Investment Insights
As we enter a brand new year, this is the time to take a very close look at your investment portfolio and do your asset allocation in order to see how each one of your stocks - or mutual funds as the case may be - have performed with respect to their particular sector of the market. In the case of mutual funds however, you need only compare a given fund to its peer group, as well as the benchmark index to which it reflects.
Modern Portfolio Theory tells us that there are three (3) types of investors: a) Conservative; (b) Aggressive; and (c) Prudent types. And before you ever begin to make any investment, it is important to your success as an investor that you know with certainty exactly which type of investor you are, because this in turn has everything to do with your tolerance for risk. So let's briefly define each of these three investor types.
a. Conservative investors: these people think that stocks and bonds are really nothing more than other forms of gambling and therefore they seek safety primarily in CDs and in money market funds.
b. Aggressive investors: these people generally have brokerage accounts, usually with full-service brokers. They like double-digit returns, and they are always on the lookout for the next hot stock or mutual fund.
c. Prudent investors: of the three investor types, this group is the largest, and they generally fall in somewhere between the other two types. Prudent investors are rather conservative by nature, and yet they do want to earn a reasonable return on their investments so they are willing to take some risks, but only if the returns appear to justify the risk.
Asset allocation really isn't any more difficult than reading a recipe about how to bake a cake. You would do that with the expectation that by properly combining the various ingredients in the recipe and setting the oven at the recommended temperature, the end result will be the desired finished cake. And so it is as investors that we have faith in the financial markets as we separate our portfolios into clear-cut asset classes that we trust will flourish in the economic arena and thereby increase our bottom line over time.
The principal asset classes of choice for most investors are common stocks, bonds, and cash. And each class differs in risk, with stocks being the most variable, bonds less so, while cash generally maintains insignificant value due to the effects of inflation.
In setting up your portfolio, when choosing its long-term allocation to stocks and bonds, you need to consider the real return that you can expect to earn as well as the amount of risk to which that portfolio will be exposed in the course of achieving the desired return. Also, you must take into account the cost of investing because every dollar spent in management fees, broker commissions and the like, will serve to reduce your return, while at the same time increasing the risks that you must take.
Asset allocation comes with three different strategies: the fixed ratio strategy, the variable ratio strategy, and the tactical strategy.
Using the fixed ratio strategy, you would rebalance your portfolio to the desired stock/bond mix and do so approximately every year. This would involve selling off a portion of whatever class provided the highest return and then reinvesting the proceeds into the asset class with the lower return, thus maintaining the target balance.
The second strategy, the variable ratio, amounts to nothing more than simply letting the profits run without doing any rebalancing whatsoever. By doing that however, you would be exposing yourself to suffer the gyrations of the market, and the end result very probably would be a severely unbalanced portfolio that is much different in terms of risk and reward than the asset allocation you had initially.
The third strategy, tactical asset allocation, is very much like the variable ratio type except that it allows for a correction somewhere along the way should storm clouds appear on the investing horizon. This policy may actually produce somewhat better returns over the long run than either the fixed-ratio or the variable ratio strategies.
Summing it all up then, it should be clear that if your goal as an investor is to seek maximum returns with a minimum of risk, then you can become more comfortable with your investments if you will take the time to understand how the markets work, and by performing your asset allocation periodically, this will help you to better balance those factors that can influence your portfolio either for better or for worse.
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Modern Portfolio Theory tells us that there are three (3) types of investors: a) Conservative; (b) Aggressive; and (c) Prudent types. And before you ever begin to make any investment, it is important to your success as an investor that you know with certainty exactly which type of investor you are, because this in turn has everything to do with your tolerance for risk. So let's briefly define each of these three investor types.
a. Conservative investors: these people think that stocks and bonds are really nothing more than other forms of gambling and therefore they seek safety primarily in CDs and in money market funds.
b. Aggressive investors: these people generally have brokerage accounts, usually with full-service brokers. They like double-digit returns, and they are always on the lookout for the next hot stock or mutual fund.
c. Prudent investors: of the three investor types, this group is the largest, and they generally fall in somewhere between the other two types. Prudent investors are rather conservative by nature, and yet they do want to earn a reasonable return on their investments so they are willing to take some risks, but only if the returns appear to justify the risk.
Asset allocation really isn't any more difficult than reading a recipe about how to bake a cake. You would do that with the expectation that by properly combining the various ingredients in the recipe and setting the oven at the recommended temperature, the end result will be the desired finished cake. And so it is as investors that we have faith in the financial markets as we separate our portfolios into clear-cut asset classes that we trust will flourish in the economic arena and thereby increase our bottom line over time.
The principal asset classes of choice for most investors are common stocks, bonds, and cash. And each class differs in risk, with stocks being the most variable, bonds less so, while cash generally maintains insignificant value due to the effects of inflation.
In setting up your portfolio, when choosing its long-term allocation to stocks and bonds, you need to consider the real return that you can expect to earn as well as the amount of risk to which that portfolio will be exposed in the course of achieving the desired return. Also, you must take into account the cost of investing because every dollar spent in management fees, broker commissions and the like, will serve to reduce your return, while at the same time increasing the risks that you must take.
Asset allocation comes with three different strategies: the fixed ratio strategy, the variable ratio strategy, and the tactical strategy.
Using the fixed ratio strategy, you would rebalance your portfolio to the desired stock/bond mix and do so approximately every year. This would involve selling off a portion of whatever class provided the highest return and then reinvesting the proceeds into the asset class with the lower return, thus maintaining the target balance.
The second strategy, the variable ratio, amounts to nothing more than simply letting the profits run without doing any rebalancing whatsoever. By doing that however, you would be exposing yourself to suffer the gyrations of the market, and the end result very probably would be a severely unbalanced portfolio that is much different in terms of risk and reward than the asset allocation you had initially.
The third strategy, tactical asset allocation, is very much like the variable ratio type except that it allows for a correction somewhere along the way should storm clouds appear on the investing horizon. This policy may actually produce somewhat better returns over the long run than either the fixed-ratio or the variable ratio strategies.
Summing it all up then, it should be clear that if your goal as an investor is to seek maximum returns with a minimum of risk, then you can become more comfortable with your investments if you will take the time to understand how the markets work, and by performing your asset allocation periodically, this will help you to better balance those factors that can influence your portfolio either for better or for worse.
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posted by Bob Moser at
6:24 PM
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