Judging your investments by raw returns alone doesn't provide a complete picture. Advances in modern portfolio theory tell us that savvy investors need to consider how much risk they're taking in order to realize any gains. After all, two different investments with similar return profiles can expose your portfolio to very different levels of standard deviation, a common measure of risk. 

This is an important distinction to make in all cases. Still, too often investors try to jump on the bandwagon of some high-profile list of "best" stocks. The temptation is to cherry pick such names to create a winning portfolio based entirely on chasing past headlines. At IFA, however, we view such a method as deeply flawed -- not to mention potentially hazardous to your financial health -- compared to a more complete risk-return analysis. 

To help illustrate this point, we've taken a look at one of the more well-known of these stock lists. It's Fortune's "Ten Most Admired Companies," which is developed with an initial screen of the 1,000 largest U.S. firms (ranked by revenue).¹ 

The list's selection process overseen by Fortune magazine considered 500 international companies with revenue of $10 billion or more. That group was narrowed to the biggest revenue generators across various industries. Executives from those companies and industry analysts were then polled to rate contenders on nine different sets of criteria, from quality of management and products to ability to hire talented teams and perceived investment values. 

Our chart (see below) starts with the rankings from 2001, the earliest year we've got complete data to accurately measure such a list. We compared the whole group on an equal-weighted basis to 10 IFA Index Portfolios (through 2019). Also shown are each of the individual stock performances on a risk-adjusted basis – i.e., returns against standard deviation. 

The results of the study indicate that the "Most Admired Portfolio" underperformed most of the index fund-based portfolios. Even the all-stock and globally diversified IFA Index Portfolio 100 produced slightly better average returns (8.03% vs. 7.96%) with lower standard deviation (16.79% vs. 17.27%). Returns were calculated on a net basis, deducting IFA's highest annual advisory fee level of 0.90%. (You can also click on the chart's "Gross of Fees" tab at the bottom to compare results over this period in which no advisory fees were added into the equation.) 

Consider, though, how much adding bonds into a portfolio can significantly reduce risk. For example, the index portfolio 90 (10% bonds) came within scratching distance of the "Most Admired Portfolio" in terms of net average return (7.65%). But its standard deviation was only 15.00. Bumping that up a bit to 20% bonds would've provided a much less bumpy ride -- the IFA Index Portfolio 80 generated 7.21% net average returns and a risk measure of 13.24%.

Another takeaway is that lagging stocks in the list not only produced lower returns than most of the index-based portfolios, but also delivered relatively high amounts of risk. Half of Fortune's Top 10 -- General Electric, Cisco Systems, Charles Schwab, Southwest Airlines and Intel -- not only didn't post a net return as great as that of the IFA Index Portfolio 100, these stock's standard deviation ranged from 27.91% (GE) on the low-end to 32.90% (Cisco) on the upper-end.

Also worth noting: Individual stocks that did outperform generally came with substantially more risk. That was especially true for Microsoft (25.57% standard deviation) and Home Depot (23.75% standard deviation). In fact, the diversified IFA Index Portfolio 100 (with no bonds) produced 60-70% less standard deviation. The lone exception was Berkshire Hathaway, which generated similar net returns with slightly less standard deviation. (For a more in-depth review of the risk-adjusted performance of this Warren Buffett-led conglomerate, you can read: "Warren Buffett, Market Efficiency and the Disappearance of Alpha").

This sort of data begs the question: If stock picking is such a fruitless endeavor, why does the mass-media keep promoting such elusive dreams? A cynical view might be that stories based on passively managed portfolios of index funds, and thoughtfully looking into the full risk-adjusted ramifications to investors over the longer haul, don't garner as much in the way of clicks. A broker isn't likely to tell his clients: "Don't hire me to trade your portfolios -- just index and relax." 

From a more positive standpoint, we find investors too frequently aren't aware enough of the most important decision in determining how to design their portfolios. As we know from leading academics like Nobel laureates Harry Markowitz, Merton Miller and William Sharpe, achieving greater returns over time is directly tied to how much risk an investor is willing to take in allocating a portfolio between different types of assets. As a result, IFA's wealth advisors find that developing a comprehensive financial plan for each person is essential to applying discipline to what might seem like a rather chaotic marketplace in which millions of investors interact on a daily basis.

Along these lines, we've developed a Risk Capacity Survey. This online survey asks several key questions related to investing in order to help an investor learn which IFA Index Portfolio captures the right mix of stocks and bonds that is most appropriate for his or her unique financial situation. 

Perhaps just as importantly, IFA's RCS is designed to be used not just by newbie investors. We find that many of our clients who are undergoing changes in their financial situations re-take the Risk Capacity Survey to make sure a portfolio's current asset-allocation plan is still a match with their longer-term financial needs and appetites to handle market risk.  

Footnote:

1. Ahmad Diba and Lisa Munoz, America's Most Admired Companies, Fortune Magazine, Feb. 19, 2001.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance.  For more information about Index Fund Advisor, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.