Which Investing Roller Coaster Are You On?

I love roller coasters. I grew up in northwest Ohio and lived close enough to Cedar Point that I would make it there several times each summer. Every time I went, I knew which roller coasters I wanted to ride, and I also knew which ones to avoid.

Some roller coasters were too rough for me. To this day, I don’t ride the Corkscrew because the last time I did, I got a headache from my head bouncing back and forth in the harness.

Other roller coasters were not thrilling enough for me. Some of the easier ones like Iron Dragon are ho-hum for me.

What could this possibly have to do with investing? In the investing world, you may hear a lot about people trying to match a certain benchmark. For example, a lot of investors like to see how they do compared to the S&P 500 index. Other investors compare themselves to the Dow or NASDAQ.

The truth is that you don’t need to match the S&P to be a successful investor. Please do not misunderstand me, you DO need to be invested in such a way to outpace inflation, but you don’t need to match the S&P necessarily.

The most important number you should know is your risk tolerance. Wait, what? Don’t you mean conservative, moderate or aggressive investor? No, I don’t. I mean that there is a scientific way to measure your personal risk tolerance and it is called standard deviation.

Standard deviation tells you the range of returns that your portfolio could get in any given year. For example, if the way your portfolio is built historically has returned about 10% per year and your standard deviation is 15%. You should expect that for the majority of the time, in any given year you could have a return of -5% to a +25%. (As a quick side note, one standard deviation would account for 66.6% of the time and three standard deviations would account for 98% of the time.)

For some people, this range is acceptable and they are like me at the roller coaster park. They have found their perfect roller coaster and they can ride it as many times as they want.

Others are on a roller coaster that is way too much for them. Their range of returns is so wide that they are not comfortable with it. Still others are riding the kiddie rides and know they could handle the next level of roller coasters and should do so.

In my experience, most investors don’t know what kind of investing roller coaster they are on. Very few know that you can actually calculate a range of returns, and even less know how to measure their own investment portfolio’s range.

You don't need to match the S&P, you need to match YOUR risk number. That is what will help you be successful for the long term. Do you know your personal risk tolerance number? Do you know your portfolio’s risk number? They should be the same. If you don’t know your number or your portfolio’s number, please contact us. We can help you so you can be on the right investment roller coaster for you.

Three Academic Investing Principles Successful Investors Use

When it comes to your investing, we have looked at three things to avoid doing, three things you should be doing, and three types of Wall Street bullies you should avoid.

Today, I want to introduce you to three academic investing principles that you can implement with your portfolio that are backed by science and research. These principles can help you become a successful investor.

The three principles are:

• Efficient Market Hypothesis
• Modern Portfolio Theory
• Three Factor Model

I will do my best to keep the explanations brief and understandable so you can begin using them. The efficient market hypothesis essentially states that the value of a company is reflected in its stock price at any given time. Also implied is that the market reacts so quickly with new and unforeseen events that it would be nearly impossible for anyone to use the new information in such a way to make money on any trading before the price changes.

An example of this would be when a particular airline has one of its planes crash. Let’s pretend you own this particular stock and based on this information you feel like you should sell the stock before the price drops as everyone expects it to do. By the time you call, email, or text your adviser, the stock has already dropped and now you won’t get as much for the sale of your stock as you would have if you sold it prior to the crash. The market simply reacts too quickly to capitalize on the information. This is a real life example of the Efficient Market Hypothesis.

Since the market moves so quickly, how would you best capture the returns? A Nobel Prize winner, Harry Markowitz, earned this award for his research on Modern Portfolio Theory. Essentially, this theory states that in order to capture the most amount of return while taking on the least amount of risk, you should invest in the parts of the market that move in different directions from each other.

For example, when stocks go up, bonds usually go down. Therefore to smooth out the ride in the market over time, it would be good to have both stocks and bonds in your portfolio. Also, stocks for US-based companies usually move in different ways as the stocks for international companies. And so on. Markowitz earned his Nobel for discovering this theory and proving it with his research.

Lastly, the Three Factor Model builds upon the Efficient Market Hypothesis and Modern Portfolio Theory. Nobel prize winner, Gene Fama, took Markowitz’s research to the next level. He identified other factors that added to the return while reducing the amount of risk investors would take on in their portfolios. In addition to the factor of being in the market (stocks) versus bonds or savings accounts, he discovered that small company stocks beat large company stocks and that value stocks would beat growth stocks over time.

Let’s put it all together.

The market reacts quickly enough that it is nearly impossible to capitalize on it once new information comes out. The best way to build a portfolio is by buying stocks and bonds that move differently from each other. The specific areas of the market to buy would include large stocks and small stocks (both US and international), growth and value stocks (both US and international AND both large and small).

When you look at your portfolio, do you see these categories? If not, or you are not sure, please contact us and we will analyze your portfolio to make sure you are set up as well as you can be to implement these academic investing principles.

Three Types of Wall Street “Bullies” to Avoid

As we seek to be successful investors, there is no shortage of products or people who will try to derail us from academically sound investing principles.

This week, we will look at three types of Wall Street “Bullies” who try to derail investors:

• Con Men
• Prognosticators
• Gurus

Con men are the easiest to see… after the fact. Bernie Madoff may come to your mind as running one of the largest Ponzi schemes of all time. Basically, he would take people’s money and pretend to invest it in a “no lose” strategy. He kept it for himself and when someone needed a withdrawal, he would use other people’s investments into his “fund” to pay the “withdrawal.” Lots of money was lost in this scheme.

How do you avoid such a con man? Be sure that your adviser, your custodian, and money manager are 3 separate entities. Bernie was all three - he met with you, he held onto your actual money (custodian), and he managed the money (like a fund manager). My clients meet with with me as their adviser, we use a third party custodian who does not manage the money, and we use a different company who provides the money management.

Prognosticators are everywhere and are among the talking heads on TV. These are the folks who make claims that they know which way the market is going next and therefore what you should do with your money. If an investor were to track such a person’s record to see how often they were correct, they would find that it is never 100%.

The truth is that for any of these predictions to work, the person would have to know the future. I don’t know of anyone who can accurately predict the future with enough certainty and clarity that I would work with them as an investment adviser.

Gurus are also everywhere and also among the talking heads on TV. These are the folks who may not outright claim that they know how the market is going to move, but they try to convince people that they are savvy enough that they can successfully navigate things to give a return better than the market would.

The truth is that virtually no one can successfully do this. Study after study has shown that net of all fees, no so-called guru can beat the market no matter how savvy they are.

What is solution then? How should investors invest their money? I recommend using Nobel-prize winning academic principles that have stood the test of time. We use investing principles such as Modern Portfolio Theory, the Three Factor Model, and passive indexing to create portfolios that don’t need a prediction of the future to work. They don’t need someone to actively react to how the market moves. These portfolios are designed with all of those things factored in. Now, it is time to let the market work.

If you would like to hear more about how we build portfolios for our clients or have questions about yours, please contact us.