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The Dominance Principle of Investing

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	10%	19%
Large Cap Fund B	10%	17%
Large Cap Fund C	10%	21%
Large Cap Fund D	10%	36%
Large Cap Fund E	10%	28%

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.

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Understanding Standard Deviation as a Measure of Risk

In the investing world, two of the most important concepts are risk and return.  Most people understand the return part, which is the amount of gain or profit produced by an investment, but the risk part is much less clear.  The reason for this is that risk is often quantified by a measurement known as standard deviation - a not so appealing term.  However, understanding this measure will help you a great deal in putting together your investment portfolio.

Standard Deviation Defined

According to Dictionary.com, standard deviation can be defined as 'a measure of the dispersion of a set of data from its mean.  The more spread apart the data is, the higher the deviation.'  Don't you love dictionaries?  To put it in slightly more useful terms, standard deviation measures the volatility of investment returns (a.k.a. risk) relative to the average return.  Still clear as mud?  No worries.  We'll explain this in more detail later in an example.

1-2-3 Standard Deviations

While standard deviation measures volatility, there are also varying degrees by which this measure is considered accurate.  For each standard deviation, there is an increasing level of reliability as shown here:

• 1 Standard Deviation = 68.27% reliability
• 2 Standard Deviations = 95.45% reliability
• 3 Standard Deviations = 99.73% reliability

Bringing It Together

At this point, we know that standard deviation is a measure of risk (or volatility) and that the number of standard deviations determines the reliability.  So here's how it works in the investing world.  Let's say you own a mutual fund that has a standard deviation of 21% and an average annual return of 8%.  What this really means is that over the long-term, you can expect the investment to produce around an 8% return, and that in any given year, the one-year return could be anywhere from a gain of 28% (8% + 21% = 28%) to a loss of 13% (8% - 21% = -13%).

Also, since it's only one standard deviation, you know that over the next year, there is a 68.27% chance that the one-year return will fall between a loss of 13% and a gain of 28%.  (In case you were wondering, the other 31.73% of the time, the returns are outside of the range)  Just looking at these numbers, this particular mutual fund likely invests in stocks and has a pretty good amount of volatility.

Real Life Application:  Morningstar.com

If you want a better idea of how risky your investments are, you can go to Morningstar.com and punch in your investment's symbol.  Follow the steps below to find a fund's risk and return characteristics.

Step #1:  Go to Morningstar.com

Step #2:  Enter the Investment's Symbol

 

Step #3:  Click on the 'Ratings & Risk' Tab

 Step #4:  Find the 3-year Standard Deviation

Step #5:  Find the 3-year Average Annual Total Return

Step #6:  Determine the Risk of the Investment

In this final step, you can see how risky your particular investment has been by doing the same calculation above.  Here is the formula for finding the expected return range at one standard deviation:

Average Annual Total Return  +/-  Standard Deviation  =  Return Range

In this example with the Fidelity Contrafund, we know that 68.27% of the time, the fund's range of returns over the last three years was:

-0.24%  +  19.01%  =  18.77% Top of Range

-0.24%  -  19.01%  =  -19.25% Bottom of Range

Final Thoughts

While understanding standard deviation as a measure of risk is helpful, it is by no means the final answer.  The reason we've taken you through this exercise is because when you go about selecting your investments to fill in your asset allocation model, many funds will have similar return numbers without much in the way of a risk assessment.  When faced with several investment options with each having similar returns, it is generally best to pick the one with the lowest amount of risk.  Understanding standard deviation will help you find a better trade-off between risk and return.

NOTE:  Morningstar uses one standard deviation measuring the last three years of data.

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