The following blog post is an excerpt of the WorthPointe e-book, The Informed Investor. We created The Informed Investor to show you a Nobel Prize–winning approach crafted to optimize your investment portfolio over time. We have designed it specifically to not only support you in your efforts to preserve what you already have, but to also efficiently capture the market’s returns for your investments. Receive a complimentary copy.
While investing can at times seem overwhelming, the academic research can be broken down into what we call the Five Key Concepts to Financial Success. If you examine your own life, you’ll find that it is often the simpler things that consistently work. Successful investing is no different. However, it is easy to have your attention drawn to the wrong issues. These wrong issues—the noise— can derail your journey.
Concept One: Leverage Diversification to Reduce Risk
Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. That’s a very simplistic view of diversification, however. It can also get you caught in a dangerous trap—one that you may already have fallen into.
For example, many investors have a large part of their investment capital in their employers’ stocks. Even though they understand that they are probably taking too much risk, they don’t do anything about it. They justify holding the position because of the large capital gains tax they would have to pay if they sold, or they imagine that the stocks are just about ready to take off. Often, investors are so close to particular stocks that they develop a false sense of comfort.
Other Investors believe that they have effectively diversified because they hold a number of different stocks. They don’t realize that they are in for an emotional rollercoaster ride if these investments share similar risk factors by belonging to the same industry group or asset class. “Diversification” among many high-tech companies is not diversification at all.
Concept Two: Seek Lower Volatility to Enhance Returns
If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return.
For example, let’s assume you are considering two mutual funds. Each of them has had an average arithmetic rate of return of 8 percent over five years. How would you determine which fund is better? You would probably expect to have the same ending wealth value.
However, this is true only if the two funds have the same degree of volatility. If one fund is more volatile than the other, the compound returns and ending values will be different. It is a mathematical fact that the one with less volatility will have a higher compound return.
Concept Three: Use Global Diversification to Enhance Returns and Reduce Risk
Investors here in the U.S. tend to favor stocks and bonds of U.S.-based companies. For many, it’s much more comfortable emotionally to invest in firms that they know and whose products they use than in companies located on another continent.
Unfortunately, these investors’ emotional reactions are causing them to miss out on one of the most effective ways to increase their returns. That’s because the U.S. financial market, while the largest in the world, still represents less than half of the total investable capital market worldwide. By looking to overseas investments, you greatly increase your opportunity to invest in superior global firms that can help you grow your wealth faster.
Concept Four: Employ Asset Class Investing
It is not unusual for investors to feel that they could achieve better investment returns, if they only knew a better way to invest. Unfortunately, many investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors. It’s often the case that using actively managed mutual funds is like trying to fix a sink with a screwdriver when you really need a pipe wrench. You need the right tools, and we believe that asset class investing is an important tool for helping you to reach your financial goals.
Concept Five: Design Efficient Portfolios
How do you decide which investments to use and in what combinations? Since 1972, major institutions have been using a money management concept known as Modern Portfolio Theory. It was developed at the University of Chicago by Harry Markowitz and Merton Miller and later expanded by Stanford professor William Sharpe. Markowitz, Miller and Sharpe subsequently won the Nobel Prize in Economic Sciences for their contribution to investment methodology.
The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting. It’s important to remember that math is nothing more than an expression of logic, so as you examine the process, you can readily see the commonsense approach that it takes–which is counterintuitive to conventional and over-commercialized investment thinking.
Read the full chapter in The Informed Investor.
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