Investing is one of the hardest parts of personal finance for an individual. Once you get your budget and debts under control, it’s time to commit to investing for your long-term goals. Every individual is different in how they view the risk related to investing in the capital markets.

There are many market types you may consider for investments — stocks, bonds, real estate, commodities, precious metals, or fine art. The stock and bond markets are typically where we begin as investors. Let’s keep our discussion around traditional stocks and bonds for simplicity. The ideas presented here are a foundation, and once you understand them, you can begin educating yourself for additional investment diversification with real estate, commodities, precious metals, or art. To begin investing, it is important to understand the ideas of investment strategy, security selection, fees, and portfolio review.

Investing Strategy

When evaluating investments, there are five questions you need to ask yourself before making a purchase. The answers to these questions will develop your investment philosophy and help guide how to manage your portfolio appropriately.

1. When you shop, am you a bargain hunter and value the deal more than the item? Or, are you attracted to more trendy things that may cost a little more, but are worth it?
2. When it comes to investing, do you believe your knowledge has an impact on your long-term success over someone else’s, or do you think we all tend to have outcomes that will give us a near average result long-term?
3. Do you like talking and learning from others about investment ideas?
4. Do you feel interested and confident about making trades in the markets that will improve your portfolio results or would you rather buy and hold for the long term as long as you can meet your goals?
5. Do you like to review your investments from time to time or do you worry less about them and know that they will be ok as long as you keep saving?

Growth and Value Investing

When you are a person who loves a deal and likes to find discounts, you would be considered a value investor. It’s about the bargain. Value investors don’t want to overpay for a security. Applying a value strategy to stocks, bonds, or mutual funds would mean that you are looking for an investment you believe will grow your assets over the long-term but you are interested in buying the security when the price is discounted compared to its peers, or competitors. For the investment to be worthwhile, there should be a high-quality management team and sustainable or reliable long-term growth opportunity. In some, but not all, areas of the capital markets, we see value investments tend to be more likely to offer income along with capital gains. Income may come as a dividend, and a history of a slow and steadily rising dividend is even better.

A growth investor isn’t as focused on the bargain as much as they are on the growth of the earnings for an investment in the future. While no one wants to overpay for the price of something, a growth investor would be willing to pay a little more if there is a strong reason for growth sooner rather than later. Growth stocks tend to offer fewer dividend payouts because their profits are more likely to be reinvested in the company.

Active vs. Passive Investing

The idea of active vs. passive investing has become more popular over time. When someone is an active investor, they are routinely looking for new opportunities or opportunities that might be better than what they may already have. A passive investor feels more that portfolio returns average out over time, no matter what we do, so they are more interested in buying a wide variety of investments, which they will change very little over time.

When an investment manager buys a basket of stocks they often define themselves as active vs. passive. An active investment manager believes they follow a method of selecting securities that will benefit the portfolio more than the broad market will, there is a reason behind every buy and sell that occurs. A passive investment manager believes they cannot actively beat the general market’s return over time. Therefore, they buy a broad selection of securities to mirror the general market.

Investment managers who are active will typically charge a higher fee than those who are passive. Warren Buffett, a billionaire CEO and investor, made a public bet in 2008 that a set of five active managers, who charge high fees and use non-traditional techniques to generate returns, could not outperform the broad U.S. stock market, represented by the S&P 500 Index, for the next ten years. He won! The point is that Mr. Buffet knows and understands the investment fees take away from total returns, and because active management charges the most, his recommendation is for investors to use mostly passive strategies when investing.

Tactical vs. Strategic Asset Allocation

Tactical or strategic investing refers to the way someone makes asset allocation decisions.

Asset Allocation

An asset allocation is the mix of strategies and security types that work together to create an investment portfolio. We can create a portfolio of growth, value, active, and passive investments. By combining different strategies that perform well in different market environments, we can reduce the overall risk or volatility of a portfolio and potentially increase the return; compared to just investing in one strategy and security type. The shorter the time frame to reach a goal the more interested you should become in reducing the volatility.

Tactical Asset Allocation

Tactical asset allocation provides a portfolio that is diversified but will rotate among more favorable investments for the current market environment. Changes to a portfolio will likely occur more than once per year, possibly quarterly. We know, by studying macroeconomics, that certain sectors of the broad market and certain countries across the globe will perform better or worse depending on the type of economic environment we are experiencing.

For example, based on historical data, we have seen that during rising interest rate environments the market is nearing its peak and investors will begin preparing for a decline in stock prices. When that happens investors want to hold investments that have historically had the smallest drop in return and those tend to be stocks that are in sectors like consumer staples, healthcare, and precious metals.

A tactical allocator would sell some of its more growth-oriented positions to buy these sectors to protect the portfolio from losing too much value during a slow economic period. A tactical asset allocator would not only select the sector that is favorable, but also the security type. They may increase their bond exposure and foreign stock exposure when the U.S. economy is beginning to slow. This will give them a chance to minimize poor returns.

Strategic Asset Allocation

This kind of rotation doesn’t happen as much with strategic asset allocation. While strategic allocators are interested in taking advantage of favorable markets and security types, they will typically only change their allocation once per year or longer. The strategic portfolio will tend to be much more diversified or broad in nature. A short timeframe for investing will cause an investor to prefer a strategic allocation because there will be a higher need for less volatility or risk. The portfolio would begin to increase its investment in fixed securities like bonds or cash.

