Background

Before I go on, I'd like to back up a bit and start with a little business background and my “street cred” before proceeding. I might give a little more detail than necessary but want to establish the amount of financial and management experience I have so you know where I'm coming from when I pick apart the portfolios I see. I've been working in the field of Finance since 1985 when I took my second-ever job as an internal auditor for a small investment shop in Rosslyn, Virginia. You see, I had an Accounting degree and was sure I wanted to be an auditor or accountant for the rest of my life—a very good job, stable income, and lots of work to be had. It took me about a month of talking to the money managers and performing internal audits to realize I loved finance and particularly the investment field. I laid out a long-term plan on how I was going to get to the point of becoming a money manager. I even considered becoming a broker for a short while but then realized that being a broker really meant being a salesman, not a money manager. This is something I'd say that the most successful brokers realize even today—hire professionals to run the money and concentrate on service. It took me 7 years and few financial job stops on the way that included me getting my MBA in finance and becoming a CFA^®** charterholder (Chartered Financial Analyst^®) before I was hired by my first mentor at Foxhall Investment Management in DC in 1992. Foxhall was a great place to work and learn the trade. I quickly began providing equity and fixed income research, as well as shadowing my boss (the president of the firm) and learning how to talk to clients, trade securities, and construct and manage balanced portfolios. It couldn't have been a better place for me to start. I slowly took on my own portfolios and spent time talking to clients. It was here I also had my first exposure to working with brokers. Our investment firm had a relationship with one of the broker houses at the time, and the broker house used us to manage the portfolios for them while their brokers concentrated on marketing and raising assets. I could write a whole chapter on those early days of “wrap accounts” where brokers charged their clients up to 3% to have their money managed by someone else. What a scheme that was. But I digress…

One of the sadder days of my young career was when Foxhall was acquired by Prudential around 1994. By 1995, I moved to New York to work for Pru, but within a year landed a new job in the Institutional world of investing at MacKay Shields (ironically in the same building as Prudential), where I joined the Growth Equity team. Working in New York fast-forwarded my career and investment acumen exponentially. At Mackay, I was allowed to be both an equity analyst and a portfolio manager. The institutional world opened up a smorgasbord of learning opportunities. There were brokerage industry and investment conferences, face-to-face analyst meetings, one-on-one meetings with company presidents and CFOs, lunches, dinners, more research material than I could ever read, along with daily phone calls from equity sales people and analysts.

At Mackay, we not only managed mutual funds but also dealt with large institutional clients. I met with institutional investment boards regularly and presented to the brokers who sold our mutual funds. I was also able to talk daily with our other managers of various asset classes of small cap, value equity, fixed income, convertible securities, high yield, and international equities, both informally and as a member of the investment committee for our total return funds. I became managing director and co-manager of the equity group in 2006 but then in 2008 the financial crisis hit and in a mind-boggling move the whole equity department was dismissed in June 2009, just about at the market bottom, as the executives at our parent (another big insurance company) decided to close down the domestic equity operations of the value, growth, mid-cap and small-cap teams. Of course, the equity market hasn't looked back since, but fate allowed me to come full circle in 2010 when I opened the doors of Forza Investment Advisory, LLC. Thank goodness I decided against opening a hedge fund (the author of this book wrote his own book on hedge funds) and decided to go back to my roots and try to bring institutional quality investment management to individuals, families, and small institutions. So in summary, I've seen a lot of portfolios, big and small, managed a lot of portfolios of all sizes including mutual funds, and provided both equity and fixed income research in my career.

Un-Portfolios and Diversification

Over the years, I've come to refer to what I often review for potential clients as un-portfolios. I call them un-portfolios because usually they appear to have little rhyme or reason as to why the assets have been grouped together, offer minimal diversification benefits, are costly, and actually tend to have assets that are highly correlated^**. I found that Fred's “un-portfolio” was what I was going to see many more times in the years to come. First, the broker had put him in a managed account and was charging him a fee of about 1.5%. Fred didn't know what the fee was that he was paying because it wasn't discussed and he didn't have an Investment Advisory Agreement (IAA^**). An Investment Advisory Agreement is the very first thing any client should get from his advisor/manager before parting with a penny. An IAA is a formal arrangement between a registered investment advisor and an investor stipulating the terms under which the advisor is authorized to act on behalf of the investor to manage the assets listed in the agreement. Since Fred was working with a broker, there was no IAA.

