The Performance Illusion: Higher returns have long been associated with higher risks.

Which would you rather have, a portfolio with an average annual return of almost 34%, or one with an average annual return of just 5%?  Let's llok at a couple of examples that show why sometimes less is more.

Exhihit 1
The  Performance Illusion:  High Average Return

Year 1
Starting Value $100,000  Return 100%  Gain or (Loss) $100,000
Ending Value $200,000

Year 2
Starting Value $200,000  Return -99.00%  Gain or (Loss) ($198,000)
Ending Value $2,000

Year 3
Starting Value $2,000  Return 100%  Gain or (Loss) $2,000
Ending Value $4,000

Average Annual Return: 33.67%
Change in Value: ($96,000)
Percentage of Initial Investment Gained or (Lost) after 3 years: -96%



Exhihit 2
The  Performance Illusion:  Low Average Return

Year 1
Starting Value $100,000  Return 15%  Gain or (Loss) $15,000
Ending Value $115,000

Year 2
Starting Value $200,000  Return -15%  Gain or (Loss) ($17,250)Ending Value $97,750

Year 3
Starting Value $97,750  Return 15%  Gain or (Loss) $14,662.50
Ending Value $112,412.50

Average Annual Return: 5%
Change in Value: $12,412.50
Percentage of Initial Investment Gained or (Lost) after 3 years: 12.41%


Which return would you rather have? Of course, to illustrate the dangers of a high-volatility approach to investing, these two examples include an extreme case. Surely no one would ever face the kind of volatility shown in the 100 percent up and 99 percent down example ... but they might come close.



Exhihit 3
Nasdaq Composite Index

Year 1999
Starting Index Value 2192.69; Return 85.59%; Point Gain or(Loss) 1876.62
Ending Value 4069.31

Year 2000
Starting Index Value 4069.31; Return -39.29%; Point Gain or(Loss)(1598.79)
Ending Index Value 2470.52

Year 2001
Starting Index Value 2470.52; Return -21.05%; Point Gain or(Loss)(520.12)
Ending Index Value 1950.40

Year 2002
Starting Index Value 1950.40; Return -31.53%; Point Gain or(Loss)(614.89)
Ending Index Value 1335.51

Year 2003
Starting Index Value 1335.51; Return 50.01%; Point Gain or(Loss)667.86
Ending Index Value 2003.37

Average Annual Return: 8.74%
Change in Index: -189.32
Percentage of Initial Investment Gained or (Lost) after 5 years: -8.63%


Exhibit 3 shows the actual results of the Nasdaq Composite Index (Nasdaq) over five years beginning in 1999 and ending on December 31, 2003.

The truly remarkable 86% return posted by the Nasdaq in 1999 was followed by a truly gruesome bear market mauling over the three years. From the start of 2000 to the end of 2002, the Nasdaq shed an amazing 2,733 points - more than 67% of its value. The year 2003 brought welcome relief, but even after a 50% rise, the Nasdaq was still more than 8.6% below where it had stood five years earlier.

An investor unlucky enough to have missed out on the gains over this time span - either by coming late to the party or bailing out before the rebound - would have suffered a massive financial setback. As of the end of 2003, the Nasdaq remains more than 3,000 points, or 60%, below its all time closing high.


Exhibit 4
The Y2K Bear Market

Nasdaq
Index Closing High 5048.62
Date Hit 03/10/2000
Index (On 12/31/2003) 2003.37
Decline -60.32%
Points from High 3045.25
Gain Needed to Recover 152.01%

S&P 500
Index Closing High 1527.45
Date Hit 03/24/2000
Index (On 12/31/2003) 1111.92
Decline -27.20%
Points from High 415.53
Gain Needed to Recover 37.37%

DJIA
Index Closing High 11722.98
Date Hit 01/14/2000
Index (On 12/31/2003) 10453.92
Decline -10.83%
Points from High 1269.06
Gain Needed to Recover 12.14%


The Exhibit 4 shows the damage the Y2K bear market has visited on three major U.S. stock market indexes. The S&P 500 and DJIA did not soar nearly as high as the Nasdaq during the technology/telecom/Internet boom of the 1990s, and they suffered much less damage during the bust that followed.

The scenarios above are to illustrate, that there are consequences to taking risks. The easy success of the late 1990s bull market lulled many investgors, including many professional investors, into believing risk had lost its bite. Why not shoot for a 30 percent return? If you don't get it, you'll probably just have to settle for 20%. But that's not how it works in the real world - at least not in the long run. The experience of the Nasdaq versus the DJIA during the Y2K Bear Market wasn't a fluke. Higher returns have long been associated with higher risks.