Navigating investing's four quadrants

Bull markets are full of temptation. The first thing most people think of is to get rid of their advisor: “Why should I pay this chump 1% of my assets when I can just invest in an affordable index fund?” Then you would almost match the market performance, right? Yep, that’s right. But is matching the market all there is to successful investing? You know the answer to that.

There are four key elements to successful investing. All of them interact and influence each other. One of them is more important than the others. The lot of them together makes a powerful, resilient portfolio.

1: EXPENSES

2: INCOME

3: RISK

4: GROWTH

THE FIRST QUADRANT: EXPENSES

Expenses are a very important part of investing. This quadrant also contains a few temptations.

Of course, you want to minimize expenses as much as you can. You also don’t want to get ripped off. You want to avoid things such as large sales commissions on products like annuities, being over-charged on trading commissions and being locked-up for years with high exit penalties.

What’s the temptation with fees? Looking only at fees and nothing else. As important as they are, expenses are not the be-all and end-all for investing. All other things being equal, if I were choosing between a fund with 2.29 percent expenses (pretty high) and 6% income or another with 0.17 percent expenses (very low) and only 1.5 percent income, I’d choose the first fund every time. I’d be well ahead due to the higher income.

THE SECOND QUADRANT: INCOME

In the 1940s and ‘50s many stocks had dividend yields in the 4-8 percent range. It was very common. That’s part of the reason past performance is so high with the stock market. In recent decades, investors have forgotten the importance of this income. If our portfolios have flat performance then we’ll lose value to inflation. If we get a portfolio income of 5.5 percent, for example, then we’d be ahead of inflation.

THE THIRD QUADRANT: RISK

Risk management is probably the biggest value I add to my clients’ investing. There’re many studies about market performance compared to actual investor performance. The stock market has averaged about ten percent annually through the worst of times. Actual investor performance is as low as 2-5 percent. Quite a difference. Individual investors make basic blunders like trying to time the market, chasing previous winners and making emotional decisions.

What happened to that buy-and-hold index investor during our last full decade? From 1999 to 2009, according to Bloomberg.com, a $10,000 investment shrank to just $9,090. Would you be happy with a drop like that? It was even worse when you factor in even minimal fund expenses.

When you manage risk you invest in multiple assets and not just one index. This diversification, while slowing down performance, significantly reduces risk and exposure to single categories.

Combine being diverse and generating income (Quadrant Two) and a risk-managed portfolio has very low odds of flat, or down, performance over a decade’s time. Not so with a buy-and-hold strategy.

Also, being in one category is very dangerous when the market takes big shocks. In March 2009, the index dropped about 50 percent! My client’s diverse portfolios did drop but closer to the 20-25 percent range. If you had $100,000 and had a choice of it dropping to either $50,000 or $75,000, which would you choose?

THE FOURTH QUADRANT: GROWTH

There has never been an investor, to my knowledge, who has consistently picked the next best-performing investment category. Even the “smart money” gets it wrong ALL the time. A recent example is billionaire hedge-fund operator John Paulson. He actually denominated some hedge funds in gold instead of dollars. This was at the height of gold fever and gold prices. He and his clients have lost quite a bit trying to pick a single-category winner. Lesson: don’t try to pick just one group. No one knows for long. No one.

What’s the solution, then? Own many unique asset classes. Currently, the U.S. market is king. We’ve been up for five years in a row (here’s where temptation sets in). Yet during this time other areas have significantly out-performed our market. I have a client in the index fund of India. In less than a year, he’s up over 100 percent. If you stuck to only the S&P 500 you would give up these opportunities.

As I’ve written about before, I think we’re in the beginning of a new “super bull” market. You want exposure to our dynamic economy. But even our market needs to readjust from time to time. It will drop. So, it’s best to be in additional markets that are cheaper, could provide more room for growth, provide income and manage your risk.