Guide to Investing

Importance of Investing

Understanding Investments

The most important, and often the most difficult, part of planning for retirement is saving. Putting a small portion of your paycheck into a 401(k) or savings account each month and accumulating what appears to be a large sum of money is often the plan of attack for most individuals. However, as pension plans slowly diminish, the deficit in the social security program increases, and the cost of living continues to rise, those retirement savings have a tough time supporting your family once the paychecks stop. Therefore, it is paramount to combine a consistent savings plan with an effective investment strategy that will allow the power of compounding to grow your retirement portfolio to levels that are sufficient and sustainable.

ASSET ALLOCATION

Consistent, year over year growth of your portfolio is attainable, but it must be managed correctly. Asset allocation is essential when investing on your own. Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in the portfolio according to the investor’s risk tolerance, goals, and time frame. Investing your portfolio today and letting it sit forever (buy and hold) is an approach that many use. It is certainly more effective than not investing at all. But, wouldn’t you like to maximize the growth of your portfolio over an extended period of time? If so, effective asset allocation is required.

Your portfolio should consist of a variety of asset classes, each weighted in a manner that coincides with your risk level and time horizon. Understanding the risks and opportunities of each type of investment in each asset class will allow you to allocate your portfolio most effectively. Are you seeking maximum growth or a portfolio that provides income? If you are younger and seeking long-term growth, a portfolio weighted more heavily to equities would be recommended. However, which type of equities – large cap, small cap, international? If you are retired and seeking some additional income to supplement social security, your portfolio is likely more heavily weighted to bonds. Which bonds are most appropriate for you – treasuries, corporates, or municipals? Each has their specific benefits that should be understood.

Bottom line: Asset allocation is the most important decision that an investor will make. While the selection of specific securities (stocks or bonds) can have a significant impact on your returns, establishing the correct blend of asset classes and weighting your portfolio among them accordingly is undeniably the most vital.

Types of Investments

Determining the Best Investments For Your Goals

Once you have determined your asset allocation mix, it is time to determine the best investment vehicle to achieve your investment goal. The four primary instruments used when constructing your portfolio include: Stocks, Bonds, Mutual Funds, and ETF’s.

Type of Investment Defintion
Individual Stocks A type of security that signifies ownership in a corporation, thus providing a claim on a portion of corporate profits and earnings.
Individual Bonds A debt instrument in which an investor loans money to an entity for a defined period of time at a specified interest rate.
Mutual Funds An investment vehicle comprised of a pool of funds that are invested in a collection of securities such as stocks and bonds. Each has a specific strategy which typically determines the underlying asset classes & holdings. The collection of holdings is priced at the end of the day as the net asset value (NAV).
ETF’s A marketable security that tracks a specific index, commodity, or basket of assets. It is priced and traded real time, similar to a stock (unlike a mutual fund).

Advantages/Disadvantages

Breakdown of Investments

Type of Investment Advantages Disadvantages Best Suited For
Individual Stocks
  • Source of long-term growth
  • Income generation through dividends
  • Inexpensive investment expense
  • Tax-efficient
  • Potential for increased volatility
  • Increased risk of loss in short-term
  • Long-term or aggressive investors
  • Investors seeking growth
  • Retired investors seeking income
Individual Bonds
  • Reduced volatility
  • Preservation of capital
  • Income generation through interest
  • Inexpensive investment expense
  • Tax-efficient
  • Low potential for growth
  • Negatively impacted by low interest rates
  • Short-term or conservative investors
  • Investors seeking capital preservation
  • Retired investors seeking income
Mutual Funds
  • Access to professionally managed, diversified portfolios for small investors
  • Access to a variety of different investment strategies and asset classes
  • Growth and income capabilities, depending on objective of selected fund
  • Expensive underlying investment expense, potential for up-front sales charges/load, tax-inefficient
  • Subject to market and/or interest rate risk depending on objective of selected fund
  • Inexperienced investors, smaller investors
  • Variety of investors depending on specific strategy of fund
  • Short or long-term investors
ETF’s
  • Daily liquidity
  • Inexpensive investment expense
  • Ease of achieving diversification
  • Tax-efficient
  • Not actively managed
  • Potentially higher trading costs
  • Inexperienced investors, smaller investors
  • Passive investors
  • Long-term investors

Styles of Investing

Determining the Investing Style For You

ACTIVE

Active management involves the use of a human element in investing, such as a portfolio manager. Initial asset allocation is constructed to match the risk tolerance and objectives of the investor. However, ongoing research and analysis is conducted to find inefficiencies in the market and the pricing of securities. As opportunities arise, the asset allocation may shift and changes will be made to the portfolio – likely into different asset classes or securities. Active management can occur on two levels: mutual fund and advisor.

Most mutual funds are actively managed by a portfolio manager and his/her team of analysts. Daily, extensive analysis is done with the goal of uncovering the next investment opportunity. While the fund is restricted by its pre-determined strategy (ex. U.S. Large Cap), adjustments to the holdings of the mutual fund occur regularly. The goal of actively managed mutual funds is to outperform the benchmark, such as the S&P 500. Actively managed mutual funds are more expensive (expense ratio) than most vehicles as the expertise of the portfolio management team is not free of charge.

