Tom Fischer is an Investment Advisor in Scottsdale, Arizona. This article has been shared to allow you to make important financial decisions about your investments.

Most investors seem to worry about picking the right stocks.  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. 

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 Company A or Company Z 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.  One conclusion might be to 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 a balance of stocks and bonds would have minimized the volatility. 

• 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.  

THERE IS A SIMPLER WAY

• 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). 

• Determine your time horizon 

Begin by considering actuarial life expectancy, and when you will really need the money. 

• 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. 

• 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 advisor 

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 help avoid conflict of interest.  Advisors who work on a commission basis may be more likely to recommend more frequent transactions in your portfolio.  If your broker is compensated on a trade basis, investigate the discounts available. 

However, clients should periodically re-evaluate whether the use of an asset based fee schedule continues to be appropriate in servicing their needs.  A list of additional considerations, as well as the fee schedule, is available in the firm’s Form AVV, Part II as well as in the client agreement. 

• 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, Japanese 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 predict short-term price trends consistently, 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 or protect against loss.  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. 

• 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 semiannual 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. 

YOUR OBJECTIVES CAN BE ACHIEVED 

With this strategy, investors will save brokerage commissions, save time talking to stockbrokers, avoid needless risks and help achieve a targeted rate of return with greater confidence. 

Mutual fund shares are not deposits or obligation of, or guaranteed by any depository institution.  The value of the shares will fluctuate so that when redeemed, shares or units may be worth more or less than the original cost.  Past performance does not guarantee future results. 

 Investors should consider the investment objectives, risks, charges and expenses of investment companies before investing.  The prospectus contains this and other information and should be read carefully before investing.  The prospectus can be obtained from the financial representative offering the product.

 Asset Allocation involves distributing funds among diversified asset classes of investments such as equities, fixed income and cash equivalents.  It is a tool of the Modern Portfolio Theory that allows an investor to classify, estimate and control both the kind and the amount of expected risk and return, but it is not a guarantee against loss.

 Dollar Cost Averaging involves continuous investment in securities regardless of fluctuating price levels.  Investors should consider their ability to invest their money continuously through periods of low price levels.  Dollar Cost Averaging does not guarantee a profit or protect investors from a loss during a declining market.

 Sources:    Financial Planning Consultants, Inc.