Right, Right Investing


Right Kind, Right Reason InvestingSM
Positioning Your Portfolio for Success

James W. Watkins, III, J.D., CFP®, AWMA®

CEO/Managing Member
InvestSense, LLC

The question, in one form or another, is always the same – “What is the secret to successful investing?”  Books, articles and seminars offer various formulas and strategies for success.  I would like to introduce yet another strategy – common sense.  A common sense approach to investing is easily understood and effective.

Legally speaking, financial fiduciaries such as investment advisers and trustees are generally held to the legal standards established under the Prudent Investor Rule   (“Rule”)1 or the Prudent Investor Act (“Act”), the legal codification of the Rule.  Hopefully, the new financial reform law will result in the fiduciary standard being required of all financial advisers.

The Rule/Act generally requires that financial fiduciaries act prudently in handling the financial affairs of others.  In acting prudently, a financial fiduciary is generally required to diversify an investment portfolio, manage a portfolio in such a way to avoid large losses, and control a portfolio’s costs/expenses.

Investors would be well-served to adopt these simple, common sense strategies in managing their own financial affairs.  In the words of Leonardo da Vinci, “simplicity is the ultimate sophistication.”


Conventional Wisdom – Diversify your portfolio by holding a large number of different types of investments.                                                                                                                 Right Kind, Right Reason Wisdom – “Effective” diversification requires “the ‘right kind’ of diversification for the ‘right reason’….[I]t is not enough to invest in many securities.  It is necessary to avoid investing in securities with covariances among themselves.”2

The referenced quote comes from a 1952 article, “Portfolio Selection,” written by Dr. Harry M. Markowitz.  In the article, Dr. Markowitz introduced the concept of considering the correlation of returns among investments in building an investment portfolio.  Markowitz suggested that by combining investments that behave differently in various market and economic conditions, the overall volatility of a portfolio can be reduced and large losses avoided. The concept, which became known as Modern Portfolio Theory, earned Dr. Markowitz a Nobel Prize.

While Modern Portfolio Theory has been the subject of legitimate criticism due to issues regarding assumptions behind the theory and weaknesses in the actual calculation process, the basic concept of combining investments that react differently to each other in order to reduce portfolio risk makes sense. A portfolio of investments that react the same in different market and economic conditions, i.e., have a high covariance/high correlation of returns, performs well in favorable times.  However, when times turn bad, a mix of highly correlated investments fails to provide needed downside protection against large losses.

Unfortunately, many of the online asset allocation sites and the commercial asset allocation software programs used by financial advisers produce recommendations that reflect the “diversification by numbers” approach rather than the “effective” diversification approach.

Investors can prove this fact to themselves by searching online for “asset allocation calculators” or “portfolio optimization calculators” and using the online program to produce a recommended portfolio. Investors will generally receive a recommended portfolio consisting of allocations to various generic asset categories such as large cap equity mutual funds, midcap equity mutual funds, small cap equity mutual funds, international equity funds, and fixed income mutual funds.  InvestSense studied the correlation of returns among four of the largest asset categories typically used in asset allocation/portfolio optimization programs (large cap equities, small cap equities, international equities and fixed income).  The study used four popular indices as proxies for the actual asset categories.

By looking at the correlation of returns for these four categories over both five and ten-year rolling periods, two patterns were quickly noticed.  First, an overall pattern of a high correlation of returns was seen among the equity funds over the past decade.  Second, the study showed that the correlation of returns between equity classes has gradually increased over the past decade.  The complete results of the study are shown in Appendix “A.”

Unfortunately, many investors have no idea whether their portfolios are “effectively” diversified, leaving them potentially vulnerable to unnecessary investment losses.  A 2007 Schwab Institutional survey of 1,400 registered investment advisers reported that approximately 75% of the brokerage accounts transferred to them were poorly structured.3  Investors should insist that their financial advisers provide them with correlation information regarding their accounts.

Portfolio Management

Conventional Wisdom – Create an investment portfolio and then maintain the same asset allocation by periodically rebalancing the portfolio to its original allocation percentages.        Right Kind, Right Reason Wisdom – Dynamic risk management in order to avoid large losses, not maximization of returns, is the key to effective wealth management.4

Conventional wisdom’s static asset allocation, buy-and-hold approach to portfolio management simply ignores the realities of the markets.  History clearly shows that the stock market is dynamic and cyclical.  Consequently, effective portfolio management requires a dynamic approach as well.  Dynamic portfolio management is also consistent with the Rule’s prudent investing guidelines, which recommend adjustments to asset allocations when changes are needed in response to changes in the markets and/or the economy.5

Advocates of static asset allocation dismiss the dynamic approach as market timing, which they claim does not work.  The classic definition of market timing is a strategy that involves being either 100% in the market or 100% out of the market, with no middle ground.

