Balancing Investment Goals

Ask investors to list their top three priorities and you’re likely to hear, “Preserve capital, achieve target returns, and beat the stock market’s overall growth.” Unfortunately, these goals are usually incompatible. To either beat the market or target more than the most conservative rate of return, you risk capital. To moderate risk and preserve capital, the usual strategy is to diversify your portfolio and offset higher risk asset classes with asset classes that have a lower risk.

During the last major market downturn (1999/2000), assuming your returns were close to the performance of market indexes, let’s look at what would have happened if you had countered the stock market’s characteristic volatility by creating a diversified portfolio of 50 percent stocks, 25 percent bonds and 25 percent cash equivalents. This time period was selected because, though not regular or typical on a year-to-year basis, it does illustrate what could happen in a future market adjustment.

Easing The Pain

In 2000, the S&P 500 stock index returned (9.10 percent). The Lehman Brothers Government/Credit Bond index returned 11.85 percent, and the Merrill Lynch 3-Month T-Bill Index for cash equivalents returned 6.36 percent. The positive returns in bonds and cash equivalents would have overcome most of your loss on stocks. Your total return would have been approximately (0.9 percent). Your diversified portfolio would have clearly beaten the stock market’s return, but you still would have fallen short if your goal had been capital preservation.

The Price Of Protection

On the other hand, in 1999 the S&P 500 gained 21.04 percent, but the Lehman Brothers/Credit Bond index returned (2.15 percent) and the Merrill Lynch 3-Month T-Bill Index returned 5.01 percent. Diversification would have reduced your overall return to 11.23 percent. You would have preserved your capital and still earned a considerable return, but wouldn’t have beaten the stock market.

Finding The Balance

Your overall investment results depend on the specific goals you decide to emphasize:

• Capital Preservation. If preserving capital is your primary investment goal, you almost certainly won’t lose money if you stay with money market funds. However, safety comes with a history of low returns. In most years, you won’t beat the stock market and you may not even beat the inflation. Another way to preserve capital is to invest your portfolio primarily in bonds or bond funds. Returns on bonds aren’t as steady as the returns on cash equivalents or as high as on stocks over the long term, but bond investments are less volatile than stocks over the short term.
• Beating The Market. Your portfolio will perform similar to the stock market if you invest in an index fund that tracks a broad market index such as the S&P 500. However, with an Index fund, you probably won’t be able to beat the market, nor will you be protecting yourself against market losses. If your goal is to earn steady returns that beat bonds and cash equivalents rather than to beat the stock market, you might invest primarily in a diversified mix of stock funds—growth and income and other fund types. While there are no guarantees and you will likely see good and bad years, over the long term, your average annual return may be near the long-term results of the overall stock market.
• Targeting Results. What if you aim to achieve a specific investment return rate? If the number is high, such as 10 percent, you could invest your portfolio entirely in equity funds. Some years, you’ll see big gains and make or surpass your goal. In other years, you’ll see a lot less and could even experience a loss.

Aiming For Success

The path to success starts by determining your investment objective, be it capital preservation, targeted results, market-beating returns or a combination that balances more than one of these objectives. Once you plan a portfolio that furthers your goals, be prepared to stay on plan, despite short-term disappointments.

This article is reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.