Did You Miss The 62% Run-Up In The Stock Market?

I normally talk only about currencies here in my Money and Markets column. But today I want to address some commonly held misconceptions many investors have about how their investment portfolios should be performing in today’s market.

For the typical individual investor it’s easy to get caught up in the hype of the stock market. These days the hype is generated 24 hours a day across major media channels. And after the major decline driven by the global financial crisis, the attention to stock prices has perhaps never been greater.

But the market has roared back 62 percent in just seven months. And there’s a vast crowd who thinks they’ve missed the boat on this historic run. A lot of that has to do with false expectations of what the stock market index offers and misconceptions on its past returns.

Remember, It’s All about Risk!

Inexperienced investors think they should be able to buy at bottoms, sell at tops and make gobs of money. But that’s a highly difficult task.

The long-run annualized return for the S&P 500 (including dividends) is 9 percent. And after fees, most professional mutual fund managers do not beat the S&P 500.

Moreover, too many investors do not understand the risk they’re asked to take to achieve a 9 percent return.

The volatility of stock market returns is best measured by looking at the dispersion of returns around the average return. This gives you a clue as to how much risk you have to endure to achieve your expected return. It’s called the standard deviation and is a good way to measure risk.

The standard deviation of the S&P 500 is 19 percent.

This means roughly 70 percent of the time, the S&P 500 should trade plus or minus 19 percent around its long-term average return. So if you use standard deviation as a gauge of risk, you’ll find that the broad stock market pays you only 1 unit of return for 2 units of risk taken.

Take a look at these two hypothetical charts …

Both investments have an 8 percent average annual return. But Investment #1 has a wide range of returns, while Investment #2 has a stream of returns that more tightly hug the average annual return.

If each of the points on the charts represents a monthly return and both investments achieve the same end result, which investment should you choose?

The answer: Investment #2 - the one with the tighter distribution of returns since it gives you a higher probability of achieving a higher return.

Here’s why: Your investment’s performance will largely depend on when you enter and when you exit. If you enter or exit at any given point along the path of Investment #2, the likelihood of success is greater than it would have been with Investment #1.

So unless you think you can pick the exact bottom to enter and the exact top to exit, you’re far better off finding investments that have a tighter distribution of returns.

The bottom line is, a buy and hold strategy in the broader stock market index just doesn’t compensate you for risk. That’s why it’s important to find more sophisticated strategies using a wide range of investments options (including stocks, bonds, currencies, and commodities) that target positive returns and offer diversification to your portfolio.

The Goal: Positive Risk-Adjusted Returns

Whenever the stock market has a down year most mutual fund managers start talking in terms of relative returns. You might see a manager’s monthly letter tout how well they did relative to the S&P 500. For example, they may be down 35 percent when the S&P 500 was down 38 percent. That’s a win in their eyes! And the manager gets a bonus.

But as ridiculous as that sounds, the same can be said for the other side of the coin … when stocks are rising, relative returns are equally as meaningless.

Alternatively, investors should keep a constant focus on achieving positive annual returns, year-in and year-out. And those returns should fairly compensate them for the risk that is being taken. By that, I mean you should expect to achieve greater than one unit of return for each unit of risk taken. In other words: You want a positive return that’s adjusted for risk.

This investment strategy will give you a better chance of growing your money during your specific holding period.

Currencies As an Alternative Asset Class

In addition to stocks, currency investments are a great way to add risk-adjusted returns that are uncorrelated to stocks to your portfolio.

What’s more, there’s always a bull market in currencies since the decline in one currency always reflects the rise in another currency. That means no matter what’s happening in stocks, bonds, commodities or real estate, you can profit!

So if you think that you may have missed the boat on the stock market’s recent surge, remember this … currencies still offer loads of opportunities to earn terrific returns … ALL the time!

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