by AAII Staff
Most stock selection strategies can be classified as active or passive; timing strategies tend to be either buy-and-hold or market timing.
Passive investing means that no active investment decisions need to be made. This consists of simply buying and holding "the market," and it would provide a market rate of return, less any management and transaction costs, which can be held to a minimum. In practice, passive investing consists of buying and holding stocks that track an index, most commonly the Standard & Poor's 500. But other market segments, such as small-cap stock indexes and international stock indexes, should also be considered to develop a diversified portfolio.
This no-style approach is the benchmark against which any other approach should be measured. An active approach is more expensive, whether it involves your own time and expenses (if you are selecting stocks yourself), or incurs a management fee charged by a mutual fund adviser or private investment adviser. In addition, stocks are usually bought and sold more frequently in an active approach, incurring both transaction costs and taxes on gains.
The index fund approach offers several advantages. It is difficult to outperform the overall stock market without added risk—even if it is possible to beat the market, it is difficult for investors to pick, in advance, an approach that will do so. Costs must be kept to a minimum, and active management can skew a portfolio toward a particular market segment, producing returns that differ from expectations. An index fund that tracks a broad-based index is, by definition, truly diversified. And it is always fully invested in the market.
For any active approach to be useful, it must produce a return above the market rate of return plus the higher costs associated with active management, without increasing the risk. This higher return represents the value of that approach.
Many investors, of course, feel that it is possible to "beat the market" and use active approaches to add value. Active stock selection approaches can be divided by methodology:
- technical analysis or
- fundamental analysis.
Technical analysis is an approach that tries to predict the future price of a stock or the future direction of the stock market based on past price and volume changes. Charts and graphs of stock prices and volume on a periodic basis (daily, weekly, monthly, etc.) are closely examined to detect developing patterns. The underlying assumption is that stock prices and the stock market follow discernible patterns, and if the beginning of a pattern can be identified, the balance of the pattern can be predicted well enough to yield returns above the market. The computer is well-suited for technical analysis, which involves manipulating large data series and extensive use of charts and graphs.
Fundamental analysis, in contrast, is primarily concerned with the underlying fundamental worth of a firm and its potential for growth. To assess this, fundamental investors focus on data from individual firms' financial statements—their income statements, cash flow statements and balance sheets. Since absolute numbers are difficult to analyze on their own, ratios—one financial figure relative to another—are used to put the numbers into perspective; ratios allow investors to compare financial data among firms, and to judge a firm's financial data relative to historical levels and industry norms.
Fundamental analysis can be divided into many camps, but two of the most popular are:
- growth investing and
- value investing.
Growth investors look for companies with rapid and expanding growth and whose stock prices will grow accordingly with the company's success. Value investors look for companies whose current stock price looks cheap relative to some measure of the firm's real current value, and whose stock price will rise once the market recognizes the firm's real worth.
In addition, some fundamental investors use a top-down approach, which analyzes industries and firms in the context of the overall economic cycle. All camps, however, use valuation formulas in an attempt to put a value on the firm, for comparison with the current price. Fundamental analysis computer programs can provide investors with a variety of valuation methods, as well as extensive databases that include the current and historical financial statement data of numerous firms.
Entering the Bond World
Active bond selection tends to focus on credit quality and maturity, both of which directly affect yields—higher yields among fixed-income securities are associated with higher credit risks and/or longer maturities. Credit quality is determined by the issuer of the bond, with the high-quality, low default-risk sector consisting of U.S. government bonds, high-grade corporate bonds and high-grade municipals. U.S. government bonds offer the most protection against default, but diversification among high-grade corporate and municipal issuers can substantially reduce this risk.
The biggest risk facing bond investors, however, is interest rate risk, and this is directly affected by maturity. Interest rate risk is the risk that a bond's price will drop when interest rates rise, and rise when rates fall. The prices of longer-term bonds are much more volatile than shorter-term bonds when an interest rate change occurs.
Some bond investors use a top-down approach that analyzes the economy and attempts to forecast the likely direction of interest rates; they then invest in the sector of the bond market that will benefit most from or be least hurt by the expected interest rate move. Other bond investors attempt to find bonds that are, in their opinion, mispriced by the market—for instance, an investor may feel that an issuer has less credit risk and therefore its bonds represent hidden value that will go up in price once the market recognizes the issuer's higher credit quality. Computer programs do not tend to focus on bond analysis, but financial information services do provide up-to-date information on bond prices and yields.
Using Mutual Funds
You don't have to rely on yourself to make active security selections. Instead, you can hire an adviser to make the security selection decisions for you by investing in a mutual fund.
A mutual fund pools investors' money to invest in a portfolio of securities that is managed by an investment adviser. Mutual funds are able to attract some of the best investment talent as portfolio managers at relatively low cost because of the economies of scale provided by the large pool of assets. Brokerage expenses can also be held down. Most mutual funds are also able to provide investors with access to a diversified group of securities that normally only a large portfolio can provide.
Mutual funds can be found in every asset category, including such diverse areas as smaller-firm stocks, international stocks, international bonds and emerging markets. There are also index funds—passively managed mutual funds that track an index, allowing investors to keep transaction costs and advisory fees to a bare minimum. In addition, there are 'asset allocation' funds that invest in all major asset categories. The low minimum investments required by many mutual funds means that investors have the flexibility to build their entire portfolio out of mutual funds, or to use mutual funds as a supplement to individual security selection. The sheer number of mutual funds to choose among, along with the wide variety of types and features offered, makes mutual funds ideally suited to analysis by computer. Many mutual fund screening programs are available to help you in your selection process.
