Fundamentals of Investing

Categories: Invest

iStock_000011625011SmallInvestment management seems to be hard to understand, but it doesn’t have to be. We will examine the three different investment management methods, as well as risk and asset classes. We will also discuss practical steps to begin constructing your investment portfolio.

Investment Management has sometimes been defined as: Managing assets and resources in relationship to your personal and financial goals, in order to most efficiently accomplish desired results.

One objective of any financial plan is to determine the right mix of investment method and asset types and accounts for you.

The Three Investment Methods: Every investment decision uses one or more of the following, and every investor should be aware of how they work:

  1. Asset Allocation: Investing in Asset Classes matched to client risk, reward and goals. Investors utilizing this method believe that diversification in various assets classes provides the most favorable investment results.
  2. Security Selection: Buying and Selling of an individual’s securities–usually stocks and bonds, but the securities can be other types. Stock (or other) pickers believe that through careful analysis of individual securities, market conditions, and economics provides the best investment returns.
  3. Market Timing: Buying and selling of securities for a particular season, often short-term, compared to buy-and-hold strategies many asset allocators or security pickers employ. Market timers look for industry, company and economic trends, and they believe this is the best way to invest.

Security Selection is deciding which stock or bond to purchase or sell. This gets the most attention in the media because it is interesting. Business news shows like to highlight stock pickers from Wall Street who talk about up-and-coming companies.

In order to be a good stock picker, you must make a careful evaluation of which stock to purchase. The goal, of course, is to purchase low and sell high. In order to make good decisions, you need a lot of information about all stocks. Security selection is challenging because of the large number of stocks that are available for purchase. Secondly, it is difficult to find accurate, up-to-the-minute information about companies, and the information becomes quickly outdated. In addition, a lot of knowledge and experience are required to be able to process and interpret the information. Investment skill requires understanding and knowledge of economics, demographics, accounting, corporations, industries, and countries, to name a few.

Great stock pickers are hard to find; however, if you do your research you will find the minority of stock pickers who have consistently beaten their respective indexes. Stock pickers can be stockbrokers who sell stock. Or they may be private money managers who usually have a staff of research people who pick stocks for clients. Investors are required to give them a minimum amount of money to invest. Mutual fund companies employ a large staff of expert researchers and analysts to help them pick securities.

Market Timing is seeing where a market or security currently is, and then betting where it may be going, and when. To break-even or win at market timing, accuracy of over 60% of the time is required to cover the losses caused by mistakes of the other 40%. It is not 50/50 because of commissions, taxes, and other transaction costs associated with trading securities. You have to be right in all four decisions: what to buy, when to buy it, what to sell, and when to sell it. A mistake in any of these may eliminate the gains in the other three. Very few market timers have shown a consistent track record of being correct more than they are incorrect. Some market timers use Options. Options are purchased contracts to buy or sell an investment at a particular price, to profit from what is usually a short-term movement (up or down in value) of the underlying security.

Asset Allocation is mainly based on the famous and comprehensive study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991.* They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection.

You don’t hear that much about asset allocation in the media, since it is boring and it doesn’t make exciting news. In addition, it is sure to draw a yawn at a cocktail party as compared to a hot new stock you may have heard about.

Asset allocation means that money in a portfolio gets divided up between the different asset classes. Most investments can be categorized into one of four asset classes: stocks, bonds, tangibles (things you can touch), and cash. There are dozens of asset classes in the U.S., and most also have mirror images in the foreign markets.

An asset allocation should be tailor-designed for each investor based on the comfort level of risk and volatility, the rate of return hoped for and the individual goals.

Most financial planning application have some sort of Investment Discovery Questionnaire. After completing the questionnaire, you will discover which of the five most commonly used investment risk tolerance categories corresponds to your input. Your investment adviser could refer to this and surely utilize his/her own questionnaire to help you arrive at the risk tolerance and asset allocation that is best suited to you.

Risk. In every aspect of life, we are faced with varying degrees of unknown outcomes. These uncertainties in life are sometimes referred to as areas of risk. In particular, financial matters are commonly described as either safe or risky or somewhere between the two extremes.

It is important to recognize that the term risk can refer to more than simply the loss of your money. Some of the different examples of these risk areas are described below.

