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7 Core Investment Beliefs At Prudent Asset Management, we have seven core beliefs about investing that guide our decision making process for clients. The seven guidelines below outline the investment philosophy at Prudent Asset Management… 1. Broad Diversification, With Exposure To All Parts Of The Stock And Bond Markets, Reduces Risk
Investors whose holdings vary substantially from overall market weightings-in terms of capitalization, style (growth or value), and industry sectors-are assuming additional risk that is unlikely to pay off over the long term. That is why at Prudent Asset Management, we do the following…
A diversified, low cost, asset allocated portfolio is the key to the investment philosophy at Prudent Asset Management. At any time, while some of your investments are living up to expectations, others may be underperforming. If you want your portfolio to provide the best possible return while also limiting the risk of major losses, you have to diversify, or spread your investment money among different asset classes, such as stocks, bonds, and cash. That's because any time all of your money is concentrated in one sector or asset class, your financial security depends entirely on the strength of that class. And no matter how sound the sector may be, there will be times when its market price falls or it yields less than the rate of inflation. The First Step...
Properly diversifying your investments is not as easy as it might sound. For starters, you need enough money to purchase a variety of investments. And, you have to judge each one not only on its own merits, but in relation to the rest of your portfolio. When we recommend investment money into fixed-income investments like corporate or municipal bonds, we also recommend equity based investments through the utilization of Exchange Traded Funds. The initial allocation decision is crucial. The Second Step...
Diversification also means spreading your investment dollars within specific types of investments. For example, your stock portfolio is not diversified if your broker recommended shares in just one or two companies, or in companies all involved in the same sector of the economy, like health care or utility companies. Nor are your fixed-income investments diversified if your broker recommended only municipal bonds issued by the state in which you live. If you invest in five mutual funds, but they all track small growth companies, you're not diversified either. At Prudent Asset Management and consistent with Modern Portfolio Theory, we know that real diversification calls for international investments. Because world economies respond primarily to what's happening in their own countries or regions, putting money into overseas markets is a good way to balance investments at home. Exchange Traded Funds provide the simplest and best ways to invest internationally, since the funds handle all of the currency and taxation issues that go along with buying and selling abroad. The Beauty Of Exchange Traded Funds...
One of the reasons Prudent Asset Management utilizes exchange traded funds for the equity component of a client's portfolio is that they are, by definition, diversified. Each fund owns dozens (and typically many more) different stocks. That way, if some of the holdings aren't performing well, they may be offset by others that are doing better. Because a fund has so much money to invest, it can achieve a breadth of diversification that no individual can.2. An Investor's Most Important Decision Is Selecting The Mix Of Assets To Be Held In A Portfolio, Not Selecting The Individual Investments Themselves.
The asset allocation decision-made in light of each investor's financial needs, risk tolerance, and time horizon-is the most important determinant of long-term returns. Multiple studies tell us the asset allocation decision accounts for more than 90% of an investor's long term return. For example, deciding what percentage of a portfolio to put in stocks will influence long-term returns more than deciding which stock fund or individual stocks to own. In devising an investment policy, or asset mix, we weigh the trade-off between return and risk. Potential return rises along with the risk of volatility in an asset mix. At Prudent Asset Management, we use a top-down approach to building a portfolio. After analyzing a client's objectives, time horizon, cash-flow needs, and risk tolerance, we focus first on establishing allocations to the major asset classes of stocks, bonds, and cash. Next we turn to suballocation-how to weight types of stocks and bonds. Specific investment recommendations come last. We focus most intently on choosing the mix of stocks, bonds, and cash investments. Once the mix is set, the suballocation decision comes next. For bonds, this means deciding degrees of exposure to issues with short-, intermediate-, or long-term maturities; with high, medium, or low credit quality; and with taxable or tax-exempt status. For stocks, attributes to consider are market capitalization (large-, mid-, and small-), style (growth and value), and domestic or international exposure. At Prudent Asset Management, we annually rebalance portfolios to maintain the target asset allocations. Research shows that portfolios that are not rebalanced have generated greater returns (because stocks over long periods are expected to outperform other asset classes), but with greater risk. Investors who take on more risk may not meet financial obligations or may find it hard to maintain an asset allocation during a market downturn. The timing of rebalancing-annually, semiannually, quarterly, or monthly- is not overly important to an investor's portfolio. But what is important is to get it done. At Prudent Asset Management, we do it annually. 3. Market-Timing And Performance-Chasing Are Losing Strategies
