Fundamentals of Investing

by Kent E. Irwin

Investment management seems to hard to understand, but it doesn’t have to be. We will examine the three different investment management methods, as well as risk and asset classes. We will also discuss practical steps to begin constructing your investment portfolio.

This is the first in a series of three articles on Investment Management; please read all three articles.

Fundamentals of Investing

“How do I Investment My Money?

Understanding Investment Accounts

“Now that I understand how to invest, I’m confused by all of the different  investment buckets like IRAs, 401(k)s, 529s and non-qualified accounts. What does this all mean?”

Investing – Do it Yourself?

“Should I hire an investment advisor or do It myself?”

Investment Management Defined 

Investment Management has sometimes been defined as:

Managing assets and resources in relationship to your personal and financial goals, in order to most efficiently accomplish desired results.

Achieving financial goals involves the use of many techniques, financial concepts, and tools. Perhaps one of the most important is the proper use of savings, investments, and retirement accounts. During your financial life you will accumulate funds from various sources, including savings, your surplus income, inheritances, gifts, company contributions to retirement accounts, and other types of financial resources.

Since savings and investment accounts are acquired over a broad timeframe, it is not unusual to find that the funds have been put into savings or investment accounts with inadequate thought as to how the various accounts relate to each other, or how they fit with your own long-term goals for financial success.

One objective of any financial plan is to determine the proper mix of asset types, classes, or groups. In order to achieve the desired results for your financial future, it may be prudent to consider repositioning assets from an existing account to other accounts that more appropriately match your goals and comfort level.

The Three Investment Methods[i]

Every investment decision uses one or more of the following, and every investor should be aware of how they work.

Security Selection

Security selection is deciding which stock or bond to purchase or sell. This gets the most attention in the media because it is interesting. Business news shows like to highlight stock pickers from Wall Street who talk about up-and-coming companies.

In order to be a good stock picker, careful evaluation of which stock to purchase is required. The goal, of course, is to purchase low and sell high. In order to make good decisions, you need a lot of information about all stocks. Security selection is challenging because of the large number of stocks that are available to purchase. Secondly, it is difficult to find accurate, up-to-the-minute information about companies, and the information becomes quickly outdated. In addition, a lot of knowledge and experience are required to be able to process and interpret the information. Investment skill requires understanding and knowledge of economics, demographics, accounting, corporations, industries, and countries, to name a few.

Great stock pickers are hard to find; however, if you do your research you will find the minority of stock pickers who have consistently beat their respective index. Stock pickers can be stockbrokers who sell stock. Or they may be private money managers who usually have a staff of research people who pick stocks for clients. Investors are required to give them a minimum amount of money to invest. Mutual fund companies employ a large staff of expert researchers and analysts to help them pick securities.

Market Timing

Market timing is seeing where a market or security currently is, and then betting where it may be going, and when. To win at market timing, accuracy of over 60% of the time is required to cover the losses caused by mistakes of the other 40%. It is not 50/50 because of commissions, taxes, and other transaction costs associated with trading securities. You have to be right in all four decisions: what to buy, when to buy it, what to sell, and when to sell it. A mistake in any of these may eliminate the gains in the other three. Very few market timers have shown a consistent track record of being correct more than they are incorrect.

Asset Allocation

Asset allocation is based on the famous and comprehensive study by Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower in 1991. They found that over 91% of long-term portfolio performance is derived from the decisions made regarding asset allocation, and not market timing or security selection. [ii] 

You don’t hear that much about asset allocation in the media, since it is boring and it doesn’t make exciting news. In addition, it is sure to draw a yawn at a cocktail party as compared to a hot new stock you may have heard about.

Asset allocation means that money in a portfolio gets divided up between the different asset classes. Most investments can be categorized into one of four asset classes: stocks, bonds, tangibles (things you can touch), and cash. There are dozens of asset classes in the U.S., and most also have mirror images in the foreign markets.

An asset allocation should be tailor-designed for each investor based on their comfort level of risk and volatility, the rate of return they hope to achieve and their individual goals.

Your eFinplan financial plan has an Investment Discovery Questionnaire. After completing the questionnaire, you will discover which of the five most commonly used investment risk tolerance categories fits you best. Your investment advisor should refer to this and utilize his/her own questionnaire to help you arrive at the risk tolerance that is best suited to you.

Risk

In every aspect of life, we are faced with varying degrees of unknown outcomes. These uncertainties in life are sometimes referred to as areas of "risk". In particular, financial matters are commonly described as either "safe" or "risky" or somewhere in between the two extremes.

It is important to recognize that the term "risk" can refer to more than simply the loss of your money. Some of the different examples of these risk areas are described below. 

