There is a secret to obtaining higher returns, but don't expect to learn it from your broker.
Many investors rely on the latest news for their investment strategy. Here's a recent example: On June 21, 2012, Moody's Investors Service downgraded the credit ratings of 15 large U.S. and European banks. How did the markets react? According to an interesting article by Dimensional Fund Advisors, you may be very surprised by the answer. The shares of most of the banks downgraded closed higher after the announcement of the downgrade. Curiously, the cost of insuring the debt of Morgan Stanley (which suffered a two-notch downgrade) dropped to its lowest level in seven weeks.
A similar counter-intuitive market response occurred when Standard & Poor's lowered the credit rating of the U.S. government. You would think having a lower credit rating would mean the U.S. would have to pay higher interest to attract buyers for its treasuries. The opposite occurred. Borrowing costs decreased.
There is a rational explanation for what appears to be irrational market behavior. The lowered credit ratings of both the banks and the U.S. government had already been factored into the prices of those stocks and bonds, well before the formal announcement by Moody's and Standard & Poors.
Currently, the economic news is terrible. The most common inquiry I get from anxious investors is whether they should "flee to safety" to avoid the worldwide economic disaster they are convinced is coming. I can't blame them for being anxious. Unemployment numbers remain unacceptably high. The news from Europe is unsettling. Political rhetoric is fanning the flames of impending doom in the U.S. Home foreclosures remain a problem for a staggering number of U.S. homeowners.
Here's the anomaly. According to a recent article by Weston Wellington at Dimensional Fund Advisors, the stock price of 22 prominent firms (and many others) hit a new 52-week high last week.
What about stocks in the beleaguered home building industry? Wellington found that nine of the 11 stocks in the Standard & Poor's Supercomposite Homebuilding Sub-Industry Index also hit 52-week highs. Clearly, trying to predict the reaction of the markets to breaking news is not a reliable investment strategy.
What is the secret to higher returns? Simple. It's risk. There is a direct correlation between the amount of risk you take in your portfolio and your expected returns. The greater your exposure to stocks, the higher your expected returns. Other risk factors can affect your returns. Tilting your portfolio towards small cap and value stocks makes your stock allocation more risky, but you could be rewarded with higher overall returns. These higher returns are far from a sure thing and are not a free lunch. That's why it's called "risk".
Before you blindly run out and take more risk, remember the penalty you may suffer. Risk is a two way street. Portfolios with a high exposure to stocks have higher short-term volatility. Unless you can weather stomach-churning, short-term losses, be cautious and realistic about the amount of risk you can tolerate.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.
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