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Given the recent financial markets collapse and the on-going U.S. Government’s budget troubles, it is not difficult to understand why hesitant investors are still holding significant cash reserves at a time when they should be considering long term equity investments. When an investor asks the question,
“What investments should I choose?” the question is often not asked as a market timing question, but a question of “How do I deal with the complexities of the market mechanics?”
For instance, how many different investment options does the average investor have available to them today? Now stop and think about an actual number…. Think about how many different US and Global stocks, US and Global mutual funds, US Separately Managed Accounts and US Exchange Traded Funds exist today that the average investor could review and use in portfolio construction.
Let’s look at a brief summary of investment options:
- US ETF’s 1,510
- US Separately Managed Accounts 6,873
- US Stocks 16,825
- US Mutual Funds 27,659
- Global Mutual Funds 53,974
- Global Stocks 94,244
When you combine the number of these investment options, you would have 201,085 different investment options to choose from! On the other hand, you can’t just add them up, you need to build a diversified portfolio too…. Thus, if you were to just take the smallest category from the above list, US ETF’s, set a limit of 15 ETF’s to be included in your diversified portfolio, then select your favorite portfolio, you would still have 345,031,052,000,000,000,000,000,000,000,000,000 different portfolio options to choose from!! Yes, the math is correct!! Now imagine how many unique portfolio options would exist if you included all 201,085 available investment options to create your 15 investment portfolio!!!!! The number is mind boggling!
So now let’s deal with some big ideas, not just big numbers. Simply put, I truly think that investors need to simplify their investment process so that they can understand that process and be comfortable with the long term results that are produced. In order to start an investment process there are six aspects that every non-professional investor needs to know:
- Be able to define, describe and quantify your personal risk tolerance before you start to invest so that you can establish the proper asset allocations. For instance are you a 70/30 stock and bond risk profile, the overall portfolio you construct should be comprised of 70% stocks and 30% bonds. You then have to divide those two large allocations in to sub categories. For instance, your stock portfolio needs to include Large-Cap, Mid-Cap, Small-Cap, Micro-Cap, International, and Emerging stocks which then need to be sub-divided into Growth or Value categories. You truly need to understand that the money you are investing is your risk capital and for you to be a successful long-term investor these funds need to be widely diversified and invested for five to ten years at a minimum for the diversification to be maximized over a market cycle. Take a long-term perspective and rebalance the portfolio allocations at least annually.
- Remove or suppress your emotions from the investment process. The greed factor loves up markets and the fear factor can’t tolerate a falling market. Both factors will misguide you over the long haul and encourage you to become an inefficient short-term day trader.
- Create an investment allocation and monitor it in order to become familiar with how your assets respond to various market conditions. Gradually rebalance this allocation as markets change and you become more comfortable with the benefits of rebalancing. When you rebalance you are selling the categories that have grown (sell high) and buying back the categories that have shrunk (buy low) to maintain your constant risk profile.
- Know all your costs of investing. Make sure you know the costs of each investment alternative because cost is one of the few items that you can fully control. These costs should include the internal investment costs of a mutual fund, trading and custody costs, manager costs, and the cost of an independent advisor if you are using one. All of your costs should be fully set forth and transparent before you invest a single dollar in any investment option. Remember, the higher the total costs of the portfolio, the greater the annual return necessary just to pay these costs. In a low return environment, your diligent cost control is an absolute necessity.
- Finally and most importantly, find a professional, independent, fee-based, and knowledgeable advisor with the experience and professional designations (CFP, CFA, CAIA, CPA, AWMA, etc.) to advise you. And no, this is not a shameless commercial for my profession; I personally do consult doctors, lawyers, accountants, florists, mechanics, and carpenters when important information is needed in my life. You should do the same when it comes to investments! Consider financial expertise at least is on a par with a level floor or a modest cardiac surgery. I truly believe that consulting a fully qualified financial professional is a critical step because, “you don’t know what you don’t know”. The professional’s knowledge and experience will be invaluable and well worth their professional fee. Studies have shown that an investment professional’s contribution in after tax savings and reduced portfolio volatility more than offset their advisor fees. In addition, remember to think long-term, because if something suddenly happens to you, that knowledge, financial plan and relationship you have established, is now directly helping to take care of your most valued asset…your family’s economic well-being during a challenging time and beyond.
I hope you found my professional insights valuable and helpful as you begin your process to invest and decide, “Which investment should I choose?”