Assignment 9 Preview Investment Basics

These 4 Investment Strategies are the most common and most powerful investment strategies available to young and old investors alike, designed to help you maximize returns and minimize risk so that you build more wealth over time.

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Assignment 9 Preview Investment Basics

What is an Investment

According to Wikipedia: Investment is traditionally defined as the “commitment of resources to achieve later benefits”. If an investment involves money, then it can be defined as a “commitment of money to receive more money later”. From a broader viewpoint, an investment can be defined as “to tailor the pattern of expenditure and receipt of resources to optimise the desirable patterns of these flows”. When expenditure and receipts are defined in terms of money, then the net monetary receipt in a time period is termed as cash flow, while money received in a series of several time periods is termed as cash flow stream. Investment science is the application of scientific tools (usually mathematical) for investments.

In personal finance, the purpose of investing is to generate a return from your invested asset. The return may consist of a gain (profit) or a loss realized from the sale of an investment, unrealized capital appreciation (or depreciation), or investment income such as dividends, interest, or rental income, or a combination of capital gain and income.

Investors generally expect higher returns from riskier investments. When a low-risk investment is made, the return is also generally low. Similarly, high risk comes with a chance of high losses.

Investors, particularly new investors, are advised to diversify their portfolio. Diversification has the statistical effect of reducing overall risk and Diversification is one of the four investment strategies we will discuss that are designed to help you minimize risk and maximize returns.

4 Investment Strategies

These are the most common and most powerful investment strategies available to young and old investors alike, designed to help you maximize returns and minimize risk so that you build more wealth over time:

What Is Diversification?

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

The Basics of Diversification

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.

Which Elevator is More Secure?

The most basic — and effective — strategy for minimizing risk is diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against a loss, it is the most important component to helping an investor reach long-range financial goals, while minimizing risk.

There are several ways to plan for and ensure adequate diversification including:

Spread your portfolio among many different investment vehicles — including cash, stocks, bonds, mutual funds, ETFs and other funds. Look for assets whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your portfolio is declining, the rest may still be growing.
Stay diversified within each type of investment. Include securities that vary by sector, industry, region, and market capitalization. It’s also a good idea to mix styles too, such as growth, income, and value. The same goes for bonds: consider varying maturities and credit qualities.
Include securities that vary in risk. You‘re not restricted to picking only blue-chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses perform regular “check-ups” or rebalancing to make sure their portfolios have a risk level that’s consistent with their financial strategy and goals.

Diversification Remembering Enron

The collapse of Enron dominated the business news here in Houston and around the world. In fact, for some people I know, the Enron story was painfully personal.

In the years just prior to the company’s collapse, the company urged employees to keep all their retirement funds in Enron stock.

One of my clients realized that was a risk she wasn’t willing to take, but another client bought the company’s promises of long-term stability.

Beth came to me a few months after the company filed bankruptcy. For all intents and purposes, Enron had ceased to exist, but she had a huge amount of money to invest. I asked, “How did you get out of there with all this money?”

She replied, “I saw the writing on the wall, so I took my money out of Enron stock well before it tanked, and I put it in other funds.”

Today, Beth’s retirement account is doing quite well.

But Frank didn’t see the writing on the wall. He believed the officers who told him, “Don’t worry. Everything will be just fine.”

In the heyday of the company, Frank had over $1 million in Enron stock in his retirement account. A few months later, he had nothing.

The financial setback was too much for him. The pain and shame caused panic attacks, then a heart attack. Frank died as another casualty of Enron’s financial mismanagement.

Diversification is a way to spread risk so the problem Frank experienced doesn’t happen to you.

My favorite illustration comes from my friend David Coney at Edward Jones. David taught me to illustrate diversification by talking about elevators.

I tell the client she has a choice of two elevators. A single cable holds up one elevator, and eight strong cables hold the other. The building, I tell the client, is 100 years old.

Then I ask, “Which elevator would you take to the top floor?”

This question often elicits a chuckle and a quick reply, “The one with lots of cables.”

The single cable may be strong for a long time, but if and when it ever breaks, people in the elevator will be in trouble.

But if one of the eight cables on the other one breaks, the other cables can hold it very securely.

This simple drawing illustrates the difference between trusting in one financial product (that is, “putting all your eggs in one basket”) and having a diverse portfolio.

This illustration also describes the benefits of mutual funds, Index Funds, or ETFs over individual stocks. In a mutual fund, the managers check the cables (individual stocks) in their diversified holdings, and replace those that aren’t performing well or have too much risk.

