertainty.

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If I mention to you some of the following asset types, what is your reaction? Emerging markets bonds, commodities, foreign stocks, private equity, small cap stocks, venture capital, mezzanine debt, junk bonds: Do those sound safe? I would guess the answer is, no, they don’t. Taken on their own, many of these asset types are not predictable and entail significant risk for both repayment and overall returns.

A single private equity investment is unacceptably risky. Fifteen such investments that total up to only 5 percent of the portfolio will improve the overall safety and predictability of the portfolio.

In a recent article in the Financial Analysts Journal, Robert Arnott showed that a portfolio with a simple evenly-weighted mix of a broad array of conventional and unconventional assets provided far more certainty of meeting the goal of good inflation-adjusted returns, and inflation-adjusted spending power.

The traditional 60 percent stocks and 40 percent bonds portfolio has not earned higher returns historically, but has demonstrated far more uncertainty and volatility.

We normally think of these unconventional assets as riskier. Yet, when they are added together and blended in small amounts into a proper portfolio, they improve the safety - and certainty - of the investor’s future income stream.

The singular hurdle in adding these assets to your portfolio is the sometimes heart-stopping fees that brokers and managers charge for access to them.

There are ways for individual investors to invest in private equity deals, but they usually involve buying shares of a fund that then invests in other funds.

The double layer of fees can put a serious damper on the final returns realized. Commodity exposure can be bought via low-cost mutual funds or exchange-traded funds. So can various flavors of foreign stocks and bonds. As always, the burden is on you to be a good consumer.

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I encourage you to broaden your thinking. True diversification does not mean owning five different stock funds. It means owning things that strike you as unusual.

A mentor of mine early in my career once said to me, “If you are comfortable with everything in your portfolio, then you are not diversified.”

I think about those words every day and continue to look beyond the normal and customary choices of investment assets.