Knowing When It’s Time To Review Your Investment Strategy

With a new year upon us and a disastrous market fall in securities in 2008 and the first part of 2009 and a recovery in the latter part of 2009 and 2010, it is probably a good time to review where your portfolio and your investment strategy is now.  Too often people investing in equities have not been educated regarding the basics of investing.  There have not been classes in high school or most colleges that provide the proper financial education.  Many start saving by investing regularly in a company sponsored qualified retirement plan.

Typically these plans have many choices in mutual funds; therefore, people tend to spread their investment dollars over several funds without knowing very much about the funds or having a well defined written investment strategy. As a result they continue to pour money into the same investments on a regular basis, hoping that they are doing the right thing. Then, when the market takes a huge dive, as it has done during the past, they panic and sell, taking some large losses. Invariably, sooner or later the market recovers, but now their loss is solidified since they sold at or near the bottom and do not come back until the recovery is well under way. This behavior is especially detrimental if one is retired and a good portion of retirement income comes from investments. Having a sound investment strategy and a disciplined approach to implementing it is the key to avoiding this behavior.

One of the key decisions to be made in establishing a strategy is whether to invest in actively managed funds or passive index funds. Actively managed funds, managed by a group of professionals, have a goal to exceed the market average return as measured by a market index for a particular market segment such as, for example, the S&P 500 index. Of course, one pays a fee for fund management and often a commission to the broker who sold it. The alternative is to invest in broadly diversified portfolio of passively managed index funds that track the return of specific market indexes. The advantage here is lower expense ratio. The average actively managed mutual fund expense ratio is about 1.5% and the asset under management fee is between 1% and 2%; the expense ratio for a passive index fund may be 0.1% to 0.3%. If the average return of the fund is 8%, one is paying about 37% of earnings for an actively managed fund rather than 1 % to 3% for a passive index fund. Over a long period of time this makes a big difference. Is the extra expense worth it? In 1990, the Nobel Prize in economics was awarded to 3 professors, Harry Markowitz, William Sharpe and Merton Miller for their contribution to Modern Portfolio and Efficient Market Theory. They showed that markets are efficient and in the long run trying to beat the law of averages through active management is a loser’s game. So why pay to loose by paying someone to try to beat the market? Probably because it is in many people’s best interest to have you believe they have a proprietary method or superior knowledge in selecting investments. The argument of passive versus active management continues but perhaps it would be in your best interest to read a few good books on the subject and decide for yourself since this is a critical decision in establishing your strategy.

Other decisions in establishing an investment strategy deal with asset allocation, tax efficiency, trading expense, the need for a given return to achieve a goal, and willingness to take a measured risk. If you are not knowledgeable yourself in these areas, a professional advisor can contribute by assisting you with a written plan and strategy which will be your guideline in good times and bad. So, think twice or perhaps do some research on Modern Portfolio and Efficient Market Theory before chasing the hottest stocks or mutual funds or selecting investments based on someone who “knows how to pick them”.

About the author

James Gallo, CFP®

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