It’s sound, established, financial logic to avoid having too many assets in a single investment, but some executives, managers, and employees view their company’s stock like it’s their first-born child.

For example, one man told me, “I’d never sell my company’s stock. I’d feel disloyal.” We talked further about the benefits of diversifying, and ultimately, logic prevailed. Some people, however, won’t budge. Their emotional investment in their pet stock is so strong that they simply can’t bring themselves to sell any portion of it.

Asset Allocation Takes the Cake

The distribution of assets to balance risk and reward is the most important principle of investing. A little wisdom makes a huge difference in the return on investment.

A lady named Kimberly came to me, and she was visibly upset. Her husband Ed had an IRA with $100,000, but he had kept it in a money market at .5% during five years the market had gained 10 to 16% each year. They were both about 35 years old.

Dozens of times, she had suggested that he move his money to more productive instruments, and finally, he agreed to meet with me. I explained asset allocation, and they both felt much more comfortable about investing the money.

Asset Classes

In order to implement the 4 Investment Strategies outlined in today’s lesson, it is very important that you understand the differences between asset classes. There are many many different asset classes, sometimes referred to as “styles”:

US Large Cap
US Mid Cap
US Small Cap
International
US Government Bonds
US Corporate Bonds
Municipal Bonds
International Bonds
And the list goes on and on…

Three Big Factors

Three factors determine the performance of your portfolio:

Asset Allocation,
The Selection of Assets (Stock Picking), and
Market Timing

In a ten-year study of ninety-one large corporate pension plans in the United States, the authors of an article in Financial Analysts Journal found that…

94% Of Performance Was Determined By Asset Allocation.

What is Asset Allocation

Investment selection accounted for only 4%, and market timing was responsible for 2%. B.G.P. Brinson, B.D. Singer, and G.I. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal (January/February, 1986.)

The metaphor I use to explain asset allocation is balancing a tire for high speed driving. When I was a mechanic, and a customer came to my shop because the car was shaking, the problem was almost always that a tire was out of balance, sometimes caused by a small bump of rubber from uneven wear.

Even a seemingly small imbalance of a quarter of an ounce could cause the tire to shake violently at high speeds. I applied a weight to counterbalance the wheel.

We checked it on the balancing machine to be sure it ran smoothly, put it back on the car, and the customer was ready to go.

Asset allocation balances the portfolio, so the assets run smoothly toward your goals. Sometimes people only need to make small adjustments, but often they need to make major changes in the distribution of assets.

Some people are so risk-averse that they want to keep all their money in cash, and they want to divide it up so they stay under the FDIC limits in each institution.

But this strategy only limits risk in the immediate future. Returns on cash accounts don’t even keep pace with inflation, so there is no opportunity for asset appreciation and they actually increase their long-term risk.

What is Dollar Cost Averaging

The best way to develop a substantial nest egg is to develop the discipline of putting money into a fund every month—no excuses. The market will go up or down, but our funds continue to grow slowly and steadily. I know people who began putting as little as $25 a month into an investment, and over time, they’ve accumulated a substantial amount of money.

When they were young, they had every reason to put off investing because they could easily use that $25 for dinner and a movie. But they were committed to save and invest, even if it was a small amount. When they got promotions and raises, they increased the amount they put away each month.

Dollar Cost Averaging with Farmer Joe

Many of us are tempted to wait for a windfall—winning the lottery or a big inheritance from Aunt Phoebe—before we even start to invest. Our hopes are high because we’ve heard stories of people who hit it big, but those stories are in the news because they’re so rare, not because they’re commonplace.

To explain the benefit of regular investing, I use the illustration of a farmer who invests each month in his favorite commodity: Cows.

Farmer Joe calls me and wants to invest $100 each month. When he begins, the market for cattle is near an all-time high. Cows are selling for $100 a head (which actually includes the entire cow, not just the head in case you’re watching Netflix while you’re reading this…).

He wonders if this is the right time to invest, but he needs more cattle.

The first month, he can buy only one cow.
In the second month, the price of cattle goes down to $50, so he buys two.
The third month, the price goes to $25, so he buys four that month.
And in the fourth month, the price of cattle plummets to a low: $20 each.

At that point he calls me and says, “Hey bucko, what have you gotten me into? Cattle are $20 a head! I bought all these cattle at high prices, and the bottom has dropped out of the market! I’m going to sell them all and cut my losses.”

I tell him confidently, “Farmer Joe, the market is very low right now. You were paying $100 a head four months ago.

You needed cattle, didn’t you? Has that changed? No? So why are you upset?

This is the best time to buy cattle, not sell. Hang in there.

You’re in great shape to benefit from this phase of the cycle.”