Upon reviewing the assets, Fred's un-portfolio consisted of a smorgasbord of high-fee mutual funds. I counted 32 different mutual funds for a portfolio of about $400K! I asked Fred what his manager's portfolio strategy was and how it related to his goals and objectives. He replied that he really wasn't sure. That's because he didn't have an Investment Policy Statement (IPS)^**. AN IPS is the next most important agreement any investor should get from his advisor. Every institution having money professionally managed has an IPS. The IPS is a document drafted between a portfolio manager and a client that outlines the rules for the manager as related to the client's objectives. Most investors do not have an IPS or IAA unless they are working with a registered investment advisor, who is required to provide them to clients.

You must think that with 32 mutual funds there had to be a ton of diversification in that un-portfolio. In its simplest terms, diversification is a risk-management technique whereby the manager mixes a variety of investments within a portfolio to minimize the impact any one security will have on the overall performance of the portfolio. Especially over a longer time horizon, downside risk can be limited through diversification. This is important because there is a risk-reward inverse relationship in any security or portfolio. In theory, the more risk you take, the greater the return potential. Individual stocks have several kinds of risk, including firm risk, industry risk, and market risk. Firm risk and industry risk are diversifiable risks; that is, you can theoretically lessen the risk by adding other securities. In a portfolio, these risks can be reduced by diversifying among different stocks and different industries. Market risk is nondiversifiable because all stock portfolios contain market risk. That is, being in the market itself and subject to those risks of the overall market. There are many studies available that have been done over the years and I suggest that all investors should research this topic to understand just what diversification is and how it works before they invest.

For instance within equities you can diversify the portfolio in many ways, including by the following:

• Individual stocks—If building your own portfolio, there are numerous studies that show the more stocks the greater the diversification benefits. At a minimum, to receive diversification benefits I believe a portfolio generally needs at least 25+ different stocks. The S&P 500, aptly named, has 500 stocks. Mutual funds and exchange-traded funds vary widely and can hold hundreds or thousands of companies. There are also funds that hold less than 50.
• Sectors—There are 10 major sectors that professionals use to divide the market. These are healthcare, financial, industrials, consumer staples, consumer discretionary, energy, technology, utilities, materials, and telecommunications. The sectors are then subdivided into hundreds of different industries. Having exposure across sectors can help reduce risk of overconcentration to one sector.
• Market capitalization—The three most common sizes used are large, mid and small cap. Large-cap companies are above $10 billion, mid-cap from $2 billion to $10 billion, and small-cap $200 million to $2 billion. (Below that are micro-caps.)
• Weighting—Each stock, sector, or cap size should be allocated a target weight. Weights can vary by capitalization (S&P 500) or can be equal-weighted, or can be arbitrary as chosen by the manager.
• International stocks—International stocks generally can offer lower correlations to domestic stocks, which provide risk mitigation benefits. Holding individual positions can be costly, but there are securities called American depository receipts (ADRs)^** that can be bought on exchanges (which I won't get into).

You can also diversify a portfolio by allocating different weights to varying asset classes, with stocks, bonds, and cash being the primary allocation strategy and then real estate and commodities being secondary. (For higher-net-worth individuals there are alternative asset classes like private equity, venture capital and hedge funds that also offer diversification benefits but these classes have their pros and cons and are not part of this discussion.)

Remember that diversification does not necessarily mean you are increasing your expected return. You are lowering your return in exchange for a lower level of risk. Thus, the risk–return trade-off. For example, below are the calculated returns and standard deviation (risk) for the period of 1991–2013 for stocks and bonds:

Without getting too technical for this discussion, standard deviation is a common measure of risk in finance used by investors as a gauge of the amount of expected volatility of returns. The higher the standard deviation, the riskier the investment. The range shows how wide the returns ranged on an individual year basis.

