Investment Secrets: Higher Returns with Less Risk

November 17, 2009
Christopher R. Jarvis, MBA

Generally, if you split your investment dollars between two investments, you would expect to get a return right in the middle. However, this is not the case if you rebalance your portfolio each year.

Of course, we can neither guarantee nor predict higher returns for any investment class or strategy. We can, however, discuss the volatility of the stock market, dropping interest rates, weakening of the dollar, and how these economic changes impact your investment returns. The purpose of this article is to describe the factors that are impacting the economy and investment landscape and then share an investment strategy that has a history of higher returns and lower risk than the S&P 500 Index (to which most advisors compare themselves).

Is the Investment Sky Falling?

With falling interest rates and the continued depreciation of the dollar, many investors seem hopeless and feel helpless. One sure thing is that there will be a great deal of uncertainty, if not considerable volatility, in the investment world in the upcoming years.

Economics Never Lie

What most investors don’t understand is that there is a very strong relationship between the changes in all of the following instruments: stocks, bonds, interest rates, currency values, exchange rates and commodity values. Investors have a choice of investing in any vehicle and can often invest in any currency they like. A truly global economy makes it easy for someone like an investor in France to purchase bonds in US dollars, stocks in Yen, or commodities in Euros. Because of the ease with which investors can move their investments, the value of one investment class is quickly effected by the changes in value of another class. Let’s look at some examples.

When interest rates go up considerably, the trend is for investors to shift investment dollars from equity instruments like stocks toward fixed income investments like bonds. This is because stocks are riskier investments than bonds and, absent a substantial perceived increased return for stocks over bonds, investors will take the less risky return of bonds. The theory in finance is that each investor will require some “risk premium” or additional expected return for investing in the riskier investment. This is the basic theory of all investing — greater risk “should” yield greater long-term expected return.

A somewhat similar economic theory applies to currencies as well. When interest rates in one country decrease (like they have in the United States), global investors look to other countries for investments that offer greater returns with similar risk (or similar returns with less risk). If a $1,000 bond with a AAA rating in the United States yields 6%, but a AAA rated bond in Euro returns 7%, investors looking for AAA rated bonds will look to investments in Euros for the higher return. When dollars leave the U.S. for other countries, the value of the dollar depreciates against those currencies so that there is a “balance.” It is a simple supply and demand example as is the case with the values of stocks or other securities. When more people want to buy a security than there are people who want to sell the security, the price will rise until the number of buyers and sellers are balanced.

There is one investment class that is not supposed to be impacted by currency, mostly because it is its own currency in a way. This investment class is called “commodities.” Commodities are those items that have universal value, like agricultural items, livestock, energy, precious metals, industrial metals, rare metals and minerals. More specific examples include corn, soybeans, pork bellies, natural gas, oil, and gold, among others. Commodity prices generally increase in value when there is more demand for the commodities than there is production. More recently, the increased demand for ethanol (which is made from corn) has driven up the cost of corn.

If the supply of gold or oil stays constant, but the value of a particular currency depreciates, you can expect the price (in the depreciated currency) of the commodity to increase. The devaluation of the dollar against the world’s major commodities is being driven by the growth in the world’s supply of dollars. The dollar is like any other commodity — print too many dollars and their value will inevitably go down. The dollar has depreciated by almost 70% against the Euro over the past 8 years. This was not a coincidence as you would expect the drop of value of the dollar to result in increased values of most commodities.

So, what can you do?

With the housing market credit crunch and the election season just finished, many experts believe that interest rates will be further reduced this year. Currently, the probability for a 50 basis point decline in the Fed Funds rate stands at 65%. As a result, you can expect the dollar to continue to plummet against the Euro and Yen. You can also expect foreign goods, like oil, to continue to increase in price. Exploring investments in commodities, especially foreign commodities, may be wise.

Historically, the Goldman Sachs Commodities Index, when compared to the S&P 500, has returned superior annual returns. The beauty of investing in commodities is that they have basically NO correlation with the S&P 500 index. This means that an investor will generate significant diversification from a portfolio that has a nice balance of domestic equities and commodities.

Strange Statistical Occurrence

Generally, if you split your investment dollars between two investments, you would expect to get a return right in the middle of the two individual investments. However, this is not the case if you “rebalance” your portfolio each year. Rebalancing is a technique investment advisors have used for ages. In the case of the S&P 500 Index and the GSCI, if you considered investing your funds 50% into the GSCI and 50% into the S&P 500 index over the last 37 years, you would see something very interesting.

The average return for the S&P was 11.39%. The average return for the GSCI was 12.37%. If you invested in an even combination and rebalanced each year, your annual return would have been 13.14%! This is 0.75% to 1.75% greater return per year with the combination!

In addition, the standard deviation (a statistical measure of volatility) over the same period was 16.61% for the S&P 500 index, 23.95% for the GSCI and only 12.5% for the combination. Over the last 37 years, an investment in the combination portfolio would have given you significantly higher returns with significantly less risk. This strategy is completely counterintuitive, but the numbers don’t lie.

The authors welcome your questions. You can contact them at (800) 554-7233 or through their website, www.ojmgroup.com.

Chris Jarvis is a principal of the financial consulting firm O’Dell Jarvis Mandell LLC where Kim Renners works as the Director of Wealth Management.