Both experience and academic studies suggest that a buy-and-hold strategy is better than market-timing (trying to discern when to "get in" or "get out" of stocks or bonds) or chasing performance (investing in the asset class or fund that has performed best lately). To succeed, market-timers must guess both the right time to get into the market and the right time to get out. And they must be correct often enough to overcome the significant transaction costs of the shifts. The dubious value of market-timing is reflected in the poor results from mutual funds that use these strategies.Similarly, experience shows that few investors do well by adopting a momentum strategy-buying an investment simply because its price has been going up or shunning an investment merely because its price has lagged. Financial-market returns tend to revert toward long-term averages-periods of above-average returns are likely to be followed by periods of subpar returns, and vice versa. A fund's past performance truly is in the past-you can't buy its past returns by investing in it today. 4. Consistently Outperforming The Financial Markets Is Almost Impossible
Academic research, Modern Portfolio Theory and decades of experience have shown that even most professional investors fail to beat the market indexes over the long haul. There are four key reasons for this. First, operating and transaction costs are higher for strategies that try to beat the markets than for buy and-hold strategies. Second, the world is simply too uncertain to permit accurate, consistent prediction of market movements or the fortunes of individual companies. Third, the financial markets are generally both very competitive and efficient. When someone spots an opportunity to outsmart the market by buying low and selling high, other investors soon catch on. Information spreads quickly and is soon reflected in the prices of stocks, bonds, and other assets. Fourth, any cash held by active portfolio managers tends to be a drag on returns, given that stocks and bonds have outperformed cash over the long term.At Prudent Asset Management, we don't engage in any sort of market timing or short term trading. Unless a client's investment objectives change (for example, once a client retires) or yearly minor rebalancing needed to bring the portfolio back to the original asset allocation percentages, there will be virtually no turnover and no timing efforts, thereby minimizing the yearly tax bite otherwise faced. Despite what is pronounced confidently by the talking heads on TV and in the Wall Street Journal, timing the market successfully over the long term is realistically impossible. It cannot be done successfully over any extended period of time. Yet the temptation to engage in the activity of market timing, to get out of the market shortly before it declines or into the market right before it goes up, is great due to the potential financial remuneration created by timing if right. Sir Issac Newton, one of the greatest physicists in history stated in 1768, shortly after being wiped out in one of the many stock market crashes of his era, "I can calculate the motions of the heavenly bodies but not the movements of the stock market". It has become accepted wisdom in financial circles that it is impossible to consistently time the markets. This has resulted partly from Modern Portfolio findings that no one can have such an advantage (legally) in their "efficient markets". In practice, the complexity of modern financial markets means that it is very, very difficult to predict the vast number of variables that can affect the markets. Who knew that Saddam Hussein planned to invade Kuwait in 1990 and the price of oil would soar? An investor predicting the unification of Germany and its resultant affect on the capital markets would have been labeled crazy by the investment pundits. It is equally impossible to establish an accurate valuation level for the markets. Compare these tasks. A small company might have a few competitors, a known product line and management. The cashflows can be identified and assessed. Even so, where we can value this company, its stock might not be appropriately valued for years and its future prospects depend on the economy in general. What about the market overall? Who is the management? What matters most, monetary policy or fiscal policy? What are demographics doing to demand? What about international considerations? That is why most market mavens have one or two great predictions before they are hopelessly out to lunch in the forecasting wilderness. While it is possible to tie it all together a few times, it is virtually impossible to do it consistently. Contrary to their confident predictions on TV and in the press, nobody knows which way the market is going to go. Should you allow your broker to time the market with your portfolio? Only if he has the necessary insight and discipline to know when to "hold" and when to "fold" as the song says. Both of these are realistically impossible to do successfully over any extended period of time. The smartest minds in the world have tried to time the market with different theories and philosophies over the years. Almost none of them have succeeded. 5. Minimizing The Costs (Fees and Taxes) Of Investing Is Vital For Long-Term Investment Success.
