Investment Planning

Not having a cohesive investment plan is in fact a plan – just not a good one.  If your investments are out of balance and not working in concert with your goals in life, it stands to reason that it will be more difficult to achieve them.

Most people do not consider investing and managing their money an enjoyable pastime.  They generally lack the technical knowledge and feel a sense of helplessness about achieving investment success on their own.
In addition, humans naturally react with either fear or greed to short term movements in the markets, especially regarding their own money.  However, developing and executing an effective investment plan will be essential to future financial success.

An effective investment plan can employ active or passive money management and does not have to be sophisticated or complex.  However, your investments must be effectively and unemotionally managed.  Moreover, your portfolio should be re-balanced periodically to maintain the appropriate risk posture and to stay flexibly positioned to take advantage of future investment opportunities.

Investment Risk

Many investors view risk as the prospect of losing money in a market downturn.  The investment industry uses statistical concepts like standard deviation and beta to define investment risk, measuring the degree of uncertainty of the expected return of your investments over time – both up and down.  The most common form of investment risk includes: capital market volatility, inflation, credit (default), interest rate, currency and timing.

From a financial planning perspective, however, the most appropriate definition of risk is the uncertainty of falling short of your financial goals, such as retiring early on a sufficient income or adequately funding your children's higher education goals.

While investment risk can be managed - but not eliminated - avoiding investment risk entirely entails it owns sets of risks, namely your capacity to realize your long-term financial goals.

Once your appropriate risk profile has been developed, investment risk is best managed through good portfolio diversification - dividing your investment dollars by industry, by sector, by geography and by asset class.

"Spreading the risk" through effective diversification will cushion the impact that a problem with a single investment might have on your entire portfolio.

Asset Allocation

Asset allocation is an investment planning strategy that seeks to reduce investment risk while pursuing a desired investment outcome by diversifying your investments as widely as possible.  Since most of a portfolio's investment return is derived from its asset allocation, this is the critical step in constructing your optimal investment plan.

An easy way to understand asset allocation is the maxim "don't put all your eggs in one basket".  Successful long-term investing results from strategic (long-term) and tactical (short-term) asset allocation.  Executing a good asset allocation plan is easier said than done, however, because it takes real discipline and persistence.

So what is your "optimal" asset allocation?   Each investor answers that question uniquely.  Each should have a personalized allocation that aligns your goals, risk tolerance, liquidity needs with investment time horizon.

A simple approach to viewing core asset allocation is to consider your career as a bond investment.  During your working career, your earned income is your major bond allocation and your investment portfolio should be allocated more towards stocks to create a balanced portfolio.  In retirement, bond investments should be emphasized and the allocation to stocks reduced.

The objective is for you to take just enough investment risk to achieve your prioritized goals in life with confidence.  Any additional investment risk is taken by choice or could be unnecessary.

A flexible asset allocation is the best approach to managing investment risk.  It sets the right core asset allocation for the long run yet allows for tactical adjustments at certain times based on market conditions.  Flexible asset allocation can effectively manage investment risk in the short run and improve wealth creation over the long run.

Money Management

Investment wealth should be managed to be most effective.  However, an eclectic collection of bank CDs, mutual funds, annuities, IRAs and old 401(k) accounts is often how busy people "manage" their investments.  Such an uncoordinated money management approach can lead to financial shortfalls down the road. 

There are three main categories of money management strategies – active, passive and a combination of the two referred to as core-satellite. 

Active money management assumes that investment professionals can effectively "beat the market" over time by managing an investment portfolio to outperform a market benchmark or a peer group.  Actively managed investments can be compared to various capital market benchmarks to measure its relative risk-adjusted performance.  In general, active money management tends to perform relatively better in down market cycles than passive management because the manager can invest more tactically and/or defensively – holding cash in the portfolio for example.

A passive money management strategy assumes that capital markets are efficient and thus difficult for active managers to outperform over time, especially when investment costs are factored in.   A "buy and hold" strategy using individual securities with low portfolio turnover is a common strategic (passive) investment approach and can be effective curing bull markets, both cyclical and secular (long term).

A core-satellite investment methodology combines the positive qualities of both passive and active management to seek risk-adjusted superior investment returns across varying market cycles over time.

Alternate Investments

From our point of view, an essential element to successful long-term investing is effective asset allocation.  Active/tactical asset allocation stressing maximum diversification across as many asset classes as possible is considered the best way to both grow and protect wealth over the long term.

An important asset allocation, risk and portfolio construction concept is called correlation.  The definition of correlation is the statistical measure of the degree to which the potential investment returns of different assets will move in the same or opposite direction with investment market changes. 

The most risk-efficient investment portfolio will include a large number of disparate asset classes that have lower expected correlation to each other over time.  Correlation among asset classes change over time, requiring asset allocation strategies be modified at times.

Adding alternative investments to a core investment portfolio can be a great way to create better portfolio diversification and lower investment risk over the long run.  In general, alternate investments can offer lower correlation to traditional investment assets, often in exchange for more volatility per individual asset class and sometimes reduced liquidity as well.

In other words, the investment returns on alternative investments often zig when core investments zag.  This divergence can create additional risk-adjusted return (called "alpha") to the portfolio while reducing the overall risk of your investments – both a good thing.

The investment objective of adding alternative investments to a core portfolio should be to lower overall investment risk over time, not to speculate for short run windfall gains.

"Sailing and Rowing"

As mentioned above, effective asset allocation is a vital component in a successful financial plan. "Effective" is transient, however, and your optimal asset allocation strategy can change over time as investment conditions change.

During secular (long term) bull markets, the optimal asset allocation would entail maximum exposure to the market risk employing a strategic allocation.  This "sailing" model features low-cost passive investing and tilts to "buy-and-hold" over active management.

Conversely, during secular bear markets, tactical asset allocation, featuring active management, alternative investments and asset preservation are all "rowing" strategies designed to protect wealth during choppy times. 

Long-term wealth creation can occur more readily if investment risk is well-managed during down market cycles.  Sometimes, when market directions are unsettled, a balanced portfolio using both sailing and rowing investment strategies is sensible.

"Sailing Versus Rowing" is an apt metaphor to help understand the two divergent asset allocation models to manage risk - tactical and strategic. 
Diversification and asset allocation strategies do not assure profit or protect against loss.