Like cooking, science should be the basis upon which you make fundamental investment decisions.

In investing, using proven principles based on historical data and research, an investor can create a portfolio using reasonable estimates for long-term expected risk and return characteristics to make long-term investment decisions. (Be aware when using estimates that there are never absolutes in predicting outcomes).

There is also a very personal element to creating an appropriate investment strategy that must be considered if you are to be happy with the outcome. The need to sleep at night requires the skillful blending of the right ingredients to get the balance you need to feel confident you have the right strategy to reduce the risk of failing to meet your goals. That is where the art of investment planning comes in.

To build the nest egg you will need for retirement requires discipline and patience. You have to treat your personal income and expenses like a business. Typically, this involves having a financial plan that incorporates short-, mid- and long-term goals for putting money aside. Like creating the “perfect” chili, you first need basic ingredients; in investing, setting aside money to invest is as basic as it gets!

Your goals must be realistic, measurable and attainable. Ultimately, you have to make sure the plan—your recipe for success—will work for you as a unique individual. This involves incorporating reasonable expectations for returns over time, as well as your own ability to accept a given level of volatility (or “risk”) in your investment strategy. There is very little return to be had without some degree of risk in one form or another. (Note: Risk can take many forms; in this article, I am only addressing volatility risk and the risk of goal failure.)

The approach to building your nest egg should be process-driven. You should document the process you will follow in a written plan, an “investment policy statement” (IPS). If something happens to you, someone else should be able to understand exactly what your rationale was.

Your IPS should be geared toward your goals, with specific parameters set for these factors:

• What you will invest in—i.e., stocks, bonds, exchange-traded funds (ETFs), mutual funds, real estate, hedge funds, etc.;
  
• The criteria used for evaluating and monitoring overall, and manager/fund, performance;
• Your return expectations;
• The level of volatility and other risks deemed acceptable to you; and
• Your time horizon.

What to Invest In

Determining what you will invest in is a very big decision. This decision will drive the returns you can expect from your portfolio and the risks you will be taking on. Whatever you invest in, my first recommendation is to make sure you buy enough different holdings in that type of investment to adequately diversify away what is referred to as “specific issue” risk. This is the risk that a company or borrower goes bankrupt and a particular, specific investment becomes worthless. Each investment in your portfolio needs to be small enough to not create a disaster if the worst-case scenario happens; always assume the worst-case scenario is possible.

Invest only in something you understand. That means understanding how gains will be earned, and, more importantly, what the risks are and what the potential for loss is. Understand the economic scenarios that are necessary to make money as well as those that will lead to failure.

For the vast majority of individual investors, the following asset classes will create an adequately diversified portfolio: cash (e.g., money market funds, Treasury bills, etc.), stocks, bonds and real estate. A global approach is best, but not necessary. If investing in foreign companies worries you, you can stick with U.S. securities.

You do not need any of the many “sophisticated” investment strategies now being marketed, such as hedge funds, derivative strategies, synthetic securities and “liquid alts.” You also do not need any of the innumerable other esoteric investments that the industry is constantly creating, repackaging and pushing aggressively as “smart money” strategies. These are not appropriate for the vast majority of individual investor portfolios.

Note that “sophisticated” and “smart money” investments are euphemisms for “you’ll never understand how or why these work, so don’t even try.” By the way, have you seen the art that “smart money” and “sophisticated” investors are paying millions for these days? C’mon ... really!?

Evaluating and Monitoring

Once you have established a plan, you need to keep an eye on things. Not only does that mean carefully deciding who’s going to play what roles in the management of your selected investments, but also deciding who is going to monitor them closely. For example, if you use money managers (either mutual fund or separate accounts) instead of buying your own stocks and bonds, you must evaluate the managers’ performance and other aspects of their operations on an ongoing basis. If you buy your own stocks and bonds, not only will these require constant attention, but you will need to know how to evaluate how well you are doing.

For evaluating performance, how you do it and what you use as a benchmark depends on what you are trying to accomplish and what you want to measure. This could be an article all by itself, as there is much to know about what to measure and how to measure it, but I will give you a summary here.
 

Compare Apples to Apples

First realize that there is a difference between interesting information and useful information. Useful information is data that will lead you to a decision; based on the outcome, you will either stay the course or change course. If you are evaluating a money manager, finding a benchmark that reflects the specific strategy the manager is employing is critical to knowing if they are doing an acceptable job.

For example, compare a small-cap value manager to a small-cap value index or peer group that is reflective of the risks and opportunities available to that manager. The Russell 2000 Value index might be appropriate, or it might not be. The suitability of this index as a benchmark depends on what the manager’s strategy and objectives are. Comparing this manager’s performance to the S&P 500 index or the Dow Jones industrial average would not only be foolish, it would be counterproductive. Comparisons should always be apples-to-apples and oranges-to-oranges.

