Third Quarter 2010 Market Analysis
I’d like to address our response to the recent volatility in worldwide markets. Since the market crash in 2008, there has been an increased focus on using alternative investments as a vehicle for providing added diversification to a portfolio. In fact, you may have seen past articles in the KMS client quarterly. Alternative investments include asset classes outside of your traditional investments (stocks & bonds). Alternative investments include commodities, gold and other precious metals, currency, Real Estate Investment Trusts, and managed futures. Since these asset classes have a low correlation to traditional investments, they can help diversify an account and lower a portfolio’s overall risk. Low correlated asset classes typically don’t move in the same manner from one day to the next. As an example, the price of gold might trend up on a day when Largecap U.S. stocks are trending down. Historically, when alternative investments are added to a traditional portfolio the overall volatility has decreased and the returns have increased. (Lower Risk / Higher Reward).
Let’s take a quick look at a case study. Suppose you invest $100.00 into two separate portfolios, and hold the investments for three years. The returns for each of the two portfolios are listed below:
Year 1 Year 2 Year 3 Portfolio Value after three Years
Portfolio A: 20% -30% 40% $117.00
Portfolio B: 8% 8% 8% $125.00
As you will note, Portfolio B had a much more consistent return over the three year period averaging 8% annually. The average annual return for Portfolio A was 10% annually, but there was far greater volatility. As you will note, Portfolio B had the highest value after the three year performance even though it had a lower average annual rate of return. The reason for this discrepancy is that large losses will need a much greater return to get back to the original value. (If you lose 50% on a $100 investment, your account will be valued at $50.00. Now, you will need a 100% return on the $50.00 in order to get back to your original $100.00 investment.
The illustration above should help explain the need for lowered volatility in a portfolio. The use of alternative investments in a portfolio can help your returns look more like Portfolio B (less volatile and more efficient). Today, we have access to many investment tools to get broad exposure to these various alternative investments. We have been recommending them in a number of accounts in order to help stabilize returns during this choppy market. If you are interested in finding ways to add them to your investment portfolio, please give us a call anytime.