The best way to increase return is to manage risk.
Last month in this column, I pointed out that advisors who market their investment skill exclusively on the basis of return (i.e., their track records) can appear foolish and--what’s worse--may be exhibiting imprudent fiduciary conduct.
Advisors can appear foolish because the return generated by an investment or a money manager is a random variable over which they have very little control. In fact, a wide variety of sources tells us that any investment (or money manager) with a good track record from the past is just as likely to perform poorly in the future as it is to continue doing well.
When advisors place undue emphasis on return, they define investment prudence in terms of portfolio performance, not fiduciary conduct. That is directly opposite of how the Uniform Prudent Investor Act defines prudence: in terms of fiduciary conduct not portfolio performance. Advisors that engage in such activities may be exhibiting imprudent fiduciary conduct.
A well-known money manager concedes: “We know that the past [i.e., superior track records] is meaningless [as a way to find future investment winners], but it is all we have.” This money manager obviously understands that track record investing has no value. He seems unconcerned, though, about his knowing participation in an activity he deems useless. This remarkable acknowledgment--particularly coming from someone that manages billions of dollars--can result, I would argue, in imprudent fiduciary conduct.
But is it really true that track record investing (and identification of investment skill itself) is “all we have”? Decidedly not! Although it seems counterintuitive, advisors can enhance portfolio wealth more effectively by consciously managing risk rather than trying to score big in the random game of identifying investment winners.
In short, the better way to increase return is to concentrate more on managing risk and less on trying to increase return via stock-picking or market timing.
This approach to investing and managing the portfolios of your clients is fully in accord with the principles of modern prudent fiduciary investing. It seems, though, as noted, to be counterintuitive: “Say what? You’re telling me that the better way to increase return is to manage risk instead of trying to pick investment winners? What are you smoking, dude?”
I’m not smoking anything (well, at least I’m not inhaling). In fact, a little-known mathematical rule known as "variance drain" /?> shows advisors why emphasizing management of portfolio risk instead of attempting to pick investment winners can lead to enhanced portfolio return.