Making the most out of future stock market investments involves capturing the "risk premium" offered by more volatile stocks. You should consider the mutual funds that invest in them.
The term "risk premium" describes the extra rate of return that the "invisible hand" of economic forces will offer to investors who can handle more sleepless nights as markets crater.
Someone investing entirely in small companies, for instance, can expect to earn 12 percent per year over 30 years as opposed to just 10 percent per year as the average long-term return for the S&P 500.
That these small company values will fluctuate more wildly over that time goes without saying.
So how do we have our cake and eat it too? The secret sauce is called "inverse correlation."
If we can find investments that are inherently risky, but ones that exhibit downdrafts at different times from each other, the net effect of the combination will look more like a straight line of results.
Attraction of opposites
Any measurement of our total investment results that looks more like a straight line represents a low-risk portfolio. The term "correlation" describes the degree to which movements of different asset types move in lock-step with each other.
"Inverse correlation" describes investments that move in opposite directions from each other.
We can handle risky investments, and benefit from what might be a 2 percent annual "risk premium" if we choose risky investment types that exhibit inverse correlation.
Foreign funds, specifically emerging markets funds, invest all over the world and have displayed widely differing returns from U.S. markets since the 1970s.
In just the past 10 years, with the exception of 2001 and 2008, foreign stocks have outpaced U.S. stocks by an average of about 8 percent per year.
During the crash of 2008, a number of news articles pointed out that world markets were now in lock-step and that investing overseas did not offer much diversification.
However, lock-step performance (high correlation) has always been the case in bear markets caused by some shock to the world financial system.
Those articles also failed to point out that this is a short-term phenomenon.
What has always followed as markets recover is a "reversion to the norm," which brings back the historical long-term inverse correlation phenomenon.
Considering two risky investments, we can compare the results with T. Rowe Price Emerging Markets and Perkins Small Cap Value funds. Perkins lost 22 percent in 2008 while T. Rowe lost 61 percent.
A year later, T. Rowe was back with an 85 percent gain while Perkins gained 37 percent. Over the past 10 years, a combination of both funds would have beaten the S&P 500 by an average margin of over 10 percent per year.
Why risk it
Gaining confidence in this market characteristic can lead to taking more risk with individual investments in a portion of a portfolio.
We can sleep at night while owning these volatile funds as long as the investments are generally out of step.
The reward for this is the "risk premium."
An extra 2 percent compounded over 20 years on a $10,000 annual investment, for example, can add about $200,000 to the end result (the difference between 10 percent and 12 percent compounded.)
Readers with a long memory may recall that I recommended some overseas funds in April of 2004 and again in February of 2007.
This time around, I'm suggesting a strategy that will soften the blow the next time they drop in value by 60 percent in a single year.
And, I'm reminding us all why it makes sense to take some risk in an effort to improve overall returns.