ARTICLE:
Finding the Right Balance Between; "Risk and Return"

When it comes to investing there are basically two kinds of financial assets, those with higher returns and higher risks (stocks), and those with lower returns and lower risk (bonds). Some investors prefer a total equity portfolio for its superior growth prospects. Others invest exclusively in fixed-income instruments, preferring to completely avoid the risks of the stock market. But most people seem more comfortable somewhere in between those two extremes. The big question is how far should you go in one direction or the other? For example, a portfolio fully invested in the stock market (represented by the S&P 500 index) over the last forty years, would have earned an average return of 10.5%. During this period, the index would have subjected any investors to a worst one-year loss of 38.9%. Anyone invested in the S&P 500 during this time would have also experienced a five-year period in which their portfolio would have remained underwater to the tune of 17.5%.

There is no perfect way to know in advance precisely what level of loss one may be willing to accept, but there are ways to help investors get a better way to manage it. In our investment seminars and meeting with new clients, we often use a table of numbers similar to the chart below, show the results in the past, of various combinations of stocks as represented by the S&P 500 Index, and bonds (5-year Treasuries), each with its own set of returns of risk. With this table, an investor who has carefully thought about his or her needs and risk tolerance can choose a combination of investments that is likely to provide the right combination of growth and comfort for their individual situation.

Stocks	Bonds	Avg. Return	Worst 1 Yr.	Worst 5 Yrs.
0%	100%	5.6%	-5.5	16.3%
10	90	5.9	-4.7	20.2
20	80	6.4	-7.7	17.4
30	70	6.8	-12.3	13.7
40	60	7.5	-15.0	10.0
50	50	7.9	-20.4	6.2
60	40	8.4	-24.7	2.3
70	30	9.0	-28.8	-1.5
80	20	9.6	-32.5	-5.4
90	10	10.1	-35.6	-9.3
100	0	10.5	-38.9	-17.5

Stocks represented by the S&P 500 Index, Bonds represented by five-year Treasuries.

Each line in the table details what the results would have been over the last for 40 years of various combinations of stocks and equities. The columns are arranged in increasing order of risk, with the least aggressive, 100% bonds at the top, and the most aggressive 100% stocks at the bottom. The way to use this table is to start by finding the column that has the results financially and emotionally you are comfortable with. For example, if you are fairly conservative, and avoiding losses is a fairly high priority for you, find the column that has a one-year loss that you think you could live with. If 15 percent is the most you're willing to give up during any 12 month period, and willing to earn a minimum cumulative return of 10% after five years, suggests you might be comfortable in a portfolio of 40 percent stocks and 60 percent bonds. As you travel across to the last column, you'll find that this asset allocation has produced an average return of return of 7.5 percent.

So the next logical question is: Would a return of 7.5 percent get you where you want to go? If a return of 7.5 percent is enough to meet your objectives within your risk tolerance level, that's a good sign that you've found a portfolio that is right for you. Most investors however find that there's a disparity between their desired or needed annual return and the losses they would be willing to accept. Their first impulse is to usually go for their desired return and figure they will "hang in there" through the bad markets, which is usually a big mistake. If your need for return and risk straddle two columns, choosing risk over return is usually the more appropriate choice for two reasons. First, the figures in this table are not predictions of the future, only results from the past. And the past is a more reliable indicator or risk than of returns. For any given combination of stocks and bonds, the pattern of volatility will be more constant and predictable than the pattern of return. Second, it is never acceptable or advisable to manage a portfolio in violation of your risk tolerance. After all, if we are not willing to accept our portfolios potential level of losses, how can we expect to earn our portfolios potential level of gains?

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