Stocks have had higher returns than bonds but your annual volatility as measured by standard deviation was 3.7x higher during the period than for bonds while average annual return was 1.6x higher. In this simple example, I show the effect of a portfolio of 50% stocks and 50% bonds on risk and return. This allocation would have lowered the volatility from an all-stock portfolio to about 2x an all-bond portfolio while increasing return by 1.25x. In summary, bonds have had lower returns than stocks but also are less volatile. Combining stocks and bonds will lower both return and risk. This is the effect of diversification. As an investor, you must determine the appropriate trade-off for you going forward. This also requires an estimated expected return over your investment horizon of the different asset classes.

Fees and the Black-Box Models

Many advisors or brokers use a standard model that spits out a recommended allocation and places you in different mutual funds across various asset classes almost regardless of your personal objectives or the economic environment. This is what I refer to as the Black-Box Model. You put some parameters into the magical black box (computer program) and you get a one-size-fits-all diversified portfolio, in my experience usually for a management fee of 1.25% to 1.5%. Only, one-size definitely doesn't fit all when it comes to money management. You need to factor in each person's individual set of circumstances as well as the environment in which we currently reside. That's called the human element!

Now, back to Fred's portfolio. So yes, many of the boxes were checked—domestic equity, international equity, fixed income, real estate, private equity mutual fund, absolute return. You name it, it was in there. You can have as many funds as you want, but if they own similar securities, then you are not getting diversification. I'm not saying they all did, but the overlap was very big in each asset class. Rather than owning 32 funds, the manager could have achieved similar diversification benefits by owning one or two funds in each asset class. And given the economic environment and his objectives, there wasn't a need for every asset class to be represented. Upon closer inspection, I also estimated that the mutual fund fees probably averaged around another 1.5%. (A more detailed review I did later confirmed this.) So just to break even, the funds had to deliver 3% return. On top of that, the advisor put him in load funds (which charge a one-time transaction fee) for about half the holdings with a front-load fee of 5% to 6%! So he was collecting a load and charging a management fee. I call that double-dipping, and it is a clear potential conflict of interest and example of not having a fiduciary standard. So now, you have to earn 8% to 9% return on those load funds just to break even. I will speak more about load funds a little later. Finally, many of the funds were within the same fund family, which most likely meant that his firm had a deal with this fund family—another potential conflict of interest. You see, often times a brokerage firm or other broker/dealer firm will have either their own proprietary funds or fund families with whom they are connected in a tighter relationship. Usually, the advisor can get a higher payout or some benefit if he steers his clients into those funds.

When I asked him about performance, Fred said that his portfolio did not seem to be doing too well. So at that point, I decided to break it down for him and show him all the hidden fees he was paying, as well as talk to him about proper diversification.

Perhaps you are thinking that there has to be a fee and it is the price of doing business. I agree, since I charge a fee for my services. But it's all in the magnitude. Consider the following table where you can see how even a 1% difference in fees and returns can have a significant impact on your returns and nest egg over the long run.

The table shows the value of an initial investment of $500,000 over various time periods at different rates of return (CAGR—constant average growth rate). That seemingly small 1% difference in return can be quite material over even 5 years. For example, the difference between a 3% and 4% return after 5 years in the simulation above is $29,000. After 20 years, this 1% difference is $192,000. That's a lot of money that could have gone a long way in someone's retirement. Too many investors don't realize this, and too many times the fees are hidden. Anybody having their money managed for them has the right to be shown in full transparency the fees they will be paying. Whether you hire an attorney, CPA, or money manager, the professionals will charge a fee for their expertise. But those fees should be discussed and transparent. Add in the fact that many portfolios are being managed improperly and the investors' loss of a few percent return can be quite significant.