Loss of Principal

Imagine that you have $10,000 invested in a stock, the stock declines in value to $5,000, and you sell the stock, then you have suffered a loss of principal. On the other hand, if you do NOT sell the stock while the value is down, and the stock recovers to $10,000, then you have not suffered a loss. Time and diversification are keys to mitigating this type of loss.

Loss of Purchasing Power

If you own a $10,000 certificate of deposit earning 5% interest, you will receive $500 per year interest. Since the account is insured by the FDIC, and the interest is guaranteed for a set timeframe, this may seem like a "safe" investment. If we experience inflation at the rate of 3% per year, the purchasing power of the $500 income will be reduced after the first year to $485, and after 10 years to $372. The purchasing power of the $10,000 after 10 years will be reduced to $7,441. This loss is a permanent one with no chance for recovery unless our economy goes into a protracted deflationary cycle.

Tax Loss

Using the same $10,000 as above, and assuming you are in the 25% tax bracket, the $500 interest would be reduced to $375 after taxes. After 10 years, the $500 interest after taxes and inflation would provide purchasing power of only $277.

Liquidity

If you place all or most of your financial assets into liquid assets (like real estate, mortgages or notes, small business interests or even tax-deferred retirement accounts with severe early withdrawal penalties), you may find that you no longer have control of your financial future. If your personal financial affairs take a turn for the worse because of a disability, loss of employment, death in the family or any other unforeseen event and you cannot readily reposition your assets to meet your new needs, then you are exposed to the risk of not being in control of your financial wellbeing.

Although there are other types of risk that could be considered, the above examples illustrate that it is important to properly plan and balance your financial assets so that all possibilities are considered.

Asset Classifications

Most portfolios contain cash, stocks, and bonds. Some investment advisors construct the portfolio to include tangibles (things you can touch).

Index Investing

Because of the popularity of index funds, any discussion about investing should include them. Index Mutual Funds are those Mutual Funds that invest only in the securities that are in the index. For example, the Standard and Poors 500 Index Funds offered by many mutual fund companies invest in only those 500 companies represented in the index. The research has clearly established that investing in Index Mutual Funds will outperform most stock pickers. Does this mean that you should only invest in Index Funds? Some very smart people have concluded this; however, consider:

n

Some mutual fund managers have consistently out-performed their respective index

n

Some mutual fund managers have consistently out-performed their index or have performed nearly as good, but have invested in securities that have less risk and volatility than the index

n

Investing in a portfolio of mutual funds may provide more diversification

Summary

The following are simple steps to begin implementation of an investment plan that is suitable for you. (Remember, eFinplan does not sell investments, this is just basic information to assist you in your education of investing). First, you should decide which investment method you prefer: Asset Allocation, Stock Picking, or Market Timing. If you are doing asset allocation, follow these steps to begin the process:

1.

Complete a financial plan to determine your goals and asset allocation.

2.

Decide if you want to use index funds or investments selected by an investment advisor.

3.

Find an investment advisor. Be sure to have them provide information regarding:

a.

Philosophy of investing: Security Selection, Market Timing, or Asset Allocation

b.

Investment Profiling: Methods to determine how they construct a portfolio for you

c.

Investment Policy Statement (IPS): Some investment advisors will construct an IPS for every client

d.

Investment Selection Process: Policy, methodology, and systems for selecting investments

e.

Investment Performance: They may or may not be able to provide this for you. It depends on how they construct portfolios and how the security regulatory agencies permit reporting.

4.

Reallocate investments into the funds chosen according to your asset allocation and investment policy statement. Evaluate tax exposure to changes prior to re-allocation.

5.

If you have funds in an employer-provided retirement plan, reallocate current balances and future contributions into those funds that fit your asset allocation. Obtain performance information from the retirement plan provider and discuss with your investment advisor

6.

If you have retirement funds left at a previous employer, open up an IRA account and roll over those assets into it. Invest those assets according to your asset allocation.

7.

Review your investments quarterly. Your investment advisor should provide you with up-to-date information about:

a.

Overall performance

b.

How your performance relates to their respective index

c.

Underlying fund information

d.

Current asset allocation balances compared to your prescribed asset allocation

Kent E. Irwin is CEO and founder of eFinplan, LLC. He is also a Chartered Financial Consultant (ChFC), a Chartered Advisor in Philanthropy (CAP) and a Chartered Life Underwriter (CLU). He can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it . For more information about eFinplan, go to the website efinplan.com.

1 Tools for Money

2 Gary Brinson, Brian Singer, & Gilbert Beebower “Determinants of Portfolio Performance: An Update,” Financial Analysts Journal, June ‘91

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