Investing

Why do we invest? If we know that we can essentially make risk-free investments by purchasing FDIC insured Certificates of Deposit or U.S. Treasuries, why do anything else? Why risk losing money? The only logical reason for assuming the risk of losing money is to gain the potential to earn a higher rate of return than you can in the risk-free investments. Please note that the key word in the previous sentence is “potential”. Once we leave the world of “guarantees” to seek higher returns by investing in the world’s financial markets, we assume some level of risk and uncertainty.

Is it worth it? That’s a question that deserves serious thought. We believe that you can best help yourself answer that question by going through a careful FINANCIAL PLANNING process. This approach can help you decide what portion of your assets, if any, you should expose to the financial markets of the world.

Strictly from a numbers point of view, it’s no mystery that higher annual returns make quite a difference over time. The chart below is a hypothetical illustration of the growth of $10,000 at several rates of return over a 20 year time frame. [This is simply an exercise to illustrate the result of higher returns, not the actual performance of any specific investment. Past performance in no way guarantees future investment results.]

Perhaps this simple chart uncovers the reason we have an appetite for risk in the first place. That is, we don’t have an appetite for risk ... we have an appetite for returns!

Regardless of our financial goals, needs and desires, we invest to achieve a rate of return that exceeds what we can earn in a safe-money, guaranteed investment … knowing all the while that as we seek higher returns, we assume some level of risk.

We believe that to best achieve long-term investment success, portfolio construction and maintenance efforts should focus on 4 main areas:

It’s important to remember that unfortunately, none of this guarantees investment results. Our hope is to build a portfolio that offers us the best chance for success.

Risk

A client’s level of risk tolerance is a critical factor in the investment management process. Investments are made in an effort to achieve financial goals, yet the rate of return the investment will produce is unknown and unpredictable. This uncertainty is one way of defining risk. Here are some others:

• Risk is perhaps most often viewed as volatility, or how dramatic and frequent the ups and downs in the investment are.
• Risk might be looked upon as the probability of a bad end result. The potentially damaging effect to your personal financial future if you’ve failed to protect your principal or earn a rate of return sufficient enough to achieve your goals.

A practical rule of thumb is that as you seek higher returns, you assume additional risk, and vice-versa.

Perhaps the greatest challenge in building any investment portfolio is striking a balance between a desirable rate of return and a level of risk or volatility one can live with.

How do we deal with risk? Investors have long recognized the benefit of balancing risk by dividing assets among major asset categories such as Stocks, Bonds, and Cash equivalents. Because different investments often react differently to economic and market changes, diversifying among investments that focus on separate and distinct segments of the market can help reduce volatility, and also has the potential to enhance overall returns.

Asset Allocation

Asset Allocation is the process of creating a portfolio that combines different assets in varying proportions.

What’s an “asset” or “asset class”? Investments can be grouped together into classes based on a very broad or very narrow set of common characteristics. And although there are many, the investment community recognizes Stocks, Bonds, and Cash & Equivalents as major asset classes.

Grouping assets into classes is useful because it allows us to gather historical data on the performance and volatility measures from each asset class. And although there is no guarantee that history will repeat itself, this information can be valuable when constructing a portfolio by providing a profile of how dramatic (or not) the ups and downs might be, and how different assets performed under certain market conditions.

This information also reveals assets with low correlations – meaning those assets that performed quite differently from one another over varying market conditions. Building a portfolio combining assets with low or even negative correlations can reduce volatility and may also improve investment results.

Important portfolio management studies and our real world experience offer strong evidence that asset allocation is a significant factor contributing to overall portfolio performance.

The goal of asset allocation is to find a combination of investments that provide you with a desirable rate of return, and a level of risk or volatility you can live with.

As an example, an asset allocation schedule may call for you to direct 55% of your investments into stocks, 35% into bonds, and 10% into cash or money markets.

Diversification

Let’s start with the saying we’ve all heard before: “Don’t put all your eggs in one basket”. Diversification is a strategy that makes a portfolio less dependent on the performance of any one investment, and can be used in an effort to reduce risk and volatility, and improve the overall results of your portfolio.

Diversification is not achieved or defined simply by the number of investments you own, but much more critically, by the different types of investments you own. For instance, the example above calls for 55% of the portfolio to be invested in Stocks. Rather than investing the entire 55% in just one area, a diversified portfolio may put some portion of that 55% in large “blue-chip” stocks, another portion in stocks of smaller companies, some in foreign stocks, and so on.

Rebalancing

Your Asset Allocation schedule represents your portfolio’s “base setting”. Built with your objectives in mind, it clearly defines what percentage of the portfolio will be invested in certain assets. However, the selected investments will almost certainly change in value at different rates. For instance, Stocks may perform notably better or worse than Bonds over a given period of time. As a result, the percentage of the overall portfolio each investment represents will change on a regular basis. Rebalancing is the process of making adjustments (buys and/or sells) to the portfolio to bring the asset allocation schedule back to its “base setting”.

If left untended, after periods in which the assets you own perform significantly different from one another, your portfolio may end up with a risk/reward profile that is quite different from its original design.

The charts below illustrate how a portfolio may take on a different shape after periods in which Stocks either significantly outperformed, or underperformed Bonds and Cash.

[Back to Top]

Looking for a CERTIFIED FINANCIAL PLANNER^TM in Orlando? GO