Farmer Joe bites his lip and decides to trust me.

The next month, the price creeps up to $25 again. Farmer Joe buys four head.
The next month, the price has risen to $50, so he buys two, and
The next month, the price of cattle is back up to its high of $100, and he buys only one head.

At that point, Farmer Joe decides to sell. During those seven months, he bought nineteen cows for a total of $700. They’re worth $1900, yielding a net profit of $1200, and the price of cattle never rose above $100 a head.

Farmer Joe’s only regret was that he didn’t sell his tractor and buy more cattle when they were $20 each.

As I explain this story, I draw a chart for my clients. It looks something like the cow chart used in the beginning of this article (except that my cows never look that good).

Portfolio Rebalancing

Portfolio Rebalancing is Like Balancing a Tire, it’s the process of realigning the weightings of assets in your investment portfolio. Rebalancing involves periodically buying or selling securities to maintain an original or desired or risk level.

For example, say your original target was 25% small cap stocks, 25% large cap stocks, 25% international stocks and 25% bonds. If the small stocks performed well during the period, it could have increased the small cap stock weighting of the portfolio to 40%. At the same time, your bonds may have gone down so much that your bond allocation is now only 15%. So, you may then decide to sell some small cap stocks at this higher price and buy more bonds at this lower price to get your portfolio back to the original target allocation of 25/25/25/25

What is Portfolio Rebalancing

Portfolio rebalancing safeguards you from being overly exposed to undesirable risks — like way too much international stock in your portfolio.

These steps are taken to ensure the amount of risk involved is at your desired level. As stock performance can vary more dramatically than bonds, the percentage of assets associated with stocks will change with market conditions. Along with the performance variable, investors may adjust the overall risk within their portfolios to meet changing financial needs.

While there is no required schedule for rebalancing your portfolio, most recommendations are to examine allocations at least once a year. It is possible to go without rebalancing your portfolio, however, regular rebalancing is one way to maximize returns AND minimize risk.

Portfolio Rebalancing gives you the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced a lot of growth.

Calendar rebalancing is the most basic rebalancing approach. It can be done quarterly, annually, or every six months. This investment strategy simply involves analyzing your investment holdings within your portfolio at predetermined time intervals and adjusting to the original allocation at your desired frequency.

Monthly or quarterly assessments are typically preferred because weekly rebalancing would be overly expensive while a yearly approach would allow for too much portfolio drift.

The ideal frequency of rebalancing can be determined based on your time constraints, transaction costs, the options available through your custodian or 401k sponsor. A major advantage of calendar rebalancing over more responsive methods is that it is significantly less time consuming and costly for since it involves less trades and at pre-determined dates. The downside, however, is that it does not allow for rebalancing at other dates even if the market moves significantly. So, when the markets move significantly, you can take a more responsive approach to portfolio rebalancing.

Portfolio Rebalancing Summary

Rebalancing is the act of adjusting your portfolio asset weights in order to restore target allocations or risk levels over time.
There are several strategies for rebalancing such as calendar-based, corridor-based, or portfolio-insurance based.
Calendar rebalancing is the least costly but is not responsive to market fluctuations, meanwhile a constant mix strategy is responsive but more costly to put to use.

Rebalancing Retirement Accounts

One of the most common and important ways to rebalance are the allocations within your retirement accounts — remember The Perfect Investment? Hint, it starts with 401K. Asset Allocation impacts your overall performance and many investors prefer to invest more aggressively at younger ages and more conservatively as they approach retirement age. Often, the portfolio is at its most conservative as you prepare to draw out funds to supply retirement income.

Rebalancing for Diversification

Depending on market performance, investors may find a large number of current assets held within one area. For example, should the value of Tesla may increase by 25% while GM only gained 5%, a large amount of the value in the portfolio is tied to the Tesla stock. Should Tesla experience a sudden downturn, your portfolio will suffer higher losses by association. Rebalancing lets you redirect some of the funds currently held in Tesla to another investment (maybe Apple or Microsoft or McDonalds).

By keeping your funds spread out across multiple stocks — and multiple asset classes — a downturn in one will be partially offset by the activities of the others, which can help you maximize returns while minimizing risk over time.

Basic Asset Classes

In order to implement the 4 Investment Strategies outlined in today’s lesson, it is very important that you understand the differences between asset classes. There are many many different asset classes, sometimes referred to as “styles”:

US Large Cap
US Mid Cap
US Small Cap
International
US Government Bonds
US Corporate Bonds
Municipal Bonds
International Bonds
And the list goes on and on…

Quiz Review:

Diversification Summary