  • Loss of Principal. Imagine that you have $10,000 invested in a stock. The stock declines in value to $5,000, and you sell the stock. Then you have suffered a loss of principal. On the other hand, if you do NOT sell the stock while the value is down, and the stock recovers to $10,000, then you have not suffered a loss. Time and diversification are keys to mitigating this type of loss.
  • Loss of Purchasing Power. If you own a $10,000 certificate of deposit earning 5% interest, you will receive $500 per year interest. Since the account is insured by the FDIC, and the interest is guaranteed for a set timeframe, this may seem like a safe investment. If we experience inflation at the rate of 3% per year, the purchasing power of the $500 income will be reduced after the first year to $485, and after 10 years to $372. The purchasing power of the $10,000 after 10 years will be reduced to $7,441. This loss is a permanent one with no chance for recovery unless our economy goes into a protracted deflationary cycle.
  • Tax Loss. With the same $10,000 as above, and assuming you are in the 25% tax bracket, the $500 interest would be reduced to $375 after taxes. After 10 years, the $500 interest after taxes and inflation would provide purchasing power of only $277.
  • Liquidity. If you place all or most of your financial assets into non-liquid assets (such as real estate, mortgages or notes, small business interests or even tax-deferred retirement accounts with severe early withdrawal penalties), you may find that you no longer have control of your financial future. If your personal financial affairs take a turn for the worse because of a disability, loss of employment, death in the family or any other unforeseen event and you cannot readily reposition your assets to meet your new needs, then you are exposed to the risk of not being in control of your financial wellbeing.

Although there are other types of risk that could be considered, the above examples illustrate that it is important to properly plan and balance your financial assets so that all possibilities are considered.

Asset Classifications Types

  • Cash or Cash Equivalents: Savings Accounts, Certificates of Deposit (CD), Money Market Accounts
  • Bonds are essentially a loan between an investor and the entity, such as a corporation or a government. They can be issued for a short term intermediate term, or long-term. In addition, they can be very safe or risky, depending upon the financial strength of the borrower/entity. Some bonds issued by municipalities may have certain tax advantages, and they are called municipal bonds.
  • Stocks are essentially an equity investment in a corporation. They can be issued by a company in your country (Domestic) or in another country (Foreign). In addition, the stock can be in a small company (Small Cap), medium size company, (Mid Cap), or large company (Large Cap).
  • Tangibles are things such as precious metals, coins, real estate, or any collectible tangible property that has value.

Index Investing. Because of the popularity of index funds, any discussion about investing should include them. Index Mutual Funds are those Mutual Funds that invest only in the securities that are in the index. For example, the Standard and Poors 500 Index Funds offered by many mutual fund companies invest in only those 500 companies represented in the index. The research has clearly established that investing in Index Mutual Funds will outperform most stock pickers’ and mutual fund managers’ choices. Does this mean that you should only invest in Index Funds? Some very smart people have concluded this; however, consider:

  • Some mutual fund managers have consistently out-performed their respective indexes.
  • Some mutual fund managers have consistently out-performed their indexes or have performed nearly as well, but they have invested in securities that have less risk and volatility than those in the index.
  • Investing in a portfolio of mutual funds may provide more diversification.

Summary. The following are simple steps to begin implementation of an investment plan that is suitable for you. First, you should decide which investment method you prefer: Asset Allocation, Stock Picking, or Market Timing. If you are doing asset allocation, follow these steps to begin the process:

  • Complete a financial plan to determine your goals and asset allocation.
  • Decide if you want to use index funds or investments selected by an investment adviser.
  • Find an investment adviser if you decide to use one.
  • After careful consideration and discussion, choose your philosophy of investing: Security Selection, Market Timing, or Asset Allocation.
  • If you work with an investment professional, ask about the methods used to determine your portfolio.
  • Some advisers use an Investment Policy Statement (IPS), for every client. Your individual IPS will outline
    1. Investment Selection Process: Policy, methodology, and systems for selecting investments.
    2. Investment Performance: They may or may not be able to provide this for you. It depends on how they construct portfolios and how the security regulatory agencies permit reporting.
    3. Reallocate investments into the funds chosen according to your asset allocation and investment policy statement. Evaluate tax exposure to changes prior to re-allocation.
    4. If you have funds in an employer-provided retirement plan, reallocate current balances and future contributions into those funds that fit your asset allocation. Obtain performance information from the retirement plan provider and discuss with your investment adviser.
  • If you have retirement funds left at a previous employer, open up an IRA account and roll over those assets into it. Invest those assets according to your asset allocation.
  • Review your investments quarterly. Your investment adviser should provide you with up-to-date information about:
    1. Overall performance.
    2. How your performance relates to the adviser’s respective index.
    3. Underlying fund information.
    4. Current asset allocation balances compared to your prescribed asset allocation.

*Gary Brinson, Brian Singer, & Gilbert Beebower “Determinants of Portfolio Performance: An Update,” Financial Analysts Journal, June ‘91