Investing

PUT CURRENT MARKETS INTO AN HISTORICAL CONTEXT

Historically, bull markets have lasted longer than bear markets and delivered price gains that are disproportionately greater than the bear market losses. Investors who react emotionally to short-term movements are at risk of making ill-timed decisions that compromise long-term performance. It is important to maintain a disciplined investment approach that views market events and trends from a long-term perspective.

DESIGN A PLAN THAT CAN SURVIVE DIFFICULT MARKETS

Your financial plan will be subjected to rigorous stress testing and designed to achieve your life goals even in the event of difficult markets. That measure of confidence is essential to maintaining an academic, dispassionate and long-term view of how to invest your portfolio during times like these.

ACCEPT THAT MARKETS WORK (EVEN IF THEY ARE TUMULTUOUS)

Markets throughout the world have a history of rewarding investors for the capital they supply. The current recession does not change the fact that companies continue to compete with each other for investment capital, and millions of investors continue to compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk.

Traditional managers strive to beat the market by taking advantage of pricing "mistakes" and attempting to predict the future. Too often, this proves costly and futile. Predictions go awry and managers miss the strong returns that markets provide by holding the wrong stocks at the wrong time. Meanwhile, capital economies thrive—not because markets fail but because they succeed.

The futility of speculation is good news for the investor. It means that prices for public securities are fair and that persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.

UNDERSTAND THE DIMENSIONS OF RISK

Evidence from practicing investors and academics alike points to an undeniable conclusion: Returns come from risk. Gain is rarely accomplished without taking a chance, but not all risks carry a reliable reward. Financial science over the last fifty years has brought us to a powerful understanding of the risks that are worth taking and the risks that are not.

Everything we have learned about expected returns in the equity markets can be summarized in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small/large and value/growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.

EMBRACE DIVERSIFICATION

Successful investing means not only capturing risks that generate expected return but reducing risks that do not. Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on "information" from rating services. To all these, diversification is the antidote. It washes away the random fortunes of individual stocks and positions your portfolio to capture the returns of broad economic forces.

For many investors, the S&P 500 represents the first equity asset class in a diversified portfolio. Although the S&P 500 Index is diversified in large US companies, investors can benefit further by adding components. Take, for example, a portfolio that holds just US stocks (S&P 500 Index), a portfolio that holds just Japanese stocks (MSCI Japan Index), and a portfolio that holds both. The diversified portfolio has not only provided higher historical return than either alone, but it has done so with fewer negative quarters.

Next Step Wealth diversifies in the amount of securities our clients' portfolios hold (thousands) and in the range of capital market strategies we employ. In this way, investors focus on the factors that drive investment returns and reduce excess and undesirable risk.

This is the power of diversification: the whole is greater than the sum of its parts.

FOCUS ON STRUCTURE

Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are several asset classes, all with average price movements that are distinct from one another. Investors can benefit by combining the different asset classes in a structured portfolio.

A full range of asset classes includes small and large stocks, domestic and international, value and growth, emerging market countries, global bonds, real estate, and even municipal bonds. Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts. Investors have the ability to achieve greater expected returns with less price fluctuation and more consistency than they would in a less comprehensive approach.

However, because no two investors are alike, there is no single "optimal" asset allocation. Each investor has his or her own risk tolerances, goals, and life circumstances that dictate the weightings of core and asset class portfolios. You should consult with Next Step Wealth to help determine an appropriate mix. In general, the greater the proportion of stocks a portfolio holds, especially small cap and value stocks, the more "aggressive" is its risk and the greater is its expected return.