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Investment portfolios - Risk, returns and fees

The topic of returns generated by a portfolio is always of interest to investors. After all one of the key factors used in planning for our financial future is the rate of returns we expect to achieve. Another factor is the consistency of those returns from one year to the next.

Consistency is just another term for the volatility of returns. A volatile portfolio may have the same long term returns as a non-volatile portfolio but the ride experienced by the investor is completely different.

Imagine travelling across Canada where you are consistently driving 90 kilometers per hour. Compare that to trip where you are driving 160 kilometers per hour half the time and 20 kilometers per hour half the time. The travelling time will be the same but the experience will be different. And during those periods where you are travelling at 160 kilometers per hour, the opportunity for a disaster becomes extremely high.

The same applies to an investment portfolio where rates of return swing wildly from one year to the next. There is an increased opportunity for disaster. As an investor you are encouraged to stay the course but that is emotionally difficult to do. If you are one of those investors who has begun to draw on their portfolio the dangers are increased with volatile portfolios.

One bad decision or an unforeseen circumstance can damage your portfolio in the same way that hitting the ditch a 160 kilometers per hour can damage your car.

A solution currently advocated by many for solving the financial challenges we face is to lower the fees we pay on our investment products. All else being equal, lowering fees will help but if you are still going 160 kilometers per hour half the time and 20 kilometers per hour half the time, you are still exposing yourself to dangers.

We wanted to examine portfolios from the point of view of risk as well as return so we went to a financial advisor. Using software provided by Vanguard Investments he constructed a portfolio using four low cost ETFs. They included a bond fund, a Canadian equity fund, a US equity fund and an overseas equity fund.

The returns, after fees over a 5 year period for the asset mix we chose was a modest 4.3% per year. Volatility is measured by the standard deviation of returns and for this portfolio it was an astonishing 21%.  Returns were net of fees.

In an ideal world you want high returns and low volatility and no matter how much you lowered the fees, the volatility of this portfolio would remain high.

The trick is to find an investment that complements the other investments in your portfolio. It provides a cushion when the others are struggling. Conversely, it will probably struggle a bit when your other investments are firing on all cylinders. In the long run it would hopefully not have a negative impact on returns and it would hopefully reduce volatility.

Traditionally it has been considered that stocks and bonds complement each other in a portfolio. When stocks are not doing will bonds are supposed to provide the buffer and when stocks are doing well the bonds are likely to be a slight drag on the portfolio. In the long run it is supposed to generate a relatively smooth return.

The trouble with that approach is that it hasn’t done much for reducing volatility over the past few years. Both stocks and bonds seem expensive right now and seem to be going up and down in tandem with each other rather than having one serve as buffer for each other.

The result has been volatile returns in portfolios. Good years have been very good and bad years have been very bad. It is certainly not a comfortable situation particularly for those who are retired or close to retirement.

Out of curiosity we wondered what an allocation to gold bullion would have done to the portfolio characteristics. Keep in mind that bullion represents the price of physical gold and not the price of shares in gold mining companies.

The advisor allocated 10% of the hypothetical portfolio to gold bullion using the BMG Gold Bullion fund. This is not the least expensive method of creating exposure to gold bullion to your portfolio and that is one of the reasons we chose it.

We wanted to find out what impact adding a higher fee investment to a low cost portfolio would have on the portfolio. Would this investment have a negative impact because of its higher fee structure?

The answers surprised us. The five year returns on the portfolio increased to over 6.0% while the volatility of those returns dropped from 21% to under 6%. The improvement in both areas was dramatic. All returns were net of fees.

The message we are trying to deliver is that yes, if all else is equal lower fees are a good thing but all else is rarely equal. Our second portfolio paid a higher fee but delivered a much better result both in terms of return and of volatility.

Be cautious of those who lead you to believe that changing one simple metric such as lowering fees is the primary answer to the financial challenges you finish. There are many issues that come into play when constructing your investment portfolio and they are unique to you. Consider all of them when making an investment decision.

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