Managers can beat their benchmark in one of two ways: they can take on more or less risk than the benchmark (beta), or they can simply pick stocks in good sectors (alpha).
Q. I currently have more than 90% of my investment assets in money market accounts. I am unsure of how to get back into the stock market without setting myself up for a loss similar to the one I sustained from 2000 to 2002. I do not want to lock my money up in long-term bonds, nor do I want to receive next to nothing in money market accounts.
A. Working with an investment portfolio is similar to treating a patient. Effective treatment requires a systematic process to take the patient from diagnosis to treatment to ongoing preventative care. Extensive knowledge about where and how things can go wrong, supported by the proper diagnostic tools, is a critical prerequisite to delivering the proper care.
In today's market environment, many investors are suffering from a condition that we call "paralysis through uncertainty." Having lived through the sharpest market downturn since the 1930s, many investors, like yourself, moved into fixed income or out of the market altogether in an effort to stem their losses.
Treating this condition requires a systematic process, usually administered by a professional financial advisor who has access to sophisticated investment tools. Most patients would never consider going to a doctor who practiced medicine only in his or her spare time, yet many investors try to manage their portfolios on a part-time basis. According to a Dalbar "Quantitative Analysis of Investor Behavior" report (which was generated from an updated study of cash flows into and out of mutual funds), the average equity-fund investor had an annualized return of 5.32% compared with 16.29% for the S&P 500 Index. This analysis was conducted using the timeframe from January 1984 through December 2000. We feel that this report clearly demonstrates the short-term effects that result from reacting out of greed and fear, rather than having a pre-established long-term investment policy.
A sound systematic investment process consists of four main components:
Each of these is discussed in turn. We introduce a number of key investing concepts along the way, such as capital markets assumptions, efficient frontier, alpha, and beta. If you are unfamiliar with these concepts, please feel free to contact us for additional material.
Risk assessment is the process of setting your goals and objectives. What purpose is this investment designed to serve? When will the money be needed? How much is needed? Without a road map, it is difficult to know where you are going or when you have arrived. A professional financial advisor has access to risk assessment tools and, more importantly, can provide a second opinion about how much risk is too much. Many investors who thought they were well within their risk tolerance while the markets were rising found out they were taking too much risk when the markets started to fall.