Investment Sense

Most investors seem to worry about picking the right stocks or mutual funds. However, abundant research on billions of investments shows that is almost impossible. Indeed, efforts to pick the right individual securities generally mean above average risks and below average returns.

A Much Better Strategy

Concentrate on building an investment portfolio that has a balance among asset classes - stocks, bonds, cash, etc. This can be done by applying the practical ideas of economists Harry Markowitz and William Sharpe, who won the 1990 Nobel Memorial Prize for Economic Science. Their ideas are known as "Modern Portfolio Theory."

The Modern Portfolio Theory helps an investor toward his or her financial objectives, while minimizing both risk and investment expenses. It guides many investment managers responsible for trillions of dollars of pension funds, endowment funds and other institutional portfolios around the world.

Modern Portfolio Basics

Investment Selection
The selection of individual investments has a negligible impact on performance. Far more important: The allocation of funds among asset classes. The decision about how much to put in stocks as a class versus bonds as a class will have more impact than the decision about whether to buy IBM or Disney stock, for example.

Use of Timing Strategies
According to Markowitz and Sharpe, market timing strategies seldom work. About 70% of market timers (people who use input such as recent past market fluctuations or the leading economic indicators to predict and profit from short-term market performance) under-perform the average. Long-term allocation strategies work better.

The Efficient Market Concept
In a totally free market, where all investors have all publicly available information, the value of the security would equal the asking price. This is considered an “efficient market.” While some markets, such as government bonds, are far more efficient than others, such as international real estate, it remains true that hardly any investors consistently outperform a market. Conclusion: Buy an asset class through “indexing,” a technique that uses the performance of an arbitrarily chosen group of securities to represent the risk and return characteristics of a given asset class. For example, you might consider an equity mutual fund that tracks the Standard & Poor’s 500 Index, or a bond mutual fund that tracks the Salomon Broad Investment Grade Bond Index.

Minimize Investment Risks
To minimize risks, a portfolio must be put together with asset classes that have a low correlation coefficient. This means that when one asset class is down, it is likely another asset class in the portfolio will be up.

Example: When the stock market crashed in October of 1987, the bond market had one of its best days of the entire decade. So, a portfolio with the right balance of stocks and bonds would have held steady, overall.

Minimize Transaction Costs
Transaction costs, principally brokerage commissions, can have a significant adverse impact on portfolio performance. They should be kept low by minimizing trading. Owning an asset class in an index mutual fund costs only a fraction as much as owning that same asset class with an active manager.

Identify Your Current Personal Financial Situation
This includes your family situation, financial objective and target rate of return (The rate of return you will need on your entire investment portfolio to achieve your objectives). Read more about this in our article Personal Budget Planner.

Determine Your Time Horizon
Begin by considering actuarial life expectancy and when you will really need the money. Read more about this in our article Countdown to Retirement

Determine Your Risk Tolerance Level
What is the largest amount of money you can afford to lose in the single worst year of your entire time horizon? Three percent is about average. Risking an amount of 8% would be very aggressive. Learn more about your own risk tolerance in our article Confidential Client Profile

Develop a Written Investment Policy
This would be in the form of a statement that provides specific instructions to an investment advisor. This policy must cover whose money is in the portfolio, targeted rate of return, risk tolerance level, anticipated annual withdrawals or contributions, emergency liquidity distributions from IRAs, desired holding period and asset classes which, for personal reasons, you want to be in or avoid.

Select an Investment Adviser
Obviously, this must be one who constructs portfolios according to Modern Portfolio Theory. Check the advisor’s ADV registration on file with the SEC or state securities department. Consider an advisor whose compensation is fee only rather than brokerage commissions, to avoid conflict of interest. Advisors who work on a commission basis may be more likely to recommend more frequent transactions in your portfolio or mutual funds that pay them to sell their funds. Read our articles About Ray Johnson and Compare Investment Advisers to Stockbrokers

Minimize Transaction Costs
Each asset class should be purchased with a no load indexed mutual fund, if available. There are indexed funds for large “cap” (capitalization) U.S. stocks, small cap U.S. stocks, large cap global stocks, oil and gas stocks, international stocks, money market instruments, one-year U.S. government bonds, five-year U.S. government bonds, precious metals, and so on.

Let Dollar Cost Averaging Work for You
Since it is impossible to consistently predict short-term price trends, purchases of indexed funds should be on a dollar-cost averaging basis, which means staggering purchases . . . perhaps every month over a 12-month period. Dollar-cost averaging does not guarantee a profit. Since this program involves investment regardless of price fluctuations, the investor should consider his or her ability to continue making purchases during periods of low prices. Read more about this in our article Dollar Cost Averaging

Rebalance Your Portfolio Periodically
This is especially warranted by significant changes in market conditions. Generally, if any asset class held in the portfolio differs by more than 5% from its original target allocation, then more should be bought or some sold until the target percentage is restored. A semi annual rebalancing is usually fine for portfolios of less than $1 million. With portfolios worth more than $1 million, a monthly or quarterly rebalancing makes sense.

Measure the Investment Performance
This should be observed quarterly and given serious review after each calendar year. Monthly reporting is even better. Use two different types of performance reports . . . time weighted and dollar weighted. To compare the investment performance of your portfolio with the performance of other investment managers, use time-weighted rates of return. To determine whether the market value of your portfolio is growing fast enough so that you can achieve your own financial objectives, use dollar-weighted rates of return.