Other Examples of Un-Portfolios

Fred's situation is just one example of an un-portfolio. Another example is an equity-only portfolio I saw from a very reputable investment professional's firm, a name many people hear every day in the investment world with several billion dollars under management. Another acquaintance of mine was unhappy with his 10-year relationship and asked me to take a look at his history. I was shocked to see the level of underperformance over 10 years from 2001 that he had endured when he gave me the portfolio to analyze, lagging the benchmark by about 15%—which in his case may have cost him $300,000 in underperformance! I saw poor asset allocation to domestic versus international markets, questionable security selection, and at one point a wholesale selling and purchasing of securities into a whole new allocation. That smacked of desperation and was a major red flag. Aside from the weak performance over 10 years, the investor paid management fees equal to half of what the performance was in that time frame (plus trading commissions). Finally, the portfolio contained about 9% allocation to banks, a sector in which the investor had specifically noted to the firm not to invest as he was employed in that industry and owned a good portion of his company stock. My guess is that the portfolio (over 7 figures) was still not big enough for a large firm to give it the proper attention it deserved. So yes, even reputable professionals can do a bad job if the allocation is structured improperly.

One final example of a portfolio of assets I was asked to analyze and later unwind is another common occurrence. In this instance, an individual had done well to save a nice amount and was trying to generate income from it for retirement. Unfortunately, that individual passed away and left the money to his wife, who had never dealt with any of this before. Spread across seven different accounts was a large array of holdings ranging from cash, individual securities, higher-fee mutual funds, a couple of non-traded REITs, a non-tradable CD, and a very large position (30%) invested in two telecom stocks. I usually see this in older individuals who have compiled assets themselves using a broker that they've dealt with a long time. Typically, the individual properly saves money during their life but improper portfolio construction and the lack of a disciplined investing strategy may have cost countless thousands of dollars left on the table.

Over the years, I've seen numerous types of “un-portfolios,” so let me try to summarize what I see when I review the holdings. It tends to fall into the following list of mostly “don'ts” in terms of building a proper portfolio:

• There is usually at least one non-publicly traded REIT. (This book deals with that security in another chapter.)
• Almost always, there are annuities that have been purchased for them and 99% of the time the investor doesn't know what type of annuity it is. There may be a place in a person's overall allocation for an annuity but it should be bought for a specific purpose. (This book also deals with that security in chapter 7.)
• Load mutual funds. In my opinion, there is NO place in a portfolio for load funds with high fees. Load mutual funds will have an entry and/or exit fee that may range from 0% to a substantial maximum fee. See discussion following.
• Various types of mutual funds, but often several funds that cover the same asset type.
• Mutual funds with very high embedded management fees.
• Too much allocated to international funds, not enough in fixed income. This varies by individual, but my opinion is that advisors or brokers are not allocating enough to the good old USA.
• A managed account that is often invested in a generic model portfolio that usually is not a customized portfolio constructed to meet the person's objectives. Often their fee is at least 1.25% to 1.5% and then they are using funds that also charge a fee.
• The “Black-Box” model portfolio that has too many funds and asset classes.
• Random individual stock positions. These positions are often at sizes that are too big and subject the owner to large amounts of individual stock risk. They often are concentrated in one or two sectors that don't offer proper diversification. And there are always some small-cap speculative issues that generally have lost money.
• Closed-end mutual funds (CEFs) bought at their IPO price. Clearly, these are bought by the broker for a significant commission and maybe represent a deal that the firm is sponsoring. Never buy a closed-end-fund on the IPO. CEFs are traded like stocks and typically trade at a discount to the true NAV (net asset value). At the IPO, the CEF is priced equal to NAV. Inevitably the traded price drops to below NAV over a short period. Wait and buy CEFs at a discount to NAV.
• Exchange-traded Funds (ETFs). Although not necessarily a “don't,” I'd like to say a few words about ETFs that you should keep in mind.

