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Generating Higher Returns Without Increasing Risk


Individual investors should focus on the other alpha. Before I get into the details of what I mean let me explain what “alpha” is. According to Wikipedia: “Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index used as a benchmark, since they are often considered to represent the market’s movement as a whole. The excess returns of a fund relative to the return of a benchmark index is the fund's alpha.

In other word’s let say your portfolio managers benchmark is the S&P 500 and it managed to obtain an alpha of 1%. This means your portfolio manager performed 1% better than the benchmark. The opposite is true if your alpha is -1%. Your portfolio generated 1% less return than the benchmark. The higher the alpha the better.

It’s worth mentioning that academic research indicates most active managers underperform the market. Essentially, they are not generating alpha which is what you’re paying them to do in the first place. Although there are times when taking an active tactical approach might make sense most investors will probably benefit from a core passive investment strategy where a low-cost portfolio is built using various asset classes. Passive investment management is characterized by low portfolio expenses (i.e. the funds inside the portfolio have low internal costs), minimal trading costs (due to infrequent trading activity), and relative tax efficiency (because the funds inside the portfolio are tax efficient and turnover inside the portfolio is minimal).

Which brings me to my next point that investors should focus on other areas that can help them generate higher net returns without taking additional unnecessary risks. Some of these areas are:

Cost

Do you know what your investment portfolio expense ratios are? Probably not. Developing a cost-effective investment portfolio is critical in helping you achieve your goals.

Gross Return - Costs (expense ratios, trading costs, taxes) = net return

Focusing on gross returns alone is missing the bigger picture.

Asset Allocation

It is widely accepted that a portfolio’s asset allocation— the percentage of a portfolio invested in various asset classes such as stocks, bonds, and cash investments, according to the investor’s financial situation, risk tolerance, and time horizon—is the most important determinant of the return variability and long-term performance of a broadly diversified portfolio that engages in limited market-timing (Davis, Kinniry, and Sheay, 2007). Vanguard “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha-September 2016”.

Stop chasing last year’s best performing asset classes and develop a low cost globally diversified portfolio in line with your investment objectives and risk tolerance.

Rebalancing

Once you’ve decided on your asset allocation you need to make sure the target allocation of each asset class stays consistent over time. When your investment portfolio starts to drift, it acquires new risk-return characteristics. Rebalancing is the act of bringing your portfolio back to its original asset allocation.

Asset Location

There are three basic types of accounts (taxable, tax-deferred, and tax-exempt). Generally speaking, tax-efficient investments should be made in taxable accounts and investments that are not tax efficient should be made in tax deferred or tax exempt accounts. Careful planning can potentially help you minimize the effects of taxes, increasing your returns in the process.

Tax-Loss Harvesting

Sophisticated investors know they can capitalize on investment losses to help them improve after-tax returns. They do this through a method called tax loss harvesting. Essentially you sell an investment that is performing poorly to realize a loss which will allow you to credit that loss against any realized gains. The asset sold is replaced with a similar investment helping you maintain the same asset allocation, risk -return levels. There are limits to this strategy and you should always consult your advisor before engaging in tax-loss harvesting or in any other strategy for that matter.

Behavioral Finance

The guidance, coaching and discipline an advisor adds to the client relationship is instrumental in the achievement of their individual goals. Developing an investment strategy and sticking to it when markets are performing poorly is not an easy task. Abandoning the markets at the wrong time can be costly. A competent financial advisor can guide you in the right direction adding to your net return while at the same time helping you accomplish your overall financial goals.

By focusing on areas other than gross return you can add significant additional net return to your investment portfolio.

Need help? Shoot me an email (hermes@simpleivest.com) or schedule a phone meeting here if you would like to discuss your unique financial situation.

Hermes Conesa CEO @ Simpleivest