Dynamic portfolio management does not advocate the “all or nothing” approach of classic market timing.  Dynamic portfolio management maintains that while investors should not respond to every twist and turn in the stock market, investors should adopt an appropriate risk management program and react to intermediate and long-term trends in the market in order to prevent large losses.   Combining “effective” diversification with an effective risk management program provides an investor with the best opportunity for consistent returns and the prevention of large, unnecessary investment losses.

Advocates of static asset allocation also point to the potential costs of a dynamic approach to portfolio management, both in terms of the potential loss of portfolio gains and increased taxes from the sale or exchange of portfolio assets.  In terms of the potential loss of portfolio gains, proponents of static asset allocation point to the cost of missing the best days of the market.

Interestingly, such reports usually fail to examine the other side of the issue, the benefits of missing the worst days of the market.  A recent study comparing the costs and benefits of the best days/worst days argument found that the benefits of missing the worst days of the market overwhelmingly exceeded the costs of missing the best days of the market.6

While taxes are always a proper consideration in wealth management, investors should be careful not to let the tax “tail” wag the “investment” dog.  Investors should always remember the primary goal, working toward achieving their financial goals.  For investors in tax-deferred accounts such as IRAs, 401(k)s, 403(b)s and other retirement accounts, tax issues are a moot point since most sales or exchanges within such accounts create no taxes at that time.  Investors in such accounts can possibly maximize the potential of such accounts by adopting a dynamic, yet prudent, approach to portfolio management.

Cost/Expense Control

Conventional Wisdom – Investors care more about returns than costs.  Costs are simply a cost of investing and reflect value received from the investment.                                      Right Kind, Right Reason Wisdom – Costs reduce returns to investors and should be minimized whenever possible.  Investors want to know, and need to know, about costs and expenses in order to effectively manage their investments.

The costs/expenses associated with investments reduce returns to investors.  This is especially true for retirement accounts such as 401(k) and 403(b) accounts.  New regulations by the Department of Labor will hopefully help plan participants receive full disclosure of such costs.

In other cases, the true cost of investments may be hidden.  Actively managed mutual funds often have high annual management fees, based on the premise that fund owners receive the benefit of the fund manager’s skills.

In truth, many of these actively managed funds receive the bulk of their returns from the overall performance of the stock market, not from active management.  By looking at a mutual fund’s R-squared rating, an investor can tell how much of the fund’s performance can be attributed to the market, not the fund’s management.  The higher a fund’s R-squared rating, the greater the likelihood that an investor could achieve better overall returns with a less expensive index fund.

In some cases, investors are effectively paying annual fees much higher than advertised.  One study found that by factoring in a mutual fund’s R-squared rating and the expenses of anequivalent index fund, a typical investor in actively managed mutual funds may be effectively paying management fees five to six times, or even higher, than the advertised annual management fee.7

Although not part of the Rule or the Act per se, a couple of situations have important implications for investors, namely relative returns and variable annuities.

Relative Returns

Conventional Wisdom – Select investments based on their track record against their competitors and market indices.                                                                                               Right Kind, Right Reason Wisdom – Select investments based on an overall portfolio strategy that seeks to produce consistent, positive absolute returns.

Investors are familiar with investment advertisements claiming that a particular mutual fund is the number one fund over a certain period of time or that the fund has outperformed a particular stock index for so many years.  The problem with such ads is that they are often misleading.

Investors have become preoccupied with beating the Standard & Poor’s 500 Index or some other market index.  The fact that a mutual fund has outperformed its peers or a particular stock index may not equate at all with helping an investor meet their financial needs and goals.  A fund could legally make such a claim even when the fund sustained serious losses, just as long as the fund lost less than the referenced funds or index.

Despite arguments that a loss is not a loss unless the loss is actually realized, a loss still represents an opportunity cost to an investor, as future gains will have to be used to recover for such losses.  Investors should be aware that it takes more to recover from a loss than the amount of the original loss.  For instance, investors must earn a return of approximately 67% to make up for an original loss of 40%.

Variable Annuities

Conventional Wisdom – Variable annuities provide an opportunity for tax-deferred gains.                                                                                                                                             Right Kind, Right Reason Wisdom – Variable annuities have serious drawbacks, including high costs/expenses and a lack of the flexibility needed to properly diversify investments within the annuity.

Our article, “Variable Annuities: What the Salesmen Don’t Tell You” details a number of issues involved with variable annuities.  The article has been cited by industry and consumer groups in letters to Congress and the Department of Labor in connection with current financial reform.8

The abuses associated with the sale and marketing of variable annuities has been well documented.  From a cost/expense perspective, one of the most onerous abuses has to do with the method used by an annuity issuer in calculating the death benefit and related annual fees.  While most variable annuities only require the annuity issuer to pay a minimum death benefit equal to the annuity owner’s actual investment in the annuity, the annuity issuer often calculates the annual fees based upon the accumulated value of the annuity rather than the actual legal obligation of the issuer.  Some variable annuities do allow for periodic “step-ups” in the death benefit, although annuity owners usually have to pay yet another fee for such benefits.

