Understanding portfolios

Many investors confuse their financial plans with a casino table and expect a certain return or a hot hand every year. They tend to look at a high one-year performance as the basis for sound financial planning.

The Andex chart

The Andex chart highlights volatility and return during different periods. In the short term, investments are unpredictable. Much of a portfolio return fluctuates between two broad ranges - from the negative extreme to the positive extreme. These extremes are determined by the asset classes in the portfolio and the level of risk a portfolio manager is willing to take.

When an investment has not achieved a particular expectation in the short term, investors become concerned. But these expectations may not be accurate. In the short term, various factors can determine a result. Certain managers may take an inordinate amount of risk and direct their portfolios to a particularly hot sector to achieve good results. However these may be temporary, as risk eventually brings them down to a normal level. This is known as "reversion to a mean". Other portfolios may not be successful if the managers have been overly conservative.

The biggest risk is to decide that a short-term "hot" performer will continue to burn. The Dalbar study has shown that the results will likely be poor. Market timing, no matter how seductive, is not prudent long-term financial planning.

In the short term (one to two years), portfolio results may vary. However, this does not mean that your investments are not meeting your long-term financial planning objectives. As the investments within your portfolio come to fruition, you will begin to see a finer range of returns.

Keep a sound intellectual framework

We all seek the holy grail of investing, which is an investment that is the tops every year. Unfortunately, like the tooth fairy and sadly, Santa Claus, this concept is a fairy tale. No investment always produces at a top rate. Even Warren Buffet, the greatest investor of all time, suffered miserably in the late 1990s, and did not recover until the early 2000s .

If you have retained a sound intellectual framework in your portfolio over three to four years, the potential for an annualized negative return is much lower. It is difficult not to be caught up in the yearly twists and turns, and not to be tempted to shift into what seems hot but what could be disastrous to your plans.

If you have a sound intellectual framework, and give it time to act, good results will begin to show.

Long-term results are better

In the chart below, by the fourth and fifth years, you have a higher likelihood of not receiving negative returns.

A full market cycle, which we define as six to eight years, is needed to observe the benefits of your portfolio.

Our portfolios are not structured to be the best in any one year, or to continually beat an index or benchmark. This is not in the best interests of the investor, as it would mean advising our clients to take on more risks than the index. Our firm designs its portfolios to fulfill financial planning objectives, structured to achieve with the least amount of volatility.

When to review

Portfolios should be reviewed at the halfway mark, i.e. three to four years into your program, and again at the end of the market cycle. At these points, you can assess if the portfolio is meeting your objectives, and if the volatility was in accordance with your expectations. The worst move you could make is to flip-flop from investment to investment, on the basis of last year's performance.

Stay with the basics of investing, establish a sound intellectual framework, and prevent your emotions from destroying it.