by AAII Staff
Fundamental Principles of Investing
Any successful plan must start with a base or foundation upon which to build. Developing a successful investment plan is no different. You may not need your computer for this section, but an understanding of the basics will mean that you can transform your computer from simply being a toy into an investment tool.
Risk and Return
Boiled down to its basics, investing is really about return and risk. The foundation of your investment portfolio rests on the investment principles of risk and return.
What is investment risk? Investment returns are never guaranteed and cannot be predicted with any amount of certainty. Instead, investors must make decisions using return expectations, which should be reasonable and mesh with reality. However, all investments are made with the possibility that your actual return won't meet your expectations. It is the uncertainty surrounding the actual outcome of your investment that creates risk; the greater the uncertainty, the greater the risk.
There are many sources of risk. These include:
Business and industry risk:
The uncertainty of an investment's ability to pay investors income, principal, and any other returns due to a significant fall-off in business (either firm-related or industry-wide) or bankruptcy. For instance, a stock's price may drop because earnings unexpectedly dropped due to an industry-wide slowdown.
The uncertainty over the future real (after-inflation) value of your investment. An investment that fails to keep pace with inflation will leave you with less purchasing power in the future than the original has today.
The risk that the general market or economic environment will cause the investment to lose value regardless of the particular security. For example, a stock may drop in value simply because the overall market has declined-this is stock market risk. A bond does not face stock market risk, but it does face its own kind of market risk: a drop in value due to a rise in interest rates. This is called interest rate risk.
The risk of not being able to get out of the investment conveniently at a reasonable price. This can occur for a number of reasons. Volatile markets can cause liquidity problems if you must sell at a particular time-for instance, you may need to sell a stock at the very bottom of a bear market, forcing you to accept a considerable loss. Inactive markets can also cause liquidity problems—it may be difficult to sell your house, for example, if there are no buyers.
All investments confront these risks, but the degree of risk varies greatly. For instance, stocks face much less inflation risk than bonds, yet they face much greater liquidity risk.
Ironically, it is uncertainty that creates the potential for higher returns. Why? Because of the risk/return trade-off. Every investor wants the highest assured return possible, but different investors have varying degrees of uncertainty that they are willing to accept. In a competitive marketplace, this results in a trade-off: Low levels of uncertainty (low risk) are the most desirable and are therefore associated with low potential returns. High levels of uncertainty (high risk) are the most undesirable and are therefore associated with high potential returns.
While potential returns should compensate you for risk, there are some risks that you will not be compensated for, and therefore they should be avoided. If you invest in a single security, your return will depend solely on that security; held by itself, the single security is highly risky. If you add nine other unrelated securities to that single security portfolio, the possible outcome changes—if that security flops, your entire return won't be as badly hurt. By diversifying your investments among 10 securities, you have substantially reduced the risk of the single security. However, that security's return will be the same whether held in isolation or in a portfolio. Diversification among securities that are unrelated substantially reduces your portfolio risk with little impact on potential returns. Diversification should occur at all levels of investing: You should be diversified among the major asset categories—stocks, fixed-income and money market investments—since these categories are affected by different market and economic factors; and you should be diversified within the major asset categories—for instance, among the various kinds of stocks (international or domestic) or fixed-income products.
Diversification is also important across market environments—the longer your holding period, the better. Time diversification helps reduce the risk that you may enter or leave a particular investment or category at an inopportune time in the economic cycle. It has much more of an impact on investments that have a high degree of volatility, such as stocks, where prices can fluctuate over the short term. Longer time periods smooth those fluctuations. Conversely, if you cannot remain invested in a volatile investment over relatively long time periods, those investments should be avoided. Time diversification is less important for relatively stable investments, such as certificates of deposit, money market funds and short-term bonds.
Your Investment Profile
A successful investment portfolio is one that is based on a balance between the risks you are willing to take and the returns you need to achieve your goals. An understanding of the various aspects of your investment profile allows you to assess that proper balance.
The amount of risk you are willing to take on is an extremely important factor to consider before making an investment because of the severe consequences of taking on too much risk. Most investors who take on too much risk panic when confronted with losses they are unprepared for, and they frequently bail out, oftentimes sustaining substantial losses. This strategy—buying high and selling low-is guaranteed to produce an unhappy outcome. Properly assessing your tolerance for risk will prevent you from making panic decisions and abandoning your investment plan mid-stream at the worst possible time.
While many questionnaires seek to grade risk tolerance, the best approach is to simply examine the worst-case scenario—a loss over a one-year period-and ask yourself whether you could stick with your investment plan in the face of such a loss.
