Balance: a state of equilibrium or equipoise; equal distribution of weight, amount, etc.
Traditionally, investors are advised to balance their portfolio between stocks and bonds to manage risk and return, a two-variable exercise. However, in working with individuals, families and institutions, this two-dimensional approach to portfolio management neglects a third, equally crucial consideration, a well-defined and, wherever possible, quantifiable set of personal goals. This three-way relationship can be visualized like this:


Each of the three circles represent areas of concern, preference and important information for investor success. None of them can be successfully managed in isolation, they must be held in a balance that may feel like dynamic tension.

For example, if the risk element is managed in isolation from goal-oriented return requirements, an investor’s preference for lower risk will likely result in lower expected returns. The investor may come to prefer short-term bonds or guaranteed annuities. While these investments indeed have lower risk, the lower expected returns shrink the probability of achieving desired goals, which are usually expressed as cash flow requirements for current and future lifestyle expenses.

Similarly, if a preference for higher expected returns is isolated from risk management, the probability of achieving the desired goal may decline. Why? As investors accept more risk, like investing a high percentage of their assets in a few speculative small companies, the range of potential returns, both positive and negative, expands. As the area of overlap among the three areas of concern shrinks, the probability of achievement of goals diminishes.

Finally, if goals increase out of proportion with capacity to invest in prudent combinations of risk and return, the likelihood of accomplishing those goals will decline. Early retirement and multiple residences are attractive, but the capital requirements for these desires may be entirely unrealistic based on an investor’s capacity to invest, both in dollars and in suitable investment options.

At first glance, balancing these competing demands can appear easy to manage, but in the real day-to-day, month-to-month, year-to-year experience of investors, it can be very difficult. Goals must be clearly defined and quantified, and their progress tracked. Investments must be selected, acquired and managed based on realistic required rates of return, associated levels of risk, ranges of return and potential maximum losses.

Balancing these three areas of concern will likely always be a source of tension, because our desires for increasingly costly goals, fear-based risk reduction, and seeking unrealistically high returns moves the three circles apart, reducing the probability of success. Finding the balance between acceptable risk, reasonable expected return and prioritized goals creates the “success overlap.” The larger the overlap, the more likely the investor will have a favorable outcome.

Think about these three circles the next time you are faced with an investment decision or are feeling uncomfortable about your portfolio. Some tension is normal, perhaps even necessary. Too much causes investors to make costly mistakes. If you are unclear about what should be in your circles, perhaps you need to carefully describe your goals and get help defining your required rate of return and risk exposure in order to confidently make successful financial decisions.

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