When we want the best of both strategic and tactical asset allocation, we can combine the ideas into a Core Satellite portfolio. The idea is to have a strategic and passive style asset allocation core of the portfolio with enhanced return opportunities as the satellites, which may be active and sector or country-specific holdings to take advantage of the current environment. Here is a visual of what that might look like:

60% Core and 40% Satellite Allocation: The strategic allocation is the traditional long-term buy and hold positions while the tactical allocation includes the shorter-term holdings that may offer opportunities for higher returns within the current or upcoming market environment.

Selecting the Right Investment

Once you have determined your asset allocation and what strategies or styles you will include, it is time to fill the “buckets” or strategy allocations with actual securities. Asset allocations can be filled with individual securities, like stocks or bonds, ETFs, or mutual funds. This article will cover the selection of mutual funds because that is what most people have access to when they first begin investing in a company retirement plan.

Mutual funds and ETFs are a basket of securities that are chosen by an investment manager and purchased with funds provided by shareholders or investors. While mutual funds are only priced at the end of the day ETFs will trade throughout the day. In a broad description, many mutual funds are considered active managers while ETFs are considered passive investments with very low costs.

The process of selecting mutual funds or ETFs will include a review of the securities that are in that basket, details about the investment manager and their historical investment returns, and fees. Here are the items you should answer yes to when considering a mutual fund for investment:

1. Has the investment management team been managing the fund for more than three years?
2. Is the fund more than three years old?
3. Are there more than $100 million in assets with the fund?
4. Does the fund follow a consistent style of investing: for example large-cap growth? (some funds will go between growth or value, and that may be ok, but you should be aware of that before investing)
5. Does the return for the last 1 year outperform the average peer?
6. Does the return for the last 3 years outperform the average peer?
7. Does the return for the last 5 years outperform the average peer?
8. Is the risk statistic* less than its peers for the last 3 years?
9. Are the fees less than its peers?

Peer group averages are available through a variety of online screening tools.

*The risk statistic is known as a standard deviation, and it will measure the volatility or swing in price for the mutual fund.

The ideal fund would have a yes for each question above, but it is essential that you understand how the investment manager will select securities, and you read the prospectus before investing. The criteria above can be applied to both mutual funds and ETFs. ETFs are often seen as passive investments, but there are new varieties that will no longer seek to match a broad market index but a more specific targeted index with a variety of characteristics. You must educate yourself about what you may be considering for purchase.

There are many screening tools for free online. Some of them are:

• Morningstar
• Zacks
• Yahoo Finance

Play with these and make sure you understand the peer group or category you are searching through and how a fund in the group will fill your asset allocation strategy.

Fees

Fees are often forgotten about when building a portfolio. There are several levels of fees you should be aware of when beginning to invest.

Advisor Fee

The financial advisor you may use to provide recommendations or place trades in your account will charge a fee. That fee may be a flat fee of a specific dollar amount per quarter, or it may be a percent of the assets in your account. It is common for advisor fees to be around 1% of a portfolio and for them to be automatically taken from your brokerage account each quarter. Make sure you understand your advisor’s fees and that they are explained in a contract you may sign.

Investment manager Fee

For mutual funds and ETFs, the investment manager’s fee is called the expense ratio, and it is quoted as a percentage of assets. Most funds have fees below 2%, with an exception for those very specialized strategies.

Other Fund Fees

Mutual funds may have additional fees that are related to a commission that is paid to an advisor recommending the fund. These are called 12b-1 fees or loads. Read the fine print in the prospectus section about fees and understand if the mutual fund you are choosing is paying a commission to someone. (A prospectus is a piece of sales literature that is required by the fund company to make available to all investors. It describes the fund’s investment philosophy, buy and sell process, fees, investment results, and risks specific to a fund. A fund prospectus is found online on the fund company’s website.)

Funds will have what are called share classes, and it is just that same fund offered with a different fee structure. For Example, Fund X share class A will pay a sales commission on the initial investment amount, Fund X share class B will pay a commission when the shares are sold. Fund X share class D may have stated they have no loads but they have a 12b-1 fee and that is another form of payment to the advisor. If you pay a financial advisor a stated annual or quarterly fee, you should not pay a commission on the funds within your portfolio. It will be your job to double check and be sure your advisor does not do this.

Custodial fee

When you open a brokerage account, a firm or a custodian will be responsible for holding your account and keeping safe your assets. Some well-known custodians are Fidelity, Schwab, Pershing, or TD Ameritrade. This custodian will collect a fee for their services, and it will come in the form of a percent of assets or a cost per trade. The percent fee is called an asset-based fee, and it is typically taken quarterly directly from your account. The other option is to have your custodial fee paid through transaction fees. A custodian may offer $4.95 per trade transaction fee and each time you make a buy or sell in your account you would be charged this$4.95. Many custodians offer a list of funds with no transaction fee. If you find a fund through your screening criteria that you like, it is ideal for it to be available as no transaction fee.

Remember fees take away from portfolio returns; it is crucial you understand them and work to keep them to a minimum.

Reviews

Reviewing your investments annually will keep you on the right track towards reaching your goals.

• Check that your asset allocation strategy is still working for you and if there are any changes you may wish to make based on the current market environment.
• Check your securities are performing in line or better than a market benchmark and peers. Double check each of them with the criteria you used to purchase them. If the reason for purchase no longer exists then consider looking for another option.
• Check the fees for your total portfolio are what you expected and look for ways to bring them down if possible.
• Review your goals and ensure you are saving enough.

The above items will help build your confidence about investing and give you a process to follow. Sometimes starting is the hardest part, and now you know where to begin. Know what you want and what strategies are comfortable for you…and not what your family or friends say you should do.