Sensible Portfolio Management™
Investment portfolios should be designed in the context of your financial plan. Once you have a clear vision and a plan to make the vision a reality, then it’s time to design your investment portfolio. Sensible Portfolio Management™ is the process of determining the appropriate balance between risk and return and managing to maintain that balance.
Investing is putting your excess capital to work to produce goods and services. Speculating is making a bet that one stock or one market segment will out-perform another because of a reaction to unpredictable, random news events. Over time, investors get paid for putting their capital to work. Speculators get paid if they are lucky enough to guess a random event in advance.
We believe it makes more sense to invest our clients’ capital rather than use it to place bets.
Eugene Fama at the University of Chicago and Ken French at Dartmouth built upon the Noble Prize winning work of William Sharp to develop a “Three-Factor Model” that explains 96% of the movement of security prices. The remaining 4% is simply reactions to random, unpredictable events. Most stock traders and active mutual fund managers try to predict the random news events and the way investors will react to that news. In other words, they focus on the 4% random error rather than the 96% explanation.
We believe it makes more sense to build portfolios that capitalize on the 96% explanation rather than the 4% random error.
Active managers focus on the 4% random errors that result from short-term reactions to unpredictable news events. In other words, they are trying to manage the unmanageable. To avoid this, investors will turn to index funds. However, the rigid set of rules that prevent them from managing factors that they could otherwise control. The solution is to find a fund that is as diversified as an index fund but allows for the management of such factors as:
- When as stock is added or subtracted from the portfolio
- Whether to pay the bid or the ask price
- The transaction fees
- The ability to lend securities to reduce transaction costs
- The ability to over-weight small and value stocks to manage risk and enhance long-term performance.
- The degree of diversification
We believe it makes more sense to have globally diversified portfolios using managers that focus on factors that are manageable.
One of the advantages of portfolio management over simply investments is the ability to identify and manage risk. However, in the age of “financial engineering” much of the information about the risks a fund manager is taking is buried deep in the Statement of Additional Information and is obscured by “legalized” language. In order to properly manage risk, this information should be up-front, readily available and easy to understand.
We believe it makes sense to make the entire portfolio and investment process transparent for our clients.
Sign up here for a two hour free, no-obligation consultation with Thom Allison, CFP®.