Exchange-Traded Funds

An ETF is an investment fund that trades on a stock exchange at its underlying net asset value (NAV). Prices are updated through the day and ETFs can be bought and sold at any time during trading hours, unlike a mutual fund, which is priced once a day at the end of trading. However, that also means you pay a commission (although several discount brokerages offer no fee ETFs). ETFs have blossomed over the years and have drawn a lot of interest from investors both on a retail and institutional level. It is estimated that there are now over 1,600 ETFs with over $2 trillion in assets compared to $13 trillion in mutual funds. Most ETFs are passively managed, meaning that they are based on a particular index and are structured to be a liquid substitute for that index. Low-fee ETFs can be a good way to gain exposure to a particular asset class in a passive management way. But there are tons of ETFs out there, and the fees can vary significantly. There are also actively managed ETFs now proliferating, and then there is the cousin of the ETF called an ETN (exchange-traded note) that is often confused with the ETF. I won't get into defining an ETN, other to say that an ETN is really a debt instrument underneath with credit risk and a maturity date, and investors should know the differences. Always verify that the ETF is liquid and the embedded fees are not too high. I like ETFs and think they are good for individual investors as well as institutional investors for exposure to certain areas especially international stocks and small- or micro-caps. However, be careful of leveraged ETFs that give you two to three times the exposure to a particular asset class by using derivatives.

I would like to wrap up this discussion of portfolios and un-portfolios with a definition—maybe a definition with which I should have started this chapter. What is a portfolio? Investopedia says that a portfolio is a grouping of financial assets such as stocks, bonds, and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals. Portfolios come in many shapes and sizes, and there are many portfolio strategies. But remember, there should only be one overall portfolio strategy for each of us, and that strategy is the one that will help you reach your own unique set of goals and circumstances.

Mutual Funds and Fees

I mentioned mutual funds in my prior example, and I'd like to spend a little time covering the topic. Don't get me wrong, mutual funds can have a place in many portfolios. For instance, investing in small, regular amounts a low-fee mutual fund that doesn't charge commissions is a good way to start building an investment egg. There are many good fund managers out there with solid track records in whose fund you can invest. I myself was a mutual fund manager for over 13 years. They come in all shapes and sizes and cover just about any major asset class you can think, of as well as some alternative classes. There are many ways to research funds to find out what they own, see the fees involved, check their historical performance, and other fund facts. Funds can be actively managed where the portfolio manager selects a particular strategy and tries to beat his benchmark—or funds can be passively managed where they are tied to a particular index and try to mimic that index. This chapter will not delve into the pros and cons of active vs. passive, as it is beyond the scope. As an active manager myself, I also can find a place in my portfolios for some passive investments so I guess I am a believer in both. My problem is not with mutual funds, but more the lack of fee transparency and misuse of mutual funds by brokers/advisors in structuring a portfolio. Too many times I see a portfolio with five or more funds allocated to an asset class that all do the same thing and are highly correlated. What this means is that if one fund goes up or down a particular day, they all follow. So there is little benefit to diversification. That is because they all probably own the same group of stocks making up the top holdings.

What many investors I talk to don't realize is that each mutual fund has a fee embedded in it that is charged by the fund manager. Fees can range all over the place with passively managed funds (those tied to an index) usually having the lowest fees and actively managed funds the highest. Morningstar (http://corporate.morningstar.com/US/documents/researchpapers/Fee_Trend.pdf) estimates that the average mutual fund fee on the universe of mutual funds was 1.25% in 2013. There is also another fee buried in the fund that is called the 12-B1 fee. This is a separate fee charged by the fund administrator for marketing the fund. This usually runs around .15% to .25%. So if you have a managed account and your advisor or broker is buying mutual funds, you are usually paying three fees—the managed account fee, the embedded mutual fund fee, and 12-B1 fees. High fee funds aren't necessarily a bad thing, but it does raise the bar for performance to recoup the fee and return a profit. Often this is done by taking on more risk.

