Increase Your Investment Portfolio Efficiency to Outperform

Mutual Funds, ETFs or SMAs all have one debilitating feature, with the amount of money deposited into each of these bundled products, it is impossible for efficiency. Pop quiz: when considering a group of ten stocks, is it better to have most of them make a substantial rate of return while some of them lose proportionately or to have each stock either make zero or a nominal rate of return. Historically speaking, bundling equities in a product like a mutual fund, would result in 6 positions with positive returns, 1 relatively flat while the rest fall into negative territory.

For example, Portfolio 1 on the plus side had 3 stocks that garnered 15%, two at 10% another at 5%. To finish off the portfolio, each stock had 0%, -5%, -10% and then -15%. I’m sure if you paid any attention to the stocks in your mutual fund, you would be pretty happy seeing those types of returns and unfortunately, many of you do. Now Portfolio 2, our high efficiency model, would have returns that brought returns of two stocks that had 10% return, 8 stocks at 5% and the last one at zero. Not very exciting, so what’s the difference. Believe it or not, Portfolio 1 has a 4% average rate of return while Portfolio 2 boasts 5.5%. It may not seem much, but over a 10 year time horizon, that 1.5% increase compounded would realize a 13.3% additional return.

Retirement accounts, 401k plans are notorious for producing adequate returns, essentially because they are so inefficient. It’s no wonder why increasingly more employers are allowing “in-service withdrawals” for employees who want to manage their own investments without incurring all the embedded costs and mediocre returns from their employer’s retirement contribution plan. There is also a growing trend for smaller companies to administer “open architecture” retirement plans where the control of investing is completely up to the participant.

Efficiency has become very prevalent in recent years, from increasing the gas mileage on a car to tax credits for installing the right windows and furnace. Corporations and families alike are looking for ways be leaner, to work more productively. We are all in search of ways where we can get out a lot with putting in a little. So why hasn’t the way we manage our assets followed suit? Ease of use, convenience and simplifying are benefits extoled by the money managers who create the euphoria of investing in cookie cutter, bundled products. As investors, where do we go from here?

Let’s look at how a collection of stocks ought to be put together. We know that there is a level of risk needed to produce gain. How much risk versus how much reward is an important lagging measurement used to quantify this adverse relationship. There have been many money managers who would tell you that the number of stocks to reduce risk should be large. I’m sure you have heard that mutual funds are ‘safer’ than individual stocks. Well, that just is not the case. We proved that with our portfolio comparison. We can though, mathematically prove that the actual number of individual stocks needed to bring the risk/return ratio in-line is 13.