Recover Your Losses Without Getting Desperate

If you've seen your portfolio take a big hit in the past couple of years, you're probably looking for ways to make back your losses as quickly as possible. Yet while the recent rally has certainly soothed the pain and helped your net worth recover a bit, a much larger question remains: should you increase the risk level in your portfolio to try to grab the best returns you can get?

Most investors are quite familiar with the maxim that higher risk means higher reward. There's an equally important follow-up to that idea, though: not all risk-taking gives you the same bang for your buck. So before you dial up the risk level of your portfolio, you'll want to feel confident that you'll really get the results you're looking for.

Risk and efficient frontiers
One of the fundamental aspects of modern portfolio theory is the concept of the efficient frontier. The general idea behind efficient frontier theory is that you should be able to find combinations of different investments that will have the top return possible for whatever level of risk you choose.

In practice, you'll most often see efficient frontier theory discussed in terms of choosing asset allocation models with bonds and stocks. When you graph the historical returns of portfolios sporting various combinations between bonds and stocks, you can see what may seem like a counterintuitive result: At first, adding a certain amount of stocks to a 100% bond portfolio increases return while actually reducing risk. However, once the stock allocation reaches a critical level will you have to accept more volatility to get a better return on your investments.

Applying efficient frontiers to retirement
A recent presentation to the Employee Benefits Research Institute's policy forum took a new look at efficient frontier theory, applying it to one of the biggest problems retirement savers face: generating sustainable income from your investments. The presentation looked at various combinations of bonds and stocks in relation to how much income they would typically generate over a 30-year time horizon, compared to the risk of a shortfall during bad market periods.

The results underscored just how much sense it makes to invest more heavily in stocks up to a certain point. The 60/40 stock-bond mix, for instance, generated over $10,000 more in annual income without increasing the shortfall amounts significantly. Pushing the mix to 80/20, however, brought relatively little extra income but with a much higher shortfall expectation in the worst cases.

Watch out for hidden risk
One thing that efficient frontier theory does that you might disagree with, though, is to define risk solely in terms of volatility. But just because a stock's returns are fairly stable over time doesn't mean that they aren't vulnerable to big price drops occasionally.

For instance, I looked at some stocks with low volatility over the past five years. Several of them, including the ones below, have suffered losses far greater than the S&P's 20% drop over the past year:

Source: Capital IQ, a division of Standard and Poor's.

Perhaps more importantly, though, relying solely on model mixes of bonds and stocks ignores one the most important considerations: which stocks you actually own. By combining various types of equities -- both large and small, foreign and domestic, growth and value -- you can reduce your overall risk versus someone who invests only in a particular subclass of stocks.

Don't panic
Although the short-term hit stocks have taken may have you scrambling to make major adjustments to your portfolio, think twice before you act. Doing whatever it takes to ramp up your returns might seem necessary in light of the losses you've taken, but you may actually be better served going with a somewhat less aggressive investment strategy that still makes the most of what stocks have to offer.

For more on surviving the recession, read about:

• Why diversification isn't dead.
• Things may be worse than you think.
• Your surprise shortcut to financial ruin.

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