From a diversification perspective, variable annuity owners may be unable to “effectively” diversify the annuity due to the limited investment options provided by the annuity issuer.  Far too often the investment options provided reflect a “diversification by numbers” approach rather than an “effective” diversification approach.

While variable annuities are generally a bad investment choice for most investors, there may be limited instances where they do make sense.  If you are considering a variable annuity, look for one of the newer versions that base annual fees on the actual legal obligation of the annuity issuer under the death benefit guarantee and offer investment options that will allow “effective” diversification.


Common misconceptions about portfolio management often result in unnecessary financial losses for investors.  Common sense and the guidelines established for financial fiduciaries under both the Prudent Investor Rule and Prudent Investor Act provide a good foundation for individual investors.

Investors need to focus on consistently achieving positive absolute returns.  “Effectively” diversifying one’s portfolio, adopting a dynamic risk management program and controlling the costs/expenses associated with investing are positive steps toward achieving absolute returns and investing success.

© 2010 InvestSense, LLC.  All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.


1.   Restatement Third, Trusts § 90 (The Prudent Investor Rule).

2.   Harry M. Markowitz, “Portfolio Selection,” Journal of Investing, March 1952, 89.

3.   Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.

4.   Charles D. Ellis, “Investment Policy: How To Win the Loser’s Game,” 2nd Ed., (Chicago, IL: Irwin Professional Publishing, 1993), 49; William F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice (Princeton, NJ: Princeton University Press, 2006), 207-208; William F. Sharpe, “Adaptive Asset Allocation,” Financial Analysts Journal, Vol. 66, No.3 (2010), 45-49.

5.   Restatement, § 80 comment d(2).

6.   Javier Estrada, “Black Swans, Market Timing and the Dow,” available on the Internet at papers.ssrn.com/sol3/papers.cfm?abstract_id=1086300, 3-7.

7.   Ross Miller, “Measuring the True Cost of Active Management by Mutual Funds,” available on the Internet at papers.ssrn.com/sol3/papers.cfm?abstract_id=7469264.

8.   Available online at www.nasaa.org/content/Files/Fiduciary_Letter_020210.pdf and www.dol.gov/EBSA/pdf/1210-AB33-676.pdf 


Rolling 5 Year Correlations of Return
SP500/2000 SP500/EAFE 2000/EAFE SP500/LB 2000/LB EAFE/LB
2005-09 0.987 0.985 0.973 0.022 -0.730 -0.072
2004-08 0.970 0.999 0.974 -0.204 -0.319 -0.242
2003-07 0.975 0.991 0.978 -0.129 -0.265 -0.228
2002-06 0.974 0.999 0.968 -0.781 -0.653 -0.786
2001-05 0.959 0.962 0.862 -0.815 -0.653 -0.821
2000-04 0.982 0.961 0.905 -0.866 -0.849 -0.882
1999-03 0.955 0.969 0.898 -0.836 -0.699 -0.827
1998-02 0.625 0.940 0.620 -0.579 -0.841 -0.782
1997-01 0.567 0.792 0.418 -0.288 -0.583 -0.680
1996-00 0.557 0.634 0.320 -0.309 -0.609 -0.735
1995-99 0.303 -0.478 -0.318 0.962 0.232 -0.421
1994-98 0.698 0.108 -0.506 0.925 0.698 0.213
1993-97 0.868 -0.396 0.104 0.782 0.938 0.216
1992-96 0.779 0.090 0.092 0.769 0.934 0.206
1991-95 0.811 0.140 0.110 0.697 0.886 0.195
1990-94 0.954 0.471 0.549 0.697 0.595 0.095
Rolling 10 Year Correlations of Return
SP500/2000 SP500/EAFE 2000/EAFE SP500/LB 2000/LB EAFE/LB
2000-09 0.947 0.975 0.903 -0.472 -0.426 -0.523
1999-08 0.948 0.980 0.900 -0.582 -0.480 -0.587
1998-07 0.716 0.929 0.774 -0.593 -0.658 -0.733
1997-06 0.730 0.766 0.736 -0.387 -0.549 -0.736
1996-05 0.729 0.757 0.725 -0.407 -0.545 -0.703
1995-04 0.751 0.739 0.734 -0.034 -0.231 -0.460
1994-03 0.770 0.752 0.708 -0.070 -0.044 -0.372
1993-02 0.791 0.648 0.566 0.115 0.111 -0.230
1992-01 0.634 0.560 0.331 0.238 0.269 -0.177
1991-00 0.611 0.388 0.210 0.393 0.476 -0.129
1990-99 0.660 0.405 0.409 0.525 0.439 -0.065
Correlation of +1.00 indicates positive/high correlation of returns
Correlation of -1.00 indicates negative/low correlation of returns

 * Formerly known as Lehman Brothers Aggregate Bond Index

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