Basic Investment Principles can Help Build Portfolio

Recently published in the Denver Business Journal, Volume 59, Number 27, December 28, 2007-January 3, 2008, (Denver Business Journal), by Richard M. Todd. A reprint of the article may be found at the Innovest Website (Reprint).

At times, we make investing too complicated. If you follow some basic tenets, you'll be a successful investor.

Here they are:

  • Determine your objectives -- Most investors have no problem determining their broad portfolio objectives, such as capital preservation, retirement, education funding, etc.
    Theoretically, the longer your time frame, the more aggressive (more in stocks) you can be. However, investors can be emotional and -- especially in difficult markets -- make crucial investment mistakes. Therefore, it's important to quantify the downside risk that you can tolerate in a short period of time. This will help determine the amount of conservative investments that should be in your portfolio.

    Although investment-grade bonds don't look like an "opportunity," the worst year for the Lehman Aggregate Index was in 1992, when it lost 2.92 percent. That pales in comparison to some of the worst years in the stock market. Bonds are a preservation tool, typically not an "opportunity."

  • Focus on portfolio design -- Studies show that most of the variability of price performance is attributable to asset allocation.

    A simple example to put this into perspective: You decide to invest with a large-cap equity manager. A year later you returned 10 percent in the investment while its benchmark, the S&P 500, gained 9 percent. Therefore, nine-tenths of the reason you made the 10 percent was your decision to invest in large-cap stocks.

    The overall portfolio allocation should be based on your objectives, which will determine the mix between conservative investments and higher-risk ones.

  • Pay attention to costs -- The portfolio cost is a direct reduction of portfolio returns.

    Commissions and sales expenses can be costly as well, and can be difficult to uncover. Often, they're buried in the internal expenses of an investment product.

    Take advantage of low-cost institutional products that can be made available to even small investors. For some strategies, passive management (indexes) can work well, but aren't a panacea.

    There are passive product peddlers who oversell index-based products. Investors must beware of biases in these products. For instance, "value" indexes recently have been crushed by large concentrations in financial stocks.

    Taxes are a direct portfolio cost. Individuals should prefer products and strategies that are sensitive to the taxable investor. Managers who defer portfolio gains until the next year -- and/or who create long-term capital gains over short-term ones -- should be favored.

  • Focus on consistent managers -- When reviewing investment performance, don't get too caught up with cumulative results. Instead, examine how managers have performed against their benchmark (make sure the benchmark is correct) for one year. A batting average of 70 percent or more is exceptional.

    Make sure the investment fund/manager's organization is stable, and the management team has been in place for some time.

  • Review and re-balance portfolio -- Once the design is established, review portfolio allocation on a consistent basis (preferably quarterly). The markets will take portfolios away from the original allocation, and studies have shown that periodic and consistent re-balancing can add 0.5 percent to 1 percent per year in performance.

    However, don't arbitrarily rebalance with taxable accounts. Make certain that the sales create long-term capital gains, not short-term gains. If not, revisit the impact of delaying re-balancing of the overall risk/return characteristic relative to your goals. It may make sense to delay the rebalancing until a long-term gain is created.

    We prefer putting ranges (typically plus or minus 3 percent) around your asset allocation target and rebalancing once a portion falls outside the range.

  • Focus on an income budget, not income -- For investors who are living off their assets, one school of thought has been to clip coupons from bonds to generate the necessary income. The current low-interest-rate environment has wreaked havoc on the income of investors using this strategy.

    Instead, determine what your income needs are and take a reasonable (generally 5 percent or less) amount from the portfolio by using rebalancing and tax-savings techniques. Take distributions from assets that are overweight relative to your target, take principle when possible to avoid taxation and favor long-term capital gains over taxable income and short-term gains.

    A disciplined portfolio can be built using the basic principles described here, and should produce a better inflation hedge and more consistent income over time.

Investors who make mistakes usually haven't followed one or more of these basic investing principles. By using them, they can dramatically improve the odds of success. Whether a high-net-worth investor or an institution, these investment principles can apply, and also will help ensure sound stewardship.