No Sweat Investing

Feb 24, 2015 by

pie chartI’ve got a guest post for you today, a liberating piece by Joseph Hogue, CFA, on easing investment and asset allocation decisions. What do you think of Joseph’s take on investment analysts? (Be gentle—he is one. Not that there’s anything wrong with that. 🙂 ) Let Joseph and I know what you think please! – Kurt

I love investing. The process of investigating a company’s potential from financial statements to the economic backdrop. It makes me feel like a financial Sherlock Holmes.

I’ve been an investment analyst for more than a decade, writing research for multi-million dollar venture capital firms and for individual investors.

But there is an unspeakable truth within the investment community. One that few want to admit but everyone knows to be true.

Most investors probably don’t need us!

I’m not saying that investment analysts don’t serve a purpose or help investors earn a return on their money. The information analysts provide is an important part of what makes the market so efficient. While most of the research revolves around absolute returns and how hard it is to “beat” the market consistently, research by PIMCO has shown that some analysts have been able to consistently earn a higher return when adjusting for risk.

But for those who want to manage their own investments, do you need the constant headache of sifting through analyst reports and working through your own projections? Do you really need to spend hours a week in the hope that you will pick up a few extra percent, or is there an easier strategy that frees up your time for the stuff that really matters?

No Sweat Investing and Asset Allocation

The fact of the matter is that most of the difference in returns across managed portfolios is due to the general direction of the market. A 2010 study of ten years of returns across more than 5,000 mutual funds found that 75% of the difference in gains was due to the general direction of the market with the rest split evenly between asset allocation and active management of the fund.

So three-quarters of a fund’s return depends simply on the right time of the market. The rest depends on which assets you own and how well the manager picks investments. Asset classes are just the grouping of investments with similar characteristics like stocks, bonds, real estate and commodities.

The lesson:

  • You can’t control the direction of the market, which will account for most of your return
  • You may or may not be able to pick market-beating investments but the time it takes will consume your free-time
  • Position your portfolio in broad asset classes and hold them for long enough that the changes in the overall market do not matter as much.

It’s not a very exciting investment strategy and you’ll have to find something else to do besides watching some yahoo jump around screaming, “Buy, buy, buy!” on TV but you’ll get market returns, very low fees and will never have to worry about the market again.

So Which Asset Classes do I Need?

Choosing the right asset classes is probably easier than you thought. Since investments within each asset class share return and risk characteristics, they can be easily matched up to your own risk tolerance and need for return.

The table below shows risk and annualized return of the most common asset classes over the last ten year period. Risk is the measure of how volatile prices have been while return is calculated as an annualized gain over the entire period. The idea is that, while stocks may provide higher returns, your tolerance for risk in your portfolio value may mean you are better off owning mostly bonds. If you are closing in on retirement or get spooked by the ups and downs of the stock market, stick with bonds and do not worry about the slightly higher returns in stocks and real estate.

asset class risk and return

There are a couple of things that should be noted about the table. The huge selloff in real estate and commodities during the ten-year period may mean each asset classes’ risk and return are not accurately measured. Risk in real estate is likely to be a little lower over the longer-term and return may be a little higher. The negative return in commodities is actually not far from the longer-term average of about 2% which is the reason many question if you even need exposure to commodities in your portfolio.

Another important note is that, while your own preference may be for one particular asset class, you will always want to hold a mix of at least stocks, bonds and real estate. Asset prices do not move in unison because they react to the economy differently. Holding each asset class, even if you only have 5% or 10% of your portfolio in a specific class, can help smooth out overall risk.

You can buy exposure to these broad asset classes through exchange traded funds (ETFs) which hold individual investments to track the direction of the asset class and trade like stocks. I highlighted the idea and ease of asset class investing and specific funds you can buy in a recent post covering basic investment principles.

If you enjoy analyzing and picking individual investments, there is nothing wrong with putting a small portion of your portfolio in your favorite choices. There is some additional return to be had from strong analysis but watch that you do not buy or sell so often that fees eat up your returns. Asset class investing is a great alternative for people that do not want to spend all their time reading the Wall Street Journal but still want to make good, long-term returns.

Joseph Hogue, CFA runs PeerFinance101, a blog where you share your stories of personal finance challenges and success. There’s no one-size-fits-all solution to meeting your financial goals but you’ll find a lot of similarities in others’ stories and a lot of ideas that will help you get through your own challenges.

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