Investment approach

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So I mentioned in my inaugural message I would probably be spending a fair amount of time on investment topics, which I haven't really done yet. Regardless, if I do start producing in that area, I figure I should have on record my current approach/strategy.

Or more correctly, my long term strategy. I am not a stock picker. Despite however much time people think i have, I don't have quite the time, or gumption, to make large bets on any one particular company. That wasn't always the case--back in 1993, I identified Microsoft as a company I'd like to work for (if that can be used as a proxy for buying stock)--not that I took a curriculum that would produce that result. But I digress...

Except our remaining Motorola stock (shoulda sold in October!), we're all in mutual funds. My belief is that costs (the expense ratio of a fund, loads, and other fees) matter, as that is the only prospective part of returns (or anti-returns) you can project. So this means Joanne & I are largely in index funds when available (ie, not her 401k), such as the S&P index, MSCI interntional, Wilshire 5000, etc. Index funds only try to match those returns, rather than making bets to beat that benchmark.

The virtues of this strategy is that an investor basically gets the returns of the market. So you're saying to yourself, "sounds like you're getting average returns. I can do better." And that thought is common and one that most people are susceptible to, and one I haven't completely escaped yet.

The bigger picture, though, is that there is a price paid for active trading--additional costs. Everyone has heard about how a monkey throwing darts beats some majority of professional fund managers or stock pickers, which demonstrates the randomness of returns. So if a pickers returns are random--just as likely to beat the market as get beaten--active fund managers not only have to beat the market, they have to beat it by more than the extra costs incurred (active funds tend to have expense ratios at least .5% higher). This is doable in the short term, but more difficult over longer periods. The day-to-day "noise" of the market obscures talent versus luck. But, in the end, over periods longer than 10 years, index funds tend to finish in the top quartile of performers.

Other advantages: tax efficiency (no need to get in and out of funds, lower turnover), easier to diversify across asset classes and no issues of manager turnover, style drift or asset bloat.

Given these advantages though, I still wouldn't classify myself as an indexer, as I am willing to own active funds, but the key is low costs, and that narrows the universe quite a bit. Active management does hold some appeal in terms of shying away from market bubbles (though they are just as likely to be "all in" like the 2000 tech bubble). Also tax issues are less of concern in tax advantaged accounts. But in taxable accounts, index funds are a good choice--since one has accepted the market return, there won't be any need to every sell the fund unless necessary, so this delays capital gains as long as possible, rather than churning to buy into new funds.

The second main part of my approach is holding funds in diverse asset classes: large, large value, small, small value, international, reits, fixed income. This "slice and dice" approach, when using index funds, increases returns by giving more latitude to buying low and selling high through periodic rebalancing.

Currently we're at 30 us large/15 us small/30 international/20 stable/5 reit. Some of that is cheating though--the stable is not all in bond funds. A fair chunk is in a balanced fund that holds about 40% bonds, but it's a fund that held up remarkably well during the 2000-2002 bear. When to incorporate a more legitimate bond fund(s) is one of three things that still needs to be addressed in terms of our portfolio makeup, the others being the divesture of MOT and proper diversification in international.

Actually, there's a fourth. Since this asset allocation is fairly new, it is strongly likely there is recency bias in how I've decided to allocate. We are small and value tilted, with a healthy percentage in international, and have established not insignificant positions in emerging markets and real estate, all of which have outperformed over the last 5 years.

Given the allocations, it's possible we bought in high to some of these areas. The key for us is to stick to this general strategy. So if the next 5 years involves those asset classes underperforming, I don't make changes with that as the sole reason. Adjustments to the portfolio plan are based our acceptance/need to take risk and the ability to increase diversification.

A general reminder for investment planning: "the greatest enemy of a good plan is the dream of a perfect plan." The more important thing is to be invested for the long term, to start sooner rather than later, to develop a strategy and risk tolerance that you can live with, and follow through with it. I think Joanne & I are on our way.

A reading list:
The Four Pillars of Investing
A Random Walk Guide to Investing
Investment Guide
Diehards
Intelligent Asset Allocator