Many investment companies have both proprietary and third-party funds. Proprietary funds are those managed in-house by the firm's investment group or investment subsidiary, while third-party funds are available on the platform and are managed by an outside advisor. This is important to you as an investor if you are represented by an agent, advisor, or broker of a particular firm. There is an inherent conflict of interest for the advisor to utilize the firm's in-house funds, as it is more lucrative for the firm as well as the advisor. Back to fiduciary duty, if the advisor is not acting as fiduciary, there is no requirement to disclose this potential conflict, so there may be a bias to push the in-house fund even though another fund might be less costly and more appropriate.

Load Funds

Now what about load versus no-load mutual funds? A load fee is a sales commission charged to an investor when they purchase or redeem shares in a mutual fund. It drives me crazy when I see a portfolio that I might be reviewing with a handful of high fee load funds in it. A load fund is a mutual fund sold to you by a broker, advisor, or insurance agent that charges a load, or fee, for putting you in the fund. According to Investment Company Institute (ICI), the average maximum sales load on equity funds in 2013 was 5.3%, but the average load paid on load funds was just 1.0% due to discounts on larger purchases and fee waivers. Therefore, you are at risk of paying more if you are investing smaller amounts in load mutual funds. This may be one reason Fred had so many smaller allocations to similar mutual funds. This load can either be front-end, where you get charged when you first buy the fund, or back-end, where you get hit when you sell the fund. So just to break even you have to gain a potentially substantial load fee, plus the embedded mutual fund fee, plus the management fee you are being charged by the broker/advisor. That could be a substantial hurdle just to get your money back! Some no-load funds can also charge an early redemption fee where you are charged upon selling if not held for a minimum specific time frame. However these go back to into the mutual fund for the benefit of other investors and are usually limited to months. So be aware of what you are buying or own. In my mind, there is no reason for a broker or agent to buy a load fund other than to generate a commission for themselves so they can get paid. I understand that commissions are part of the business. But there are thousands of mutual funds they can choose from that don't charge loads. This gets to the concept of fiduciary duty.

Fiduciary Duty

Earlier in the chapter I mentioned fiduciary duty. Anyone evaluating hiring an advisor should always first ask, “Will you be acting as my fiduciary?” I think this is one of the most important yet most overlooked topics that any investor should be aware of when choosing someone to manage their money and become their advisor, and is also one of the biggest differences between an investment advisor^** and a financial advisor^** or broker^**. Although the terms sound similar, investment advisors are not the same as financial advisors and should not be confused. Investment advisors are registered and governed by the Investment Advisors Act of 1940^**. The term financial advisor is a generic term that usually refers to a broker (or, to use the technical term, a registered representative). By contrast, the term investment advisor is a legal term that refers to an individual or company that is registered as such with either the Securities and Exchange Commission or a state securities regulator. An investment advisor is governed by and held to the fiduciary standard^** while the broker is held to the lesser suitability standard^**. Fiduciary duty is a higher legal standard that legally requires an investment advisor to put their client's best interest ahead of their own. The Suitability doctrine requires a broker to know a customer's financial situation well enough to recommend investments that are considered suitable for that particular client. You may be asking, “Why does this matter? It sounds the same to me.” It is most definitely not the same and the brokerage industry is fighting an ongoing battle to require brokers to adhere to the fiduciary standard. In laymen's terms, a broker may in fact sell you the investment that pays him/her the most commission, so long as the investment is deemed suitable. Brokers are also able to sell you proprietary products if their firm offers them. A firm's proprietary product usually brings more revenue to the firm, and they may have a higher payout to the broker who places their clients in the product. Finally, they may be subject to conflicts of interest that could influence their investment recommendations while at the same time not being required to disclose those conflicts of interest to the client.

Below is a summary of the differences between an RIA and a broker.

