When selecting investments for your portfolio, the dominance principle of investing is something that you must know. While it is a somewhat intuitive principle, it's always a good idea to review what it means and how it applies to your investment portfolio. The dominance principle states:
Among investments with the same rate of return, the one with the least risk is most desirable. In addition, given a group of investments with the same level of risk, the one with the highest return is most desirable.
Sounds like commonsense, right? Unfortunately, most investors fail miserably to adhere to this fundamental investing principle. Reasons for this vary, but now that you know this principle exists, let's work on how to use it.
The most common case where this principle comes into play is when selecting investments in an employer based retirement plan like a 401k, 403b, or 457 plan. Usually, these plans will have multiple investment options in any given investment category. As an example, a 401k plan might have five large cap stock funds in its lineup with each having similar long-term returns. To make things easy, let's consider a lineup of imaginary funds as follows:
|Investment Name||Return||Std. Dev.|
|Large Cap Fund A|
|Large Cap Fund B|
|Large Cap Fund C|
|Large Cap Fund D|
|Large Cap Fund E|
All of the funds have the same return for the given time period. However, the standard deviation (a measure of risk) varies widely from 17% up to 36%. What this means is that while the rates of return are the same, the risk level of Large Cap Fund B is less than half that of Large Cap Fund D. Using the dominance principle, the most desirable fund in this lineup is Large Cap Fund B.
Though this has been an important hypothetical exercise, using this principle in the real world can help you maintain an investment portfolio that keeps a lid on risk. Often, when markets get hot, investors can be sucked into purchasing high risk funds by looking only at recent returns while ignoring risk altogether. Invariably, the market drops later and high risk funds demonstrate why they're so risky - they suffer much larger losses than their less risky counterparts.
If your investment provider doesn't give you standard deviation statistics, you can go to Morningstar.com and look them up. To learn how, see our article, Understanding Standard Deviation as a Measure of Risk.