Look for the Right Indicators of Success

Keep in mind that looking for a manager is a lot like dating—you are looking for reasons ahead of time as to why the marriage might fail. There are all kinds of criteria that should be considered to reject managers (and funds). In the simplest form, you’ll want to evaluate a manager’s (or fund’s) people, philosophy, process and then, last and most certainly least, performance.

Why would I say performance is the least of the four criteria for evaluating a manager? Performance brings with it its own complications, not the least of which is that past performance is not a good predictor of future results. In fact, nothing leads to greater error in investing than blindly evaluating an investment based on its recent performance. When you understand the cycles that markets and managers go through, you can understand why.

 

This is not to say performance is unimportant; your whole purpose is to get performance from your investments. But blindly accepting three- and even five-year performance numbers as somehow indicative of the quality of a manager or fund is naïve, at best. The quality and experience of the people, their investment philosophy and the prudent, diligent process employed by the firm are far better indicators and predictors of future success.

Keep a Long-Term Focus

Once you have “dated” enough to finally get married, your goal is to find reasons to make it a long-term relationship, if at all possible. Regularly changing a manager, fund or strategy because of a period of underperformance is a formula for long-term failure. This happens far too often, even when an investment adviser is used. When an advisory or consulting firm is concerned more about marketing and growing their business than their existing clients, they will change managers and funds often to increase the odds of their “stable” of managers always having great three- and five-year track records to show prospective clients. This can be very harmful to an investor’s portfolio.

You may not like suffering through a period of underperformance, but if you (or your adviser) did a good job during the dating game, then you selected a partner you need to commit to for the long term. There are many good reasons to quit a manager relationship; performance alone is rarely one.

Over the years, I have seen more than one research report conclude that when big pension funds with billions at stake fire a manager and hire a replacement manager, the fired manager does better than the new manager almost two thirds of the time—a much higher probability than a coin toss! Why? Because managers and funds go through cycles like everything else in nature (including the markets and economic conditions). Most managers/funds get hired during a period when their strategy has been particularly successful and most get fired after their strategy has been particularly unsuccessful. As a general rule, on any date that you look at the 10-year return data of the top 10 funds or managers in any asset class or subclass, you will find that all of them, without exception, will have had at least one year where they performed in the bottom quartile of their peers and significantly underperformed their benchmark. (If you find an exception to this rule, just know it’s the exception that makes the rule.)

Even the best managers will go through cycles of ups and downs. Even mediocre managers can catch a wave from time to time, and when they do they get hired because they have a “great” three- and five-year track record. One or two outstanding quarters can turn a lousy three- or five-year performance record into a great one. These managers tend to get hired right about the time their cycle has peaked.

Like buying high and selling low with stocks, you can do the same thing with managers/funds. Therefore, your criteria needs to include more than just “who has the best performance lately?” This seems sensible enough, but many investors focus first and foremost on the performance question. The reason is obvious: It is easy to do and counter-intuitive not to.

If you are indexing, you have to expect not to do better than the index that the fund or ETF is structured to mimic. Indexing does not give you license to be complacent, however. The fund or ETF may do a better or worse job of tracking its index. You want to monitor the fund to ensure it does not lag behind its benchmark by any more than its fees and expenses.

Return Expectations

The reasonableness of return expectations can be difficult to assess. Many investors simply use historical rates of return, typically beginning with 1926 for stocks, bonds, Treasury bills and inflation. Table 1 shows these numbers. Given this long period of time, you would think that the averages over the past 90 years would be relatively stable and predictable over time. Just by glancing at the 20-year periods in Table 1, you will notice how wildly different returns can be for reasonably long periods of time.

Table 1. Asset Class Returns for 20-Year Periods from 1926–2015

An alternative to historical returns is to use the capital markets expectations (CME) of one or more experts who take historical returns, and their relationships to inflation, then predict an inflation rate and current market conditions and provide a prognostication of returns and volatility for each of a number of asset classes (and subclasses).

Most modern portfolio theory (MPT) “efficient frontier” asset allocation software programs will have a CME option available to the user. Table 2 shows a sample of a popular MPT efficient frontier modeling program covering the past 10 years. Comparisons of these returns to actual returns demonstrates a more conservative leaning toward future returns than using purely historical returns for comparison. I believe that is prudent.

Table 2. Sample Capital Markets Expectations (CME)   

Risk and Volatility

Let’s take a moment to define “risk” as it is used in the investment business when discussing long-term portfolio construction. An appropriately diversified portfolio will have significantly eliminated the types of risk associated with investing in one company’s stock or bonds, such as when a company fails to meet expectations or goes bankrupt. Although such events certainly may happen to an individual security held in a diversified portfolio, if appropriately diversified, the probability that a company’s failure would materially affect your returns will be small.