Independent Registered Investment Advisor (RIA):

• RIA is in the business of giving advice
• Independent RIA firms are typically not owned by another and not beholden to any platform of products or services
• Fiduciary: legally required to put clients' interests first (a higher standard than suitability)
• Typically fee-based or fee-only compensation for advice
• Regulated by the SEC or states (as applicable) primarily under the Investment Advisors Act of 1940 and the rules adopted under that statute

Registered Representative (Stockbroker):

• Brokerage firm primarily in the business of buying and selling securities for a commission or fee
• Registered representative is an employee/contractor of brokerage firm
• Typically compensated by commissions on product transactions
• Often experience greater profit from selling company's own proprietary product
• Held to suitability standard, not the higher fiduciary standards
• Often “look like” an advisor in marketing and websites (read the fine print)
• Regulated primarily by NASD (but also by SEC and states)

There are many articles that talk about the difference between suitability and fiduciary standard and I suggest that you take to the Internet and read several of them and make your own decision whether this is important or not. Personally, this is one of the top things I would require before I moved forward with any investment relationship.

Portfolio Management Basics

I thought that now might be a good time to talk about the basics of portfolio management. Whether building a portfolio yourself or hiring someone to do it for you, you can follow these concepts to help you build a diversified portfolio or see if your manager has diversified your holdings:

1. Investment Philosophy

   Establishing an investment philosophy is the starting point for building your portfolio. You can accomplish this either by yourself or with a professional by doing the following.

   • Review your overall financial situation, past and present, to identify your financial objectives.
   • Set your financial priorities for the future. Determine your monthly and annual cash flows based on expenses and revenue sources.
   • Determine the tolerance for risk you are willing to undertake to capture the potential return.
   • Identify the resources you will need to meet your goals and outline a systematic plan to meet your objectives.
   • Determine solutions for reaching your goals by developing a customized investment portfolio and asset allocation based on your unique situation.
   • Monitor and update the plan on an ongoing basis, making adjustments when there is a change in your priorities or long-term objectives.

   The most basic of goals is to achieve consistent and competitive returns while managing risks and lowering investment costs. How do you do that? First, you have to have a plan.

   The trait most common among successful investors is discipline. Disciplined investors use a set of proven rules that protect them and guide them through the ups and downs of the market. A common disciplined investment approach (and the one that I use) combines elements of top-down macroeconomic analysis and fundamental bottom-up company and security analysis. The macroeconomic analysis—which includes an assessment of factors such as GDP growth, interest rates, inflation, monetary policy and demographic trends, world economics—serves to create a strategic backdrop for portfolio construction. The bottom-up analysis is done more on the individual security level where you determine the investment merits of a particular investment. Whether you use a top-down or bottom-up approach, you must have discipline in executing and following your strategy. My old boss in my early years in the business used to like to say, “You gotta have a plan. It doesn't necessarily have to be a great one, but you gotta have a plan!”

2. Asset Allocation

   Proper asset allocation is crucial to balancing risk and return. With proper asset allocation, it may be possible to lower the amount of risk in your portfolio while still producing a decent return. What does asset allocation mean, and why is it important? Asset allocation is an investment strategy that aims to balance risk and return by allocating a portfolio's assets among different asset classes according to one's individual financial goals, risk tolerance, and investment time horizon. Each asset class (stocks, bonds, cash, commodities, international, etc.) has a different level of risk and return, so each will behave differently over time depending on the macro environment. This level of behavior can be measured by a statistical figure called correlation. In general, assets that are highly correlated will act the same and don't offer much diversification benefit. Since we cannot predict the future, we will always face risks in making investment decisions. One asset class may be down while another may be up in the same timeframe. Although there is no simple formula to find the right asset allocation for every individual, it has been well documented through various industry studies that asset allocation policy is the single most important factor in determining portfolio performance. In other words, your selection of individual securities is secondary to the way you allocate your investments across asset categories. Asset allocation allows more control over how much return you can possibly get in exchange for assuming a certain level of risk.

   Let's step back for a second and look at the big picture. Following are three common ways to manage money:

   1. Market timing—making an investment decision and moving money among investments by attempting to predict future price movements based on a forecast over a specific time frame.
   2. Security selection—deciding which security to buy or sell compared to others in the same asset class.
   3. Asset allocation—the process of deciding how money gets divided up between different asset classes. Asset allocation can be dynamic (market timing) or static and long-term in nature.

