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2015 5th Edition (Other Editions)


Most investors seem to worry about picking the right stocks. However, abundant research on billions of investments shows that is almost impossible. Indeed, efforts to pick the right individual securities generally mean above average risks and below average returns.


Concentrate on building an investment portfolio that has a balance among asset classes - stocks, bonds, cash, etc. This can be done by applying the practical ideas of economists Harry Markowitz and William Sharpe, who won the 1990 Nobel Memorial Prize for Economic Science. Their ideas are known as "Modern Portfolio Theory."

The Modern Portfolio Theory helps an investor toward his or her financial objectives, while minimizing both risk and investment expenses. It guides many investment managers responsible for trillions of dollars of pension funds, endowment funds and other institutional portfolios around the world.


The selection of individual investments has a negligible impact on performance. Far more important - the allocation of funds among asset classes. The decision about how much to put in stocks as a class versus bonds as a class will have more impact than the decision about whether to buy Company A or Company Z stock, for example.

According to Markowitz and Sharpe, market-timing strategies seldom work. About 70% of market timers (people who use input such as recent past market fluctuations or the leading economic indicators to predict and profit from short-term market performance) under-perform the average. Long-term allocation strategies work better.

To minimize risks, a portfolio must be put together with asset classes that have a low correlation coefficient. This means that when one asset class is down, it is likely another asset class in the portfolio will be up.

Example: When the stock market crashed in October of 1987, the bond market had one of its best days of the entire decade. So, a portfolio with a balance of stocks and bonds would have minimized the volatility


This includes your family situation, financial objective and target rate of return (The rate of return you will need on your entire investment portfolio to achieve your objectives). Determine your time horizon

Begin by considering actuarial life expectancy, and when you will really need the money. Determine your risk tolerance level

What is the largest amount of money you can afford to lose in the single worst year of your entire time horizon? Three percent is about average. Risking an amount of 8% would be very aggressive.

This would be in the form of a statement that provides specific instructions to an investment advisor. This policy must cover whose money is in the portfolio, targeted rate of return, risk tolerance level, anticipated annual withdrawals or contributions, emergency liquidity distributions, desired holding period and asset classes which, for personal reasons, you want to be in or avoid.

This is especially warranted by significant changes in market conditions. Generally, if any asset class held in the portfolio differs by more than 5% from its original target allocation, then more should be bought or some sold until the target percentage is restored. A semiannual rebalancing is usually fine for portfolios of less than US$1 million. With portfolios worth more than US$1 million, a monthly or quarterly rebalancing makes sense.

American Institute of CPAs www.aicpa.org
Morningstar www.ibbotson.com
Financial Planning Consultants, Inc. (4/1/14)