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"Relative" investors seek returns in line with market returns. Market returns could be defined as returns coming from a portfolio consisting of United States bonds (25 percent), stocks (40 percent), real estate (5 percent) and foreign stocks (30 percent) with each part performing in line with its market. Relative investors define risk as significantly underperforming the market returns over any short or long period.

"Absolute" investors seek returns which will have many years with positive returns and only a few years with small negative returns. Absolute investors seek positive annual returns and manage unwanted risks. Absolute investors see risk as the probability of losing money during any single year.



Case Study

Judy, a relative investor, is young and recently completed her medical training. She wants her investments to work just as hard as she does at the hospital. She said, "If the market is up 20 percent, I want to be up 20 percent. And, I will not lose any sleep if the market falls sharply." Judy seeks high returns and is willing to take significant risks. Judy said the market rewards those who are willing to take risks, and over the long term, relative investors will accumulate much more wealth.

Eddie, an absolute investor, is about the same age as Judy and works hard, too, but he would hate to see his hard-earned savings drop in value. Eddie seeks average long-term returns and will actively manage his risks. Eddie said you will win the game of investing not by hitting home runs but by consistently hitting singles and doubles. By avoiding big losses, absolute investors will in the long term be ahead.

Question

How do Judy and Eddie achieve their different goals and objectives?

Judy's relative approach: Judy's asset allocation will closely fit her definition of market returns as described above. She likes passively managed index mutual funds which: a) closely track the returns of United States bonds and stocks, real estate and foreign stocks; b) stay fully invested; c) have very low management fees; and d) beat a large majority of actively managed mutual funds. Regardless, in certain equity sectors she prefers actively managed funds.

The stock market will have large positive and sometimes painful negative bounces. No one can successfully time the market. History tells us that stocks provide the highest returns, bonds less and cash the least. Investors need to remember that over a 25-year period, the volatility of stocks and bonds are very similar, and only stocks provide positive returns after inflation in every 25-year period.

As time passes, Judy's actual asset allocation will drift away from her targeted allocations. She must periodically make appropriate adjustments. Based on perceived opportunities, she may over or under weight selected equity and bond styles to capitalize on these opportunities.

Eddie's absolute approach: The annual volatility of bonds is much lower than the annual volatility of stocks, and bonds have a low correlation with stocks, which means they are a good diversifier. Therefore, Eddie will seek to minimize his losses by having a higher allocation to bonds than Judy. His other diversification benefits come from including domestic and foreign stocks, large and small stocks and growth and value stocks in his portfolio. By achieving reasonably good returns when the market is up and by avoiding losing his shirt when it is down, he said his conservative approach will produce higher long-term performance than that of others.

To get good returns with fewer down years, Eddie will actively manage his portfolio. He will search to find the few actively managed stock and bond funds that have consistently outperformed passively managed index mutual funds. He will actively manage his asset allocation by over- or under-weighting various equity and bond styles as he sees opportunities.

He will actively manage risks to reduce the number of years with negative returns. If the stock market exhibits irrational exuberance or starts sharply falling, Eddie will reduce his exposure to stocks and increase his bond or cash positions. He may short an existing security to protect against loss. To insure against a severe, unanticipated loss due to a fall in the stock market, he might buy a long-term S&P 500 put option at a strike price well below its current level. The premium is affordable. If a severe downturn occurs, losses below the strike price would be insured under your contract. Eddie may implement a "costless collar," which consists of an option bought to protect against losses and another option sold for the same premium that limits your upside profits.

Hedge funds, also known as fund of funds, have high fees and are frequently viewed as risky investments. Yet some hedge funds can reduce your risk of losses. Investors are paid to take risks. If all risks were hedged, your expected returns would go away. So, only unwanted risks should be hedged.



Conclusion

Judy and Eddie are similarly situated, yet each has a different willingness to take risks. How a portfolio is managed should fit an investor's goals and objectives. A person's willingness and ability to take risks is a key consideration. One approach does not fit all.



Next month: Exchange traded funds.



Roger E. Muns, CFA and CPA, of Wealth Management, LLC, in Jackson, is president of Chartered Financial Analysts® (CFA) Society of Mississippi.




January 2007

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