Costs matter a great deal because investment returns are reduced dollar for dollar by the fees, commissions, transaction expenses, and, for taxable assets, any taxes incurred. Investors as a group are the market. Therefore, investors as a group earn the market return before fees, expenses, trading costs, and taxes, and they earn somewhat less than the market return after subtracting all those costs. By minimizing costs, investors (and mutual funds) improve their odds of posting superior relative returns. At Prudent Asset Management, we utilize low cost Exchange Traded Funds for our clients. We entirely avoid actively managed funds and their exorbitant management fees, sales loads, 12b-1 fees, and operating expenses. Need proof for why we index through Exchange Traded Funds? Consider the following information regarding the 25 year period from December 1980 to December 2005. During that quarter-century, the Vanguard Index 500 earned a compound annual rate of return of 12.2 percent per year, compared to a rate of just 9.9 percent for the average equity fund. "Big deal" you might say? Consider the amount in hard earned dollars. Assuming a $10,000 initial investment in each, the investment in the index fund grew by $162,500 during that period, compared to growth of just $95,000 by the average equity fund, fully 40 percent less than the index fund accumulation. That 2.3 percentage point gap in favor of the passively-managed index fund is suspiciously similar to, albeit slightly lower than, the estimated all-in annual costs incurred by the average actively-managed equity fund: a total expense ratio of 1.5 percent (including some deferred sales charges), estimated front-end sales charges of 0.4 percent, hidden portfolio turnover costs of at least 0.8 percent, and 0.4 percent in opportunity cost. Please realize that in the real world, the index fund advantage gets even larger. While the annual return of each investment drops by the same 3 percentage points per year when adjusted for inflation during the period (active fund real return, 6.9 percent; index fund real return, 9.2 percent), when we compound those returns, the gap in favor of indexing reaches staggering proportions. That $10,000 in the index fund grew by $78,000 in real dollars, while that same investment in the active fund grew by just $42,800. The active fund, then, produced a cumulative real profit that was a mere 55 percent of the profit that lay readily at hand simply by passively owning the stock market itself-with the broadest possible diversification, sustained over the longest possible time horizon, operated at the lowest possible cost, thereby assuring the highest possible share of whatever investment returns our financial markets are generous enough to provide. Buying American business and holding it forever, at minimal cost, is what indexing is all about. And its success can't be questioned (even though your full service broker will attempt to do so) And don't think for a second the triumph of indexing only applies to the equity component of your portfolio. In the other major segments of the mutual fund industry, the triumph has been equally evident. The Vanguard Bond Index Fund, nearly two decades old, has surpassed its peer group average in 12 of its 19 years. And Vanguard's Balanced Index Fund has outpaced its average peer in ten years of its 12-year history. Indexing works as well for the fixed income portion of an investor's portfolio as well. 6. An Investor Should Not Expect Future Long-Term Returns To Be Significantly Higher Or Lower Than Long-Term Historical Returns For Various Asset Classes And Subclasses.
No method for predicting market returns is perfect-the future is unlikely to precisely repeat past patterns. But when estimating future returns for asset classes (stocks, bonds, cash investments) or subclasses, long-term historical returns are a good place to start. The major asset classes have long histories and well-established risk/reward characteristics. The financial theory used to support investing in total markets is called the "Efficient Market Hypothesis," or "EMH" for short. (It is also known as EMT, or Efficient Market Theory). This theory was first proposed by Eugene Fama at the University of Chicago in the 1970s. It has since become a cornerstone of modern academic Finance. The Efficient Market Hypothesis states that modern financial markets are "efficient." This means that they quickly react so that prices reflect all available information. For example, new information can often cause prices to rise or fall on the world's major stock and bond exchanges to adjust appropriately within only minutes. Prices of individual securities, market sectors and style segments, and entire stock and bond markets are therefore always "correct" in the sense that they always reflect the collective beliefs of all investors taken together as a whole about their future prospects. One major consequence of the EMH is that unless an investor is just plain lucky, it is impossible to exploit the market to make an abnormal profit by using any information that the market already knows. Another consequence is that for someone without any such private information, it does not make any sense to talk about "undervalued" or "overvalued" individual securities, sectors, styles, or markets. This is why even in 1999, at the apex of investor mania surrounding the "new economy" and Internet stocks, we were recommending 50% of a retired client's portfolio be invested in bonds, CDs and other fixed income assets. The 50% that was invested in equities was invested in large, medium and small capitalization stocks, growth and value, along with an international component. These sorts of portfolios can weather all storms. At Prudent Asset Management, we expect that returns from various subclasses of the stock market (growth and value stocks, for example, or small-, mid-, and large-cap stocks) will be similar to each other over long periods. Also, we expect that the long-term return for stocks will be higher than that for bonds, and that bond returns will, in turn, exceed returns on cash investments over long periods. That is why at Prudent Asset Management, we recommend asset allocations with a significant commitment to both stocks and bonds. We also ask our clients to have realistic expectations about future returns. Investors who depend on earning returns above the long-term averages for the various asset classes are apt to fall far short of their goals. We think in decades rather than months and we avoid panicking during market turns. This allows us to avoid making drastic moves in asset allocations in periods of market turbulence. 7. Investing Is For Long-Term Financial Goals; Saving Is For Meeting Short-Term Goals
Money that will be needed for a short-term objective-two years or less-should be kept in short-term vehicles such as money market funds, bank accounts, or U.S. Treasury bills to protect principal. The risk of short-term price declines is too significant in the bond and stock markets to hazard money kept for short-term goals. |
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