Timeless Investment Principles (Part 1): Investment Risk and Diversification

Wall Street and the Media project the idea that investing is complicated and requires professional expertise for success. This idea serves to create demand for their services: Wall Street Investment Products and Media Content.

On the other hand, there is Vanguard, the investment firm that has become synonymous with simplistic, low-cost investing that is accessible to investors of all sizes. Eric Balchunas, a Senior ETF Analyst at Bloomberg, calculates that Vanguard's innovations have saved investors more than $1 Trillion in fees!

Vanguard's Core Investing Principles extend beyond just low fees. The principles promote investment habits that have proven successful and can be implemented by investors of all sizes without requiring expert knowledge.

In this article, we'll discuss building a simple, effective and efficient investment portfolio. At Taurus Financial Planning, we prioritize and implement these principles to construct resilient, cost-effective portfolios for our clients.

The Two Most Important Drivers of Wealth Accumulation

While goals are unique to each investor, some common ones are funding an ideal retirement, purchasing a home and leaving a financial legacy. Investment goals can also be more abstract such as growing your wealth to attain more financial flexibility and security.

Investors achieve their financial goals through a combination of Savings and Investment Returns. Time is a critical component to success. Even small savings contributions can lead to significant wealth.

The below graph illustrates the contribution of your investment balance from Savings and Investment Returns. Over time the investment returns become a crucial piece to building wealth while short-term horizons savings have a bigger impact. Savings Rate and Time are the two most important drivers of wealth accumulation.

What is Risk? Good or Bad?

Investors earn an investment return in exchange for taking on investment risk. But what exactly is risk? Risk is the level of uncertainty surrounding an expected outcome.

An investor's risk tolerance is determined by both their willingness and ability to take on risk. Risk willingness reflects how comfortable an investor is with potential fluctuations in the value of their portfolio, while risk ability refers to an investor's capacity to endure a decrease in the value of their investments while still maintaining the lifestyle they desire.

Risk tolerance is a crucial factor in portfolio construction. While high investment returns are desirable, they typically come with higher risks. If experiencing market downturns leads to stress, sleepless nights, or cutting back on essential expenses, it's a sign that the portfolio's risk level needs to be adjusted downward.

Conversely, if an investor aims to fund a 30-year retirement but is invested in conservative securities offering insufficient returns to cover retirement expenses, they may need to either work longer, reduce spending, or increase the risk in their portfolio to achieve their financial goals. There is risk to NOT taking investment risks.

What are Good Investment Returns?

When building a portfolio, investors decide the long-term investment return needed to meet their goals and the asset mix (stock, bonds, cash) is needed to attain that target.

The graph below illustrates the average return and variability of portfolios ranging from 100% bonds (lower risk) to 100% stocks (higher risk) since 1901. As expected, portfolios with a higher allocation to stocks exhibit both higher average returns and greater variability—both upward and downward—around those averages.

It's worth noting that while stocks carry inherent risk, avoiding them and their potentially higher returns also poses a risk to meeting the investment return target necessary for achieving your goals. Therefore, striking a balance between risk and return is crucial in portfolio construction.

Diversification: The Only "Free Lunch" in Investing

Well, I'm not sure it is "free," but it is table stakes. Diversification simply means spreading your money across different types of investments and is a powerful tool to manage financial risk.

Investors diversify across asset classes - such as stocks, bonds, real estate and commodities - to reduce exposure to risks specific to an asset class. The below chart illustrates the benefit of diversifying across different types of equity investment types. By having some exposure to several asset classes, you ensure that you participate in stronger areas while mitigating risks of the weaker performers. For example, look how Real Estate (RE) performance has jumped around sine 2006.

Investors also diversify within asset classes to reduce exposure to risks associated with a specific company, sector or geography. For example, the below chart compares the performance of Walmart Stock and a broad market index over the last 20 years. Walmart has been a fantastic stock that provides stable growth, performs well in economic downturns and pays a dividend. That said, an over-concentrated position in the stock limits your ability to benefit from the growth of high performing stocks and sectors - think of Walmart in the 1970s!

Since 2004, the SP 500 is up 336% vs Walmart shares up 183%.

Wrap-Up

It is a great time to be an investor, thanks to innovations that enable access to a wide range of asset classes and facilitate diversification in a simple and cost-effective way.

Gone are the days when advisors charged clients high commissions or 1% of assets for simply managing their accounts. In the next article, we will discuss the Low-Cost principle, which encompasses fund expenses, advisor fees, and taxes—all of which negatively impact your investment returns.

Thanks for reading,

Mark Chisenhall, CFA, MBA

Taurus Financial Planning

Mark@taurusfinancialplanning.com

​www.taurusfinancialplanning.com​​

Taurus Financial Planning is a Fee-Only Wealth Management firm based in Bentonville, AR. The firm offers comprehensive financial planning, tax planning and investment management to corporate executives across the country.

Taurus Financial Planning is a Registered Investment Advisor with the State of Arkansas. This information is provided as a guide to assist you in your financial planning. The specific examples are provided for illustration purposes only and are not representative of specific investments or guarantees of future returns. Please consult with a professional for specific questions regarding your particular situation. If there is any error or inconsistency between this document and the official company plan documents, your company plan documents will govern.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.