Active management can also be found at the financial advisor level. Typically through the analysis of an investment committee, financial advisors provide active management to a client’s asset allocation. Advisors use a variety of investment vehicles when allocating a client’s portfolio, such as mutual funds, individual stocks, individual bonds, and index funds/ETF’s. The combination of these generates a well-diversified portfolio. However, every investment instrument is subject to some form of risk, so the advisor and his/her investment committee must actively monitor the markets and the investments in their portfolios to determine if the risk is worth the reward. While maintaining a long-term view, changes are made throughout the year in an effort to limit the downside and maximize the returns of the portfolio.

PASSIVE

Passive management is the opposite of active management in that the objective is not to outperform a specific benchmark or sector, but to mirror it. Passive investors believe the market is efficient, meaning that all information and analysis is reflected in the current price of the markets and consistent, new opportunities are not regularly available. Because this form of investing does not require a team of analysts to actively manage the fund, index funds are typically much less expensive to purchase and own. Passive funds essentially are “buy and hold” investments; therefore, the turnover of the underlying positions is minimal, which results in a much more tax-efficient vehicle.

WHICH IS BETTER?

Determining which investment style is best is difficult to do and often depends on who you ask and their investing philosophy. If predictability of returns, low-cost, and tax-efficiency are priorities, or if you believe the market is truly efficient, then passive investments are most suitable for you. If you are not satisfied with identical returns of the stock market or a specific sector (upside and downside) and prefer to have a team managing your money in an effort to protect on the downside and maximize the upside, then an active strategy is more fitting for you. However, many investors will utilize both styles in conjunction.

The passive piece of the portfolio will provide predictability of returns, which for retired investors tends to be a priority. The actively managed component of the portfolio will provide the “alpha” to the overall account, thus limiting the downside or providing additional upside depending on the specific market environment. Alpha is a measure of performance on a risk-adjusted basis. The outperformance against a market benchmark leads to alpha, which combined with some passive investments will provide an investor with a portfolio that is less volatile, but potentially greater upside/lower downside than the general market.

Investment Strategies

Investment Strategies for All Ages

An investor’s objectives, risk tolerance, and time horizon are essential in crafting an investment strategy that is suitable. Younger clients, who are in the midst of their careers, typically prioritize maximum growth in their portfolios, whereas an older, retired client focuses more on capital preservation and the generation of supplemental income. However, career status and age do not always determine your long-term portfolio goals. A younger investor may prefer to preserve capital with modest growth in their portfolio in order to save up for a new house purchase. Or, a retired investor with a pension that covers living expenses may want to achieve maximum growth over their lifetime to leave a legacy for their descendants. It is important to truly understand your financial situation, the level of risk you are willing to take on, and your ultimate goal for the portfolio. Often, a balanced portfolio that is positioned for growth and income is the solution.

GROWTH

A growth investor has a long-term time horizon (10 years or longer), an aggressive appetite for risk, and a goal of maximizing growth and accumulation in the portfolio. Whether you are 25 or 55 is irrelevant – the presence of the aforementioned factors will result in a portfolio that is geared for growth. A growth portfolio is weighted more heavily to equities (stocks). Equities are an extremely broad asset class that consists of many types which vary based on the size and geographic location of the geographic location.

Types of equities include:

  • S. Large Cap
  • S. Mid Cap
  • S. Small Cap
  • International – Developed
  • International – Emerging Markets
  • International Small Cap
  • Real Estate (REIT)

Each type of equity has certain characteristics and features that could lead to inclusion in a growth portfolio. Contrarily, each has specific risks that may cause an investor to avoid them. However, many growth-oriented portfolios will have a combination of most, if not all of these types of equities. Due to the differences in each type, a portfolio consisting of them all would be highly diversified. While growth portfolios are more heavily weighted to stocks, they often will include a portion, albeit small, in fixed income (bonds). The allocation to fixed income is used to limit the volatility that comes with stocks, while providing a small level of regular income (via bond interest) to the portfolio. Typical growth portfolios will have 80% or more in equities, with the balance in fixed income and/or money market funds.

PRESERVATION & INCOME

An income investor has a short to mid-term time horizon (1-10 years) or a specific goal of generating regular income from the portfolio. These investors tend to have a more conservative approach and are risk-adverse. Age is not a primary driver for these investors; rather the need for supplemental income or the goal of capital preservation is present. With that being said, the majority of investors focused on preservation and income are retired or elderly. An income portfolio is weighted more heavily to fixed income (bonds). Like equities, bonds are an extremely broad asset class that consists of many types which vary based on the issuing entity, the geographic location and the length of time to maturity.

Types of bonds include:

  • Government
  • Corporate
  • Municipal
  • Mortgage-backed
  • International – Developed
  • International – Emerging Markets

Each type of bond has certain characteristics and features that could lead to its inclusion in a conservative portfolio. Similar to stocks, each has specific risks or tax implications that may result in their exclusion. For example, a municipal bond is tax-free, while a corporate bond is taxed as ordinary income. High income earners may elect a lower yield that is tax-free vs. paying income tax on a bond paying slightly more. Proper analysis is crucial to ensure your portfolio is designed and allocation most appropriately for your specific situation. Many income-oriented portfolios will have a combination of multiple types of bonds to achieve a certain level of diversification in the portfolio. While income portfolios are more heavily weighted to bonds, they may include a small portion to equities. The typical equity in a preservation/income-oriented portfolio is U.S. Large Cap because of their propensity to pay a dividend (insert link to blog on dividend), which can serve as another form of income to the investor and considered a more conservative stock. The allocation to dividend-paying equities provides some growth potential while satisfying the primary goal of income generation. Typical income portfolios will have 70% or more in fixed income, with the balance in conservative, dividend paying stocks.

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