BCR Wealth Investment Strategy

Most investors worry about picking the right stocks. But abundant research on more than $500 billion of investments show that's almost impossible. In reality, efforts to pick the right individual securities often mean above average risks and below average returns.

Much Better Strategy

Concentrate on building an investment portfolio that has the right 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 Noble Memorial Prize for Economic Science. Their ideas are known as Modern Portfolio Theory.

The Modern Portfolio Theory enables an investor to achieve financial objectives, while minimizing both risk and investment expenses. It guides investment managers responsible for trillions of dollars of pension funds, endowment funds and other institutional portfolios around the world.

Modern Portfolio Theory Basics

• Investment Selection

The selection of individual investments has a negligible impact on performance. Far more important is 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 IBM or Disney stock, for example.

• Use of Timing Strategies

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) perform under the average. Long term strategies work better.

• The Efficient Market Concept

In a totally free market, where all investors have all publicly available information, the value of the security would equal the asking price. This is considered an "efficient market." While some markets, such as government bonds, are far more efficient than others, such as international real estate, it remains true that hardly any investors consistently outperform a market.

Conclusion: Buy an asset class through "indexing," a technique that uses the performance of an arbitrarily chosen group of securities to represent the risk and return characteristics of a given asset class.

For example, you might consider an equity mutual fund that tracks the Standard & Poor's 500 Index, or a bond mutual fund that tracks the Salomon Broad Investment Grade Bond Index.

• Minimize Investment Risks

To minimize risks, a portfolio must be put together with asset classes that have a low correlation coefficient. What does this mean? When one asset class is down, it's 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 the right balance of stocks and bonds would have held steady, overall.

• Minimize Transaction Costs

Transaction costs, principally brokerage commissions, can have a significant adverse impact on portfolio performance. They should be kept low by minimizing trading. Owning an asset class in an index mutual fund costs only a fraction as much as owning that same asset class with an active manager.

There Is A Simple Way To Invest

• Identify your current personal financial situation. This includes your family situation, financial objectives and target rate of return. The rate of return you'll need on your entire investment portfolio to achieve your objectives.

• Determine your time horizon.  Begin by considering actuarial life expectancy, and when you'll really need the money.

• Determine your risk tolerance level.

• Develop a written investment policy. This would be in the form of a statement that provides specific instructions to an investment counselor. 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 from IRAs, desired holding period and asset classes which, for personal reasons, you want to be in or avoid.

• Select an investment counselor. This must be one who constructs portfolios according to Modern Portfolio Theory. Check the advisor's ADV registration on file with the SEC. Consider one whose compensation is fee-only rather than brokerage commissions, to avoid a conflict of interest. Advisors who work on commission may be more likely to recommend more frequent transactions in your portfolio. If your broker is compensated on a trade basis, investigate the discounts available.

• Minimize transaction costs. Each asset class should be purchased with a no load indexed mutual fund, if available. There are indexed funds for large "cap" (capitalization) U.S. stocks, small cap U.S. stocks, large cap global stocks, oil and gas stocks, Japanese stocks, money market instruments, one year U.S. government bonds, five year U.S. government bonds, precious metals, and so on.

• Let Dollar Cost Averaging work for you. Since it's impossible to consistently predict short term price trends, purchases of indexed funds should be on a dollar cost averaging basis, which means staggering purchases, perhaps every month over a 12-month period. Important: Dollar cost averaging is usually worth the added transaction costs only when dealing directly with a no load mutual fund company, with investment increments of at least $10,000, or with a discount broker, with investment increments of at least $25,000.

• Rebalance your portfolio periodically. 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 semi-annual rebalancing is usually fine for portfolios of less than $1 million. With portfolios worth more than $1 million, a monthly or quarterly rebalancing makes sense.

• Measure the investment performance. This should be observed quarterly and given serious review after each calendar year. Quarterly reporting is even better. Use two different types of performance reports: time weighted and dollar weighted. To compare the investment performance of your portfolio with the performance of other investment managers, use time weighted rates of return. To determine whether the market value of your portfolio is growing fast enough to achieve your own financial objectives, use dollar weighted rates of return.

With this strategy, investors will save brokerage commission, avoid needless risks and help achieve a targeted rate of return with greater peace of mind.