Archive for July, 2011
The Finer Points of Proper Investing
Friday, July 22nd, 2011
Getting Started
One day I met with a seemingly sane man named Bob in the offices of Charles Schwab, a referral from the team there. Distraught because his investments were vanishing, his plan to buy Microsoft when it went down and sell it when it went up had stopped working. Day trading…. great in theory, until the day that it went down two days in a row. He kept watching the stock as it fell and before long he was frozen, not willing to sell and unable to buy more (he had been buying more on the way down.) Emotion is just one of many factors that can destroy a long term investment portfolio. Bob had no hard sell policy and no diversification. (He thought the size of MSFT would be diversification enough.)
It is very important to have a strategy for your portfolio. A sound portfolio management strategy begins with your goals and time frame for your portfolio assets. Your best bet is to start with an allocation to various types of investments, thereby spreading your risk to different companies, countries, markets, and types of assets. This is called asset allocation. Dividing your investments among the many categories of equities, bonds, and cash, will be the result of taking your cash needs, timing and goals into account along with an assessment of your comfort with the ups and downs of the market. Once you set a broad asset allocation (the amount you want in equities or bonds or cash), only then, can one make finer distinctions within each broad category. For example, within the equity category, you could diversify among large, small, and international companies. Within the bond category you could separate short-term, intermediate-term and long-term bond investments not to mention credit quality, taxability, and risk.
Modern Portfolio Theory is the basis for this type of diversified investing. The theory is that most investment categories have unique characteristics of risk and return that set them apart from others. By mixing and matching the assets we can develop a portfolio with less risk and\ more consistent (or less volatile) long-term performance. Obviously, as Bob learned, you can’t get that simply by rapidly trading a single stock.
Rarely do all the categories rise or fall at the same time. In 2008 we saw an example where most markets moved in virtual lock step as the very fabric of our financial markets was called into question and panic ensued. Some called it the end of Modern Portfolio Theory! Soon after the investing public realized that it was not the end of the financial world, the markets snapped back into reality and more normal risk and return characteristics returned.
Setting the Course
So, what do you do now that you have a better understanding of the right way to invest? First, determine when you will need your money (e.g., a house purchase next year or retirement in twenty years?). Make sure you keep enough cash aside for short term and emergency needs. You should only invest money in the markets that you will not need for at least five years. Otherwise, you should invest such funds in savings accounts, money market funds, CDs or very short-term treasuries In today’s environment, you won’t make much interest, but you’ll be grateful should you have a job loss or big expenses (think car or house problems). Remember that investing in money-market funds is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency, but your bank savings account is probably protected…do your homework!
You should also think about paying off high interest rate credit you owe. This strategy guarantees you a high return (interest you won’t pay) and your monthly payments can fall as well, improving your cash.
Once you have your financial house in order and a list of goals for your money, start to think about how well you will sleep when the market inevitably takes a 10% tumble, let alone a possible 25% correction? If you’ll be up all night tossing and turning, invest more conservatively. There are many online risk assessments and the one at http://www.docstoc.com/docs/21922002/Investment-Risk-Tolerance-Quiz does a pretty good job assessing your tolerance for risk. Once you determine your appropriate risk level and a corresponding timetable for your needs, look at your investment options.
Determining the right mix of investments for your portfolio is complex. Let’s take a closer look at how various investment types can complement each other and offer potentially higher returns while allowing you to sleep at night.
Going to the Core!
Core investments are the stodgy boring traditional portion of your portfolio. They’re designed to generate solid long term performance and offer your portfolio stability over that long term.
Your core holdings may include stocks of U.S. companies in developed foreign markets and high-quality interest-paying securities, such as bonds and money market funds. (Please note that bonds are subject to interest rate risk. Generally, as interest rates rise, bond values fall.) Bear in mind that stocks generally provide the best growth potential, but at a greater risk than bonds and cash investments As discussed above, diversification through an asset allocation plan can reduce overall portfolio risk and volatility.
I suggest that you start simple with a core portfolio of stock and bond mutual funds. The more conservative you are, the more cash and bonds funds you should start with. If you are a more aggressive and fearless investor, you should weight your portfolio toward equities.
Because bond performance has limited correlation to stock performance — meaning bonds often do well when stocks are down — owning both can even out your investment performance over time. The same is true of owning foreign stocks, which provide similar growth potential to U.S. stocks but generally move out of step with the U.S. stock market.
You may further diversify your portfolio by dividing your stock holdings between contrasting investment styles. For instance, you can pair a growth fund with a value fund or blue-chip stocks with up-and-coming small-cap stocks.
Venturing out to more risky (and possibly more rewarding) Investments
Noncore investments act to capture extra return or outpacing performance in your portfolio by adding diversification and increasing its performance potential. Noncore investments might include specialized asset classes, such as real estate investment trusts (REITs), commodities, emerging foreign markets, high yield bonds, or alternative investments (like hedge funds and private equity).
For example, investing in REITs, gets you very diversified shares of real estate ownership. REITs are a popular investment choice because they’re similar to stocks but have limited correlation to U.S. stock markets. Absolute return hedge funds similarly provide a range of returns based upon a benchmark, with little correlation to stocks, bonds or REITs and they are a good diversifyer as well.
Non-core investments are long-term nature, with fluctuating income risk, and sometimes lack of liquidity (like in a hedge or private equity fund). You should work with a financial professional to determine if these are suitable for your portfolio.
High-yield bonds, or junk bonds, are debt securities issued by credit-challenged companies. Though some can be quite risky, they can generate significant income over the returns on a core bond portfolio.
Further diversification and performance benefits can be reaped by adding stocks from emerging markets, such as Russia, China, Indonesia, Eastern Europe and South American countries. Commodities, such as metal-based (gold, silver, copper, platinum, etc.) stocks or mutual funds can also be risky but add to a portfolio’s performance. There are special risks associated with international investing, such as increased political, social and economic instability. These risks are heightened in emerging markets. Even individual-sector mutual funds (for example, those that invest only in health care or technology) can be part of the noncore portion of your portfolio if you feel they will provide you will excess return and help maintain a reasonable level of overall portfolio risk.
On its own, each of these investments lacks diversification, thus introducing substantial risk. But by owning them in small amounts surrounded by a strong group of core investments they can help you build a successful long-term portfolio. Once built, keep to the plan and rebalance your investments back to their planned percentages. Do this a few times a year or when the market makes a big move. DO NOT get emotionally attached to any investment and stick to the plan.
Charting the best course for you
Get your financial house in order first. Then start to invest with a core of diversified investments. Once you get comfortable with that, you can start to venture into more exotic areas. Just being diversified will put you ahead my Microsoft friend. And sticking unemotionally with your plan and rebalancing will make you a solid long term investor.
There is no one-size-fits-all solution for determining which investments belong in your investment portfolio and how much you should invest in each area. You can, however, craft a proper overall investment plan that takes into account the level of risk you are willing to take, your time horizon and goals, and your income tax profile. Evaluating your portfolio in terms of core and noncore investments can help you achieve the mix that allows you to earn the highest returns possible at a risk level you’re comfortable with.
If you think this is all great but you’ll never have the time to set it up and keep on top of it, a fiduciary investment professional can help you figure it all out and monitor it all for you. If you find the right advisor they will enable you to rest comfortably in the knowledge that there is a trusted, seasoned professional watching out for you!
Copyright Wealth Management Advisors, LLC 2011