Investing strategically assumes an understanding of some investing basics and critical decision points regarding five key elements of investing.

Investing Basics:
Risk/Reward – Decades of research and historical market performance underscore a basic tenet of investing:  “There is no reward without taking risk”.  Concurrent with this is the understanding that if there is not an adequate perceived or expected reward, then the risk is obviously not worth taking.  Therefore, as investors seek to build their financial security, they must constantly balance their perceived risk with their expected reward.  Most investors have little knowledge of the potential risk in their investments or whether that risk is justified based on the probable reward or rate of return for those investments.  One of the early decision points we work through with a client is a clear and quantifiable understanding of their personal risk tolerance.   A strategic, portfolio allocation is then recommended that fits both the client’s acceptable risk tolerance and the desired rate of return from that portfolio.

Individual Stocks vs. Mutual Funds – Each of the next five elements of investing are independent of  the  risk/reward issue described above, but each has a direct impact on the overall risk/reward of one’s investments and thus the ultimate success in achieving financial security.

1. The decision of whether to use individual stocks or mutual funds within a portfolio affects not only the risk level of the portfolio but also expenses and probable rate of return.  Individual stocks are cheaper to purchase because they do not carry the internal expense ratio or a loaded fee that most mutual funds charge to own a particular fund.  The downside of individual stocks is the difficulty of holding enough stocks to be well diversified.  The loss of a holding in Enron or Washington Mutual can have a significant impact on the overall growth and return of a stock portfolio that has limited diversification.  Without having significant assets to invest in individual stocks diversifying and protecting those assets is difficult.  Additionally, buying individual foreign stocks is a challenge for most investors who lack the time and experience to adequately understand the foreign markets.  For these reasons, Compass Investments recommends that most investors use quality mutual funds with no loads and acceptable expense ratios of less than 1%. 

Active Management vs. Passive Management – While mutual funds offer an investor some significant benefits over individual stocks, there is that lingering feeling that the expenses of mutual funds can quickly erase any advantage over individual stocks which have no internal expenses or fees.  For this reason Compass Investments recommends that investors use a special type of mutual fund called passive index funds.

 Most mutual funds are actively managed, meaning that fund managers are regularly tweaking the individual stocks within the funds in order to try and optimize their overall performance.  While this sounds reasonable and even desirable, the actual historical evidence shows little if any optimized performance.  And yet, there are some definite negative side effects to using actively managed mutual funds, especially the higher expenses.  The professionals who manage such funds have to be paid and those salaries translate into higher expense ratios and loads that are often a part of these funds.  In contrast, passively managed funds, known as index funds, are composed of individual stocks selected based on their specific asset class (large cap growth) orientation and diversification within that asset class.  While individual stock fundamentals are not ignored, individual stocks are selected more for asset class coverage and diversification of industries and sectors within the asset class.  So a typical index fund representing the U.S. large cap value asset class will be composed of a couple thousand  large cap value companies diversified across the various U.S. industries and sectors such that the investor owns the essence of those companies for that asset class.  The diversification and depth of holdings within that particular fund has been proven to be a far more important contributor to a better capital market performance for that asset class than the scrutiny of active managers seeking to place value on a company stock due to its basic fundamentals.

Index funds are the best choice for most investors in that they provide the diversification necessary to protect a portfolio and reduce the incumbent risk that comes with less diversification.  They also make the fees of mutual funds acceptable, eliminating costly loads and providing internal expense ratios of less than 0.5 percent.

Asset Class, Geographical, and Industry Diversification – Research has confirmed that one of the most important decisions impacting the overall returns earned from the capital markets is the selection of asset classes.  An asset class is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). (Investopedia)  Asset classes are further sub-categtorized based on other characteristics such as size by market capitalization, book-to-market value which distinguishes growth and value asset classes, etc.  Thus within the equities asset class we have subcategories of U.S. large cap growth, U.S. small cap value, International large cap value, Emerging Markets, etc. 
Historical markets also demonstrate that having all major asset classes within a portfolio is the number one greatest contributor to improved market returns than any other factor.  Owning all the major U.S. asset classes during the 2000-2003 capital markets greatly improved a portfolios’ performance as opposed to owning only the U.S. large cap growth asset class which suffered a 44% loss over that three year period (as measured by the S&P 500 Index).  The performance was even better if a portfolio owned all the major International asset classes as well.  And industry diversification beyond the booming technology sector resulted in even better returns.

Equity and Fixed Income Balance – While each of the above elements of investing has its own particular impact on portfolio risk and performance, none has more impact than the balance within a portfolio between equity (stock) funds and fixed income (bond) funds.  Fixed income funds invest in safer more conservative bond funds (or laddered individual bonds).  These funds may invest in corporate bonds, U.S. Treasury bonds, Municipal bonds, Mortgage backed bonds like GNMA, etc.  Bond funds composed of a basketful of individual bonds will have varying maturity averages.  The longer the maturity, the greater the risk.  The safer, short-term bond funds have had average annual returns around 7% over the past three to four decades.  The greater the percentage of fixed income (bond funds) in the portfolio, the lower the risk and thus, the lower the loss in tough markets.  But, as noted earlier, the lower the risk, the lower the probable rate of return as well.  Heavier percentages of fixed income in a portfolio is appropriate for someone in retirement where the name of the game is more on preservation than on capturing the higher rates of return.  The appropriate blend of equity funds with fixed income funds is thus a critical decision point that Compass Investments focuses on in helping clients build a truly strategic portfolio.

Strategic Investing:
Many investors today have no strategy for why they hold what makes up their portfolio or how those assets are held.  If they are managing their own accounts, their portfolios often hold the stocks or mutual funds that a friend or acquaintance has recommended or they read about somewhere.  Often these holdings are concentrated in only a few asset classes -- typically those that have been doing well lately.  If an investor is working with a professional broker, again they often have a portfolio composed of those assets that have been doing well lately and sold to them because good performers are simply easier to sell. Additionally, brokerage accounts are often full of mutual funds with high expense ratios and loads because the broker is paid higher commissions to sell such assets.   Even well intentioned professionals frequently load up a portfolio with only a few asset classes represented and only few a investments which diversify the client across world-wide capital markets.

Strategic investing specifically and intentionally builds a portfolio based on the critical characteristics that have been discovered by decades of the best academic research and verified by years of historical market performance.  These characteristics include:

1.  Diversification across all major asset classes (large growth, large value, small growth, emerging markets, etc)
2. Diversification by asset classes across major world capital markets (US, Europe, Asia, S. America, etc.)
3. Appropriate blend of asset classes for potential higher return without additional risk (value and small asset classes).
4. Balance of equity  and fixed income assets to achieve acceptable risk and rate of return
5. Low fees by avoiding funds with high expense ratios or loads  (Index funds)
6. Use of tax-efficient funds in the appropriate types of accounts (taxable vs tax-deferred IRAs)

This is the Strategic type of investing that Compass Investments believes will give you, the investor, the best chance for consistent ‘market-like’ returns with much less risk than the overall capital markets.  Our passion is to chart this path of strategic investing to the personal, individualized situation and need of each investor.