Playing Defense: How to Get The Best of Both Worlds
Conventional wisdom tells us that, if we need higher returns, we should be prepared to assume more risk. It also tells us that the best way to reduce investment risk is to invest in a diversified portfolio made of both equities and bonds. We find it hard to disagree, but at the same time, we believe that blindly following those two notions can be an expensive proposition.
Let’s start with the first notion, namely that you need to sacrifice high returns in order to reduce investment risk. Consider the table below, which depicts the risk vs. return profile of two funds. Both funds, if analyzed individually, are not of the low risk category. At the same time, both funds have each delivered some of the strongest results among their peers. If you combined both funds in your portfolio, you would have achieved a decent return exceeding 15.5% over the last three years (as at July 31, 2000). Concurrently, your investment portfolio would have depicted very reasonable volatility, as reflected in a low standard deviation of 8.6%.
| Fund | 3-Year Return | 3-Year Standard Deviation |
| Fidelity Canadian Growth (Fidelity) | 15.5% | 10.5% |
| AGF International Value (AGF) | 15.7% | 10.3% |
| Portfolio (50% Fidelity+50% AGF) | 15.6% | 8.6% |
The key to achieving this seemingly ideal situation is to combine funds that do not go up and down at the same time. In the statistics jargon, those are referred to as negatively correlated funds. When two funds move in opposite directions rather than in tandem, one fund’s gains offset the other fund’s losses. The long-term result is a smooth climb.
This brings us to the second concept, namely that you need a combination of equity and bond funds in order to build a diversified portfolio. While this may often be true (not always, mind you), the price of following this cliché can be too high. Since equities out-perform bonds over the long-term, you will automatically be forgoing additional income every time you increase the bond component of your investment portfolio. To reduce the weighting of the bond component, you may try a different kind of diversification, by combining negatively correlated equity funds instead of combining equities with bonds. This strategy should lead to superior returns over the long-term, with very reasonable volatility.
The table below illustrates our point. The first portfolio, which combines a small cap equity fund (Fidelity Canadian Growth) with an international equity (AGF International Value), depicts a much better return than the second portfolio, which combines the same small cap fund with a bond fund. True, the second portfolio has a lower risk, but look how much return you will have sacrificed, for such a small reduction in risk. If you are still skeptical, let's add that the standard deviation of my first portfolio is much lower than the standard deviation of the average balanced fund!
| Portfolio | 3-Year | Risk |
| First Portfolio (50% Fidelity Canadian Growth+50% AGF International Value) | 15.6% | 8.6% |
| Second Portfolio (50% Fidelity Canadian Growth+50% Altamira Bond) | 10.9% | 6.3% |
How do you put this interesting theory into implementation? Some mutual fund companies, such as Mackenzie Financial Corporation, offer portfolio building services based on the same concept. When the Mackenzie Star plan was first introduced around three years ago, we were fascinated by the concept. We could, however, see one missing link: Mackenzie, of course, has a vested interest in promoting its own funds. So the Mackenzie Star plan would limit investors to the Mackenzie funds (which for that matter includes an excellent collection of top funds). Yet, wouldn’t be ideal if you could combine funds from different families, rather than be restricted to one company?
For that, you really need a tool that allows you to measure the risk and return of a group of funds, when combined together. Our RiskCalculator, the only tool of its kind, does just that. Using it, you can mix and match highly rated funds from different categories, and compare the risk and return of each portfolio, until you reach a reasonable combination that suits your tolerance for risk.
A note of caution: do not bet the farm on this strategy, because what worked in the past may not always work in the future. In other words, funds that have parted ways in the past may decide to converge towards the same direction (this unusual phenomenon is referred to by the experts as "correlation risk"). But isn’t that true for any investment tool?