The Investment Answer

1. The Do-It-Yourself Decision: Seek Professional Help

"Finance is complex, the odds are stacked against you, and the stakes are very high: your entire financial future."

Emotional pitfalls abound. Most individual investors lack the skills, time, and emotional discipline to manage their investments effectively. Our natural instincts often lead to poor decision-making, such as buying high and selling low due to fear and greed. Studies show that the average investor significantly underperforms market indices over time.

Professional guidance is crucial. A qualified financial advisor can provide:

• Disciplined approach to investing
• Access to superior resources and tools
• Emotional detachment from day-to-day market fluctuations
• Comprehensive financial planning beyond just investments

When choosing an advisor, opt for an independent, fee-only advisor who acts as a fiduciary, putting your interests first. Avoid retail brokers who may have conflicts of interest due to commission-based compensation structures.

2. Asset Allocation: The Primary Driver of Investment Returns

"The single most important investment decision you will make!"

Risk and return are related. Asset allocation refers to how you divide your investments among stocks, bonds, and cash. This decision accounts for the majority of your portfolio's risk and return characteristics. Stocks offer higher potential returns but come with greater risk, while bonds provide stability at the cost of lower expected returns.

Your ideal asset allocation depends on:

• Risk tolerance
• Time horizon
• Financial goals
• Age and earning capacity

As you age, gradually reduce your stock exposure to lower portfolio risk. Remember, it's not about maximizing returns at all costs, but finding the right balance that allows you to sleep at night while still achieving your long-term financial objectives.

3. Diversification: Beyond Simple Asset Spreading

"Focus on the performance of your portfolio as a whole, rather than the returns of its individual components."

Correlation matters. True diversification goes beyond simply owning multiple investments. It involves understanding how different asset classes relate to each other. Aim for a mix of assets that don't all move in the same direction at the same time, reducing overall portfolio volatility.

Key diversification strategies:

• Include domestic and international stocks
• Mix large-cap, small-cap, and value stocks
• Add real estate investment trusts (REITs)
• Incorporate high-quality, short-term bonds
• Consider emerging markets exposure

Remember, diversification doesn't guarantee profits or protect against losses, but it can help manage risk and smooth out returns over time.

4. Active vs. Passive Investing: The Case for Index Funds

"The preponderance of evidence shows that their efforts are unsuccessful."

Active management underperforms. Despite claims of superior skill, the vast majority of actively managed funds fail to beat their benchmark indices over the long term. This underperformance is largely due to higher fees, increased trading costs, and the difficulty of consistently predicting market movements.

Advantages of passive investing:

• Lower costs
• Greater tax efficiency
• Broader diversification
• More consistent returns
• Reduced manager risk

Passive investing, particularly through low-cost index funds, allows investors to capture market returns efficiently. By accepting market returns rather than trying to beat them, you can focus on more controllable aspects of investing, such as asset allocation and cost management.

5. Rebalancing: Maintaining Your Risk Profile

"Rebalancing is an automatic way to buy low and sell high, without your emotions getting in your way."

Drift control. Over time, market movements can cause your portfolio to deviate from its target asset allocation. Rebalancing involves periodically selling overweight assets and buying underweight ones to bring your portfolio back in line with its intended risk profile.

Benefits of regular rebalancing:

• Maintains desired risk level
• Forces disciplined buying and selling
• Can potentially enhance returns
• Helps overcome emotional biases

While rebalancing may feel counterintuitive (selling winners and buying losers), it's a systematic approach to maintaining your long-term investment strategy. Work with your advisor to determine the most appropriate rebalancing method and frequency for your situation.

6. Benchmarking: Comparing Apples to Apples

"Knowing that risk and return are related, it should come as no surprise that the long-term expected return of the S&P 500 is lower than that of the total stock market and many other equity asset classes such as small-cap and value stocks."

Proper context is crucial. Many investors mistakenly compare their diversified portfolios to a single benchmark like the S&P 500. This can lead to unrealistic expectations and poor decision-making. Instead, use appropriate benchmarks for each asset class in your portfolio.

Benchmarking best practices:

• Use multiple benchmarks that match your asset allocation
• Compare bond holdings to bond indices with similar maturity and credit quality
• Consider risk-adjusted returns, not just raw performance
• Focus on long-term results rather than short-term fluctuations

A well-constructed benchmark provides a fair comparison and helps you understand if your portfolio is achieving its intended goals.

7. Alternative Investments: Proceed with Caution

"Our belief is that you don't need alternative investments in your portfolio to have a successful investment experience, particularly considering their higher costs, lack of diversification, and liquidity constraints."

Complexity doesn't equal superiority. Alternative investments like hedge funds, private equity, and commodities are often touted as essential portfolio diversifiers. However, they typically come with significant drawbacks:

• Higher fees and costs
• Lack of transparency
• Limited liquidity
• Increased complexity
• Potential for large losses

For most investors, a well-diversified portfolio of traditional assets (stocks, bonds, and cash) is sufficient to achieve their financial goals. If you do consider alternatives, thoroughly understand the risks and how they fit into your overall investment strategy.

8. The Power of Disciplined Investing: Everyone Can Succeed

"Investing is not about winning and losing. It is not a competitive sport."

Success is achievable. Contrary to popular belief, successful investing doesn't require predicting the future or beating the market. By following a disciplined approach based on sound principles, any investor can achieve their financial goals.

Key elements of successful investing:

• Develop a clear, long-term investment plan
• Diversify broadly across asset classes
• Keep costs low through passive strategies
• Maintain discipline during market volatility
• Focus on what you can control (asset allocation, costs, behavior)
• Regularly review and rebalance your portfolio

Remember, investing is about capturing your fair share of market returns, not trying to outsmart other investors. By staying disciplined and avoiding common pitfalls, you can build wealth over time and achieve financial success.

Last updated: August 15, 2024