If I were to offer you the opportunity in the coming year to have above-average returns while taking on below-average risk, would you take the offer? Isn't this the goal of portfolio -- to achieve sufficient returns to accomplish your goals without assuming more risk than necessary? If you answered yes, it's likely that your portfolio underperformed the S&P 500 in 2013. But there is a perfectly legitimate reason for this underperformance.
What did you expect?
Allow me to clarify my idea of maximizing returns while minimizing risk. Let's say you're a long-term investor with a time horizon of more than 10 years, and you are comfortable with a moderate asset-allocation of 70% stocks and 30% bonds. Let's also assume that the long-term average annual return for stocks is 10% and the average for bonds is 6%.
By doing some simple math, you can project an expected long-term annualized return. First calculate what each asset is expected to contribute to your portfolio. Multiply your stock allocation percentage (70%) by your expected return (10%), and you arrive at 7%. Now do the same for bonds (30% times 6%), and you get 1.8%. Now add those two products together (7% plus 1.8%), and you get a total expected long-term portfolio return of 8.8%.
Over the course of your projected investment time frame, you will expect your portfolio to outperform that 8.8% estimate in some years and underperform that mark in other years
The purpose of portfolio construction
If your ultimate goal were achieving high returns while paying no heed to market risk, you might put all of your eggs in one basket and invest in a single security or asset you believed would provide the best return over a given period of time. But this investing behavior borders on gambling; it is a roll of the dice.
The ultimate purpose of constructing a portfolio is diversification; you want to achieve reasonable returns while taking on a level of market risk that you can accept. To do this, you simply build a portfolio that has a mix of asset classes
2013 demonstrates the power and simplicity of diversification
So why build a diversified portfolio? Because no one knows with certainty what financial markets and economies will do in the future. Now look back at 2013 for an example. A reasonable expectation for the year would have been for stocks to put in an average performance and for bonds to put in a below-average performance. But who would have expected stocks to record their best performance in 15 years? Further, considering the tremendous amount of negative press for bonds, who would have expected only a mildly negative year?
Returning to my simple portfolio example of 70% stocks and 30% bonds, and the calculations for total portfolio return, plug in the 2013 numbers for each asset class using index funds. For your stock allocation, assume you began the year with 70% in the SPDR S&P 500 (NYSEMKT:SPY) exchange-traded fund and 30% in Vanguard Total Bond Market ETF (NASDAQ:BND). The stock ETF had a total return of 32.3%, while the bond ETF lost 2.3%.
Now calculate what each fund contributed to your portfolio. Your stock allocation return is 22.6% (32.3% times 70%), and your bond allocation return is -0.7% (-2.3% x 30%). Now combine the two (22.6 minus 0.7%) for a total portfolio return of 21.9%.
Success in maximizing returns and minimizing risk
If your 2013 portfolio results were anything similar to my example, you had a successful year. Consider the expected long-term portfolio return of 8.8% and compare that to a 2013 return of 21.85%. Any time you can more than double your expected return with only a moderate level of market risk, there is cause to celebrate. You did not match or beat the S&P 500, but that is not the goal for Fools like you and I. The likely reason you underperformed the stock index in a year like 2013 is because you did a good job of constructing a diversified portfolio.