Investment portfolio “risk” and “market volatility” become synonymous for the well-diversified investor. This is not to say that the risk of not achieving your ultimate goal is unimportant, it is that risk that drives the decision to accept greater or lesser degrees of volatility in the first place. For purposes of developing strategies that can reduce the downward swings of the market with the least amount of sacrificed return, risk is defined as volatility. The presumption here is that company-specific risk has been eliminated, leaving only market risk (and the risk of not meeting the goal, which can never be eliminated, but rather only mitigated).

 

Once you have established how much you will need and when you will need it, mitigate the risk of failing to achieve your goal by adopting a strategy designed to achieve that goal. Be willing to accept the volatility—the ups and downs—along the way. There are no free lunches, as we learned in Economics 101, and this is especially true in investing. If your goal is far enough out, however, the reliability of an appropriately diversified strategy is as close as you’ll ever get. The key is not to panic when the world seems to be coming to an end.

Time Horizon

The single most important factor in building a portfolio is your time horizon.

The “best” strategies for building a nest egg for retirement and investing for other goals will likely be different. I won’t say they must be different, but many times they should. It’s all a function of your time horizon. If your goal is to accumulate a certain amount of money in two or three years, your strategy should be radically different from your strategy for investing for retirement, which can last 20 or more years once you get there. In the former case you shouldn’t be in stocks at all; in the latter, they may be a necessity to meet your goal.

In the short run, investing in stocks is speculative; you are counting on unpredictable short-term events for your returns. Yet your retirement, even if you’re already retired, will require funding for many years. It is really a series of annual spending goals, some of which may still be many years in the future.

For short-term liquidity needs, staying in cash equivalents is essential to eliminate market risk. Unfortunately, today the term liquidity has been changed to mean marketability. Marketability is the ability to quickly and easily find a buyer and execute a sale. If the price the buyer will pay is not known until the transaction takes place, the asset is not liquid even though many advisers, publications and investors today confuse the two terms. A liquid investment is highly marketable, but it has virtually no specific issue or market risk, nor virtually any interest rate risk to speak of. It is essentially the equivalent of a dollar. Examples include T-bills, money market assets and money market funds, and FDIC insured 30- to 90-day CDs, savings and checking accounts. The dollar in your pocket is the most liquid of all assets. The fact that it doesn’t earn anything is not relevant to the definition.

For a long-term, strategic approach, it is not important to analyze where the market is going to be in six months, 12 months or two years. The cost of moving money and, more importantly, the cost of being wrong are too great to bear. Being out of the market on just a handful of days, even over extended periods of time, can cost you up to half or more of the market returns for that period.

Conclusion

Know and understand what you’re investing in and be comfortable with that knowledge. Hedge funds and similarly complex investments should be avoided unless you understand them well enough to explain the risks and sources of returns to your brother-in-law. Good luck with that.

Unreasonable expectations are very costly to one’s portfolio and have led to significant underperformance of the average investor’s portfolio. This is because these investors are always disappointed and looking for a better deal based on what a manager did last month, last quarter or last year! They’ll always find somebody doing better. The problem of course is that past performance is no guarantee (or even a necessarily good indicator) of future results.

So make sure your expectations are realistic. Having unrealistic expectations leads to bad decisions. For years, research has shown that the average investor has expectations way out of line with reality. Step back and become educated enough to know what’s truly reasonable. You don’t want to constantly chase after that nonexistent pot of gold at the end of the rainbow.

Understanding the basic science of investing and the nuances that make it an art are essential to your long-term financial well-being. Whether you are a do-it-yourselfer or are looking for someone to cook up a plan for you, know the fundamental truths behind the art of investing. I have recommended two books for years to anyone really interested in learning about the science of investing (with some art thrown in as well): They are “Wealth Management” by Harold Evensky [originally published by McGraw-Hill in 1997 and updated as “The New Wealth Management,” John Wiley & Sons, 2011] and Roger Gibson’s classic, “Asset Allocation” [fifth edition, McGraw-Hill Education, 2013].

Finally, if you decide you need help in managing all this, be sure to hire an adviser willing to be a fiduciary to you at all times, for all your assets. This is an adviser who must always put your best interest first and must be qualified as a competent expert to give advice, not just a darn good salesman. Finally, know that while a registered investment advisor (RIA) is required by law to be a fiduciary, a broker adviser is not. In most cases, brokers’ firms will not allow them to act as such except for a retirement account covered by the Labor Department’s new fiduciary rule. Ask the question “are you a fiduciary to my account?” and get the response in writing.