   Each investment decision utilizes at least one method and more than one method may be used. For instance, you can combine asset allocation with security selection to build your portfolio.

   To understand the benefits of asset allocation, you must also understand correlations and returns. Correlation is simply defined as the degree to which one asset class moves in tandem with another. Correlations among classes can vary significantly over the long term. Returns may also vary from year to year and asset class to asset class. In general, you build a diversified portfolio by combining asset classes with low or negative correlations. One caveat to keep in mind, correlations are backward looking, and there may be periods (such as 2008) where correlations may be high among asset classes, thereby reducing the benefits of asset allocation in the short term.

   To summarize, one's investment strategy can be based on the following building blocks:

   • The future can't be predicted therefore we all face risks. These risks include economic risk, geopolitical risk, interest rate risk, inflation risk, market risk, business risk, credit risk, currency risk, and reinvestment risk among others. We attempt to manage these risks through investment diversification.
   • Diversification is achieved by asset allocation. Asset allocation is the most important factor in the investment process and is a long-range planning decision that has little to do with market timing—it should not be tinkered with solely because of short-term market fluctuations and is achieved by allocation among assets with low or negative correlation. Asset allocation requires diversification among different asset classes as well as within an asset class.
   • A disciplined investment process for choosing securities is the only way to provide replicable results over the long run. I believe in investing for the long-term with a disciplined strategy and low turnover that reduces transaction costs and tends to provide tax-efficient results. The investment process should focus on long-term results of the entirety of one's assets over a market cycle.
   • Remember that risk and returns will vary among asset classes over the long term. Asset allocation should be made based on a belief in long-term results that can produce a satisfactory reward while reducing overall risk.

   So remember, asset allocation is a planning tool that allows you or the investment manager to structure the investment portfolio in a manner most likely to accomplish the goals of each specific individual. An asset allocation plan is a long-range, semi-permanent planning decision that has little to do with market timing or hedging—it should not be tinkered with solely because of short-term fluctuations. Properly diversified and allocated portfolios can help protect you from severe market fluctuations.

3. Benchmarking

   One of the key attributes of determining if your portfolio is performing at a high level and according to your specific set of goals and objectives is for the manager to utilize benchmarks. In the institutional world all portfolios are measured against benchmarks. So why shouldn't an individual's portfolio be measured against them? A benchmark is an index or combination of indexes that varies for each individual based on their goals and objectives. The two most basic benchmarks are the S&P 500 for US equities and the Barclays Bond Aggregate for Fixed Income. When working with my clients, I construct a custom index for each client and report performance along with the indexes each quarter so they can see how their portfolio is performing relative to our agreed-upon objective and the financial markets. I see no reason why individuals shouldn't have the benefit of utilizing benchmarks just like institutions. Even if you manage your own money, you should utilize a benchmark to monitor your relative performance rather than just looking at your total return as an absolute number.

Summary and Conclusion

I touched on a lot of topics in this short chapter but barely touched the surface. There's so much more and every day can be a learning experience, which is why I love this profession. But I hope I was able to educate you on some of the things to look for in deciding on how to manage your own hard-earned money, whether by hiring someone or doing it yourself. Rule #1 is, do your homework. Managing money is a full-time job, and since you worked hard to build your nest egg you should have proper time devoted to managing it. The loss of even a percentage point of performance can be costly in the long run. Determine your objectives, know your risk tolerance, and develop a disciplined investment plan and strategy. Have a properly constructed portfolio that meets your objectives. Stay away from high fees and assets that don't offer any benefit to your particular situation. If hiring a professional, ask questions. After all, this is your money. Ask about fiduciary duty and conflict of interests. Most importantly, don't take everything you are told at face value. Demand transparency and if you can't get it, move on and find someone that will give it to you. Above all, remember that investing comes with risk. Even diversified portfolios with asset allocation can and likely will go down in a particular year based on a host of factors. So there is some luck involved, too. But if you know your tolerance for the risk you are taking and stick to your plan over the long term, then in baseball parlance you are ahead in the count and your odds of success are better.

Bonus Section