Keep in mind that it isn't necessary to eliminate a risky investment just because you have a low tolerance for risk—even a low-risk investor, for instance, can benefit by diversifying into riskier investments with part of their portfolio, while maintaining a low-risk profile. You should examine risk in the context of your total portfolio, rather than a single security or investment category.
Investors, of course, take on risk for the possibility of return. However, individuals differ greatly in their return needs. If you depend on your investment portfolio for part of your annual income, for example, you want returns that emphasize relatively higher annual payouts that tend to be consistent each year and protect principal. On the other hand, individuals who are saving for a future event—a child's education, a house, or retirement, for instance—want returns that tend to emphasize growth. Of course, many individuals may want a blending of the two-some current income, but also some growth.
Determining your return needs is important because you can't have all of everything—there is no investment that offers a high certain payout each year, protects your principal, and offers a high potential for future growth.
There are a number of trade-offs here, based on the risk/return trade-off. First, the price for principal protection is lower returns, usually in the form of lower annual income. There is also a trade-off between income and growth: The more certain the annual payment, the less risky the investment, and therefore the lower the potential return in the form of growth.
Your time horizon will also affect your investment plan. Time diversification-remaining invested through various market cycles—is most critical for volatile investments such as stocks, where prices fluctuate greatly over the short term, but are considerably smoothed over longer time periods.
If your time horizon is short, you cannot effectively be diversified across different market environments. Longer time horizons allow you to take on greater risks—with a greater return potential—because some of that risk can be reduced through time diversification.
How should time horizon be measured? Your time horizon starts whenever your investment portfolio is implemented and ends when you will need to take the money out of your investment portfolio. If you are investing to save for a specific event, such as tuition payments or the purchase of a house, your time horizon is fairly easily measured—it ends when you need the cash.
If you are investing to accumulate a sum for periodic withdrawals, such as during retirement, your time horizon is more difficult to quantify as you approach the time when withdrawals begin. For instance, when you retire, you may need to take out only part of your investment portfolio as income each year. Your time horizon will be a blend—partly short-term and partly intermediate- or longer-term.
What constitutes short-, intermediate-, and long-term horizons? To diversify over various economic cycles, you must be invested through one complete economic cycle at the very least. In general, the economic cycle lasts about five years, which can be considered a long-term horizon.
What about short- and intermediate-term horizons? Since these horizons are less than five years, stocks shouldn't be considered. In addition, the sooner you need the investment, the greater the need for principal protection and ease of selling. The time horizon effectively limits you to fixed-income securities:
- If you need the money within a year or two, you are limited to the shorter end of the fixed-income spectrum-money market funds, very short-term bonds and short-term certificates of deposit.
- An intermediate-term outlook—two to five years—allows you a little more room to earn higher returns using intermediate-term (less than five years) bonds and intermediate-term certificates of deposit.
Your Investment Plan
A successful investment plan matches the investment characteristics of the various asset categories to your personal risk and return needs. You can get a rough idea of the risk/return trade-offs in a portfolio by using the approach illustrated in Table 1: Portfolio Risk and Return: A Rough Guide. First, calculate the percentage (weighting) of the total portfolio that is invested in each of the broad asset categories; then multiply the weightings for each category by estimates for growth, yield, total return (growth plus yield) and the worst one-year possible loss; lastly, add up these results.
|Portfolio Weight||Potential Capital Growth||Current Yield||Total Return||Downside Risk Potential|
|Money Market Funds||10||0||5||5||0|
|Growth & Income||30||5||4||9||-20|
* Potential growth and current yield are long-term average estimates based on historical relationships among mutual fund categories; significant year-to-year variation can be expected.
The downside risk figures are estimates of annual decline during severe bear market conditions; the downside risk for the portfolio is based on the conservative assumption that all asset categories would decline simultaneously.
** Portfolio weight multiplied by return or risk. For example, Downside Risk Potential for the portfolio is:
(20% x –10) + (30% x –20) + (20% x –30) + (10% x –40) + (10% x –40) = –22%
How do you estimate return and potential loss? The potential growth, yield and total return figures in Table 1 are estimates based on long-term historical results for each of the asset categories; significant year-to-year variation, however, can be expected. The downside risk figures are the worst bear market declines for each category; the downside risk for the total portfolio assumes that all asset categories would decline simultaneously—a very conservative assumption.
Of course, there are several possible portfolio combinations. While the approach in Table 1 provides a simplified method for analyzing a portfolio, computer software programs offer more sophisticated approaches as well as long-term historical data that can help you tailor a portfolio to fit your needs. These programs also can help you monitor and maintain your portfolio once you have developed your investment plan. Successful stock investing is not a matter of picking stocks willy-nilly, but rather involves an overall style or strategy. This refers to the techniques used to select individual stocks and combine them to form stock portfolios. In addition, there are broad timing decisions concerning when to enter or exit the stock market.