Along with choosing among strategies, your investment decisions also involve how often and when you will buy and sell securities. There are two basic approaches to the timing question:
- market timing or
A market timing approach involves an attempt to leave the market entirely during downturns and reinvest when the market begins to head back up. Although it is often associated with technical analysis, certain fundamental investors sometimes attempt to time the market—for instance, if they feel the market is overvalued on a fundamental basis. A bond market timing approach attempts to forecast the direction of interest rates and invest accordingly.
If investors could actually enter and leave the market at the right time, it would lead to much higher returns. However, there is no satisfactory evidence that market upturns and downturns, or the direction of interest rates, can be predicted with enough precision to offset the increased transaction costs, not to mention the adverse tax consequences. And if you guess incorrectly, your actual return could be substantially different than expected. In addition, a market-timing approach does not allow time diversification to work in your favor-being invested across different market environments. In general, the longer your holding period, the better.
Buy-and-hold simply means that the portion of your portfolio committed to stocks is fully invested in the stock market at all times. In other words, while you may buy and sell individual stocks, or change to a different mutual fund, your stock portfolio remains invested in the stock market. A buy-and-hold approach to bonds simply commits a portion of the portfolio to bonds without attempting to forecast the direction of interest rates.
Tracking Your Investments
All investors want to know: How are my investments doing? There are several ways to answer this question.
Examining Your Portfolio's Return
First, there is your overall portfolio. Calculating the return of your total portfolio isn't that difficult and many portfolio management computer programs will perform the calculations for you. But is it really necessary to measure the performance of your portfolio as a whole? Measuring the performance of your total portfolio is useful primarily for one reason—to see if the long-term terminal value that you hoped to achieve with your investment strategy is still realistic.
In general, you should be examining the return on your portfolio to make sure it is within the target range you expected, based on your investment mix. If it isn't, you may need to make some adjustments in your future projections—for instance, you may have to increase your savings rate, you may have to take on more risk to achieve the target that you set, or you may simply have to adjust your target value downward, settling for less in the future. This needn't be done frequently—certainly not more than once a year, since you are examining a long-term strategy.
Measuring the Separate Elements of Your Portfolio
Measuring the performance of the various investments that make up your portfolio, on the other hand, should be done much more frequently—either quarterly or semiannually. The purpose of this monitoring is to see how well the professional expertise you have hired (or are performing yourself) is doing.
For instance, you should examine the performance of each mutual fund against its peers (funds with similar objectives) and an appropriate index (an index that covers investments similar to those the fund is investing in) over the same time period. The index and peer-average returns provide benchmarks that allow you to better judge the manager's performance. For example, if your fund is up 10% for the quarter and the benchmark index is up 12%, your portfolio manager hasn't really added any value to your investment. On the other hand, if your fund is down 10% while the index is down 15%, your manager has added considerable value—he or she has limited the loss.
You do not need to make your own calculations to measure the performance of your mutual fund holdings; there are many publications that provide information on mutual fund performance and that also provide appropriate benchmarks for comparison.
If you are investing in stocks or bonds on your own, measure your individual stock or bond portfolio performance against an appropriate index or similarly managed mutual fund as a test of your own investment decision-making ability.
To Sell or Not to Sell
What do you do with this performance information? For mutual funds, if the performance figures are good relative to the benchmarks-no problem. If the figures are unsatisfactory, you have to decide if you want to sell the fund and look elsewhere. Keep in mind that if you sell, you need to find a suitable replacement-one that you feel will do better in the future. And you would not select a fund based on only a short-term track record. Similarly, you should not dump a fund simply because performance has been sub-par in the short term. While you should examine performance quarterly, don't be overly jumpy if results are poor. Instead, use the opportunity to take a closer look and try to determine why the performance is off; see if you still have confidence in the manager's ability over the long term.
If you are managing your own stock portfolio, you probably won't want to fire yourself even if performance is off. But you may want to consider revising your overall stock selection strategy. Consider the evaluation of the individual stock performance within your stock portfolio. That process should be an ongoing function of your stock selection strategy, not part of your overall portfolio maintenance program.
Monitoring and Rebalancing Your Portfolio
In addition to performance measurement, you also need to review the overall composition of your portfolio and make adjustments when necessary. There are three primary reasons for making adjustments:
- There are changes in your investor profile that may necessitate an overhaul of your allocation strategy.
- There have been a number of successful investments in the portfolio, and they have become so overweighted that your current investment mix no longer reflects your original plan.
- There are particular investments within the portfolio that are not performing as well as expected, and they may need to be dropped.
When making adjustments to your portfolio, for whatever reason, there are several important considerations to keep in mind:
- Try to avoid tax liabilities.
For example, if you need to rebalance your portfolio—for instance, stocks have become overweighted or your profile has changed and you want to de-emphasize stocks—use new money generated from salary, income, and capital gains distributions, or from one-time sources such as poorly performing investments, property sales, and inheritances. Investments should be sold because of poor performance, not to rebalance your portfolio.
- When you are making a major transition from one major investment category to another, do so gradually so that the effects of the market at one point in time don't dramatically affect your portfolio value.
For example, if you are moving to a heavier commitment in stocks, don't accomplish this by investing one large lump sum; instead, divide the lump sum into equal parts and invest it periodically (monthly or quarterly) over a long time period of one or two years; this is known as dollar cost averaging.
- A decision to sell an investment can be complicated by tax considerations and the need to find a suitable replacement. Make sure you focus on future return and not on the past.