In the previous article, I spoke on how I believe buy and hold investing is no longer going to provide a good return on investment. In reality, it never has apart from the dramatic ride the market took from 1982 to 1999. The stock market historically pays an interest rate of 3.73%. If you don’t believe me see Buy and Hold Investing is Dead.

Here I’ll give you a few tips on how you can dramatically improve your results with investing. This is for educational purposes only and I’m not providing investment advice, just investment theory. In fact, I don’t think you should buy stock if you don’t know what you’re doing.

Investment Allocation is King

Forget everything you know about asset allocation. This is the act of indiscriminately combining stocks and bonds in a portfolio. We are going to instead use math to build a portfolio with a risk level you are comfortable with and then get you the greatest return at that risk level.

By using some math formulas we can make highly accurate predictions on what would be the maximum potential loss for a given portfolio. Then you can decide on how much potential risk your willing to take and then know that your portfolio will act accordingly.

Treasury bill’s will represent the least risky investment in my portfolio. While penny stocks (stock’s worth less than $5) will represent my riskiest investment. I will for now not include options in this portfolio, because they may confuse you. It’s impossible to make the best portfolio without them, but I’ll leave them for a later article.

Just know that how you structure your portfolio will determine your result’s in 94% of day to day market movement’s.

Time for a Little Jargon

Risk Equals Standard Deviation

Let me assume, that I can expect ABC company to increase in value by 25% after 10 years. I then must only fear that I’ll be forced to withdraw at a point when the value has unexpectedly fallen. This rise and fall from the average growth rate is known as Standard Deviation. When people talk about risk, they are referring to Standard Deviation.

As you add more risk to your portfolio, you are increasing the chance that it’s price will deviate from an expected return. But, my risk less 1 year treasury bill is only paying me .35%. I’m guaranteed to get that .35%, but I can also be sure that inflation will be higher than .35%.

Standard Deviation Example

Excuse me as I jump back into the fantasy days of the 80’s and 90’s. Here I listed some of the best performing mutual funds and show you both their average returns as well as their standard deviations from 1987 to 2003. These funds were the best at not only earning money, but also at minimizing their standard deviations

I’m not telling you to buy any of these mutual funds! Actually many don’t exist, have new money managers or are closed to new investors.

Let’s look at the best performer, being Smith Barney Aggr Growth. It provided it’s investors an average return of 27.83%, and in any one year was expected to provide a minimum return of 18.03 % = 27.83 – 9.8. This number is calculated this way: Worst Expected Return = Average Return – Standard Deviation.

Let me stop for a moment to explain why these investment’s don’t exist anymore. By buying this mutual fund you received at worst a return of 18.03% per year, and at best 37.63%. Whats funny is that when I was a broker, people thought this was a bad return! Seriously!

I just want you to understand this new way of looking at securitys. Think not only about expected average returns but also think of their deviation from this average. If you understand that the goal is not just to get a good average return, but also to minimize standard deviation, you really are starting to understand investing.

The Capital Allocation Line

The Capital Allocation Line depicts in graph form, the fact that as you increase your standard deviation your potential return also increases. The CAL is created by looking at all potential investment pools of investments along with their expected return’s versus standard deviation. Here is an example:

As you see the portfolio I’m emphasizing has an expected return of 15%, the only problem is the standard deviation is 32%. This mean’s if I’m comfortable potentially losing 17%, this is a good portfolio, if not it’s bad.

Diversification

Most people think that blind diversification will protect them from risk. They think it is a good idea to randomly add different investments to their portfolio. Wrong!

As you can see in this chart, if a computer randomly pulls together a portfolio, you are no longer able to minimize Standard Deviation simply through diversification after you reach 20 random investments. I then continue to show you the result’s with 100, 200, etc.

The Efficient Frontier

Now we are getting into a territory your stock broker probably doesn’t even understand. If we chart the following:

Every investment based on it’s expected return versus standard deviation

Every portfolio including the best of these investments

We get the following graph.

I’ve already described what the CAL line is.
The little dots represent all of the investment opportunities out there.
The line that curves away from the CAL is known as the Efficient Frontier. It represents all portfolio’s with the best return at the lowest standard deviation.
The Optimal Portfolio represents the point in which you are getting the best return at the lowest risk level.

The Optimal Risky Portfolio represents the point at which you receive the highest return versus all other possible portfolio mixes.

If you are a bit confused don’t worry. It comes down to this simple concept. We want to create a portfolio that will provide the best return, with the lowest amount of risk. That’s it! But, how is the optimal portfolio created? If you understand standard deviation, there is just one more piece to this puzzle. Covariance!

Covariance Analysis

I wrote in the last article about how when some stock’s go up others tend to go down. A candy companys growth potential is directly related to the price of sugar. So if sugar price’s sky rocket, chances are the candy companys stock will fall.

This is known as Covariance. It’s a measure of the degree to which two assets value’s move in tandem. If 2 stocks have a negative covariance that means they move more opposite from one another.

So one way to hedge risk in one asset is to find the other assets that effect it’s value and add them to the portfolio. This act helps to minimize standard deviation.

Wrapping Up

As mentioned before, a hedge fund named NWQ (North West Quadrant) made huge returns based purely off of creating Optimal Portfolio’s. Their name refers to the Efficient Frontier. They constantly readjusted their portfolio’s based off of expected changes in expected return’s and standard deviations.

They did this with computers, but the computer sitting in front of you now is probably as fast as the one they used back in the 90’s. In future articles I plan on showing you the math behind this article. It really isn’t that complicated. You just need to plug in day to day price changes for all of your investments. They then provide you with the investment’s:

• Standard Deviation
• Covariance in Relation to the other Investment’s
• The Expected Return

Then all you have to worry about is general market risk. As history has shown us though, market risk only will effect you 6% of the time with the right asset mix.

And, if you think doing all this is way to complicated, in my opinion, don’t buy stock if you don’t want to do it intelligently. If you think a brokerage house will do this research for you, I say again good luck!

If you have any question’s leave them in the comment section below.

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