As background, Benjamin Graham is widely known as the father of value investing and was a mentor to Warren Buffet, one of the most prominent investors of our time. His words remain powerful to this day and this article walks you through some of the basics concepts used to implement that advice.
Invest, you must
The power of compounding is a wonderful thing because over time, your money builds on itself and creates wealth for you and your family. Failure to invest because you fear losing money or making an investment mistake means your hard-earned savings instantly lose value to inflation, effectively providing you with a negative return on investment.
Know your time horizon
You may have several portfolios, each serving a different purpose and each having its own time horizon. The different portfolio scenarios below ought to demonstrate the value of knowing your time horizons.
One example might be a home purchase portfolio where you plan to liquidate the portfolio in its entirety in the very near future. That portfolio would minimize equity exposure and lean towards short term bonds and cash.
Another example would be a college education portfolio where it accumulates over a longer period and typically liquidated over a period of four years. This type of portfolio would lean towards equities in the early years, but gravitate towards bonds and cash as the tuition bills come due.
Finally, there is the retirement portfolio which accumulates over a long career and liquidated over the course of thirty or more years. With a portfolio like this, one may very well maintain a constant allocation between asset classes over your lifetime. Since you really do not know your life expectancy, it makes sense to view this portfolio as perpetual, something to leave behind for your heirs.
Knowledge of your time horizon helps keep you on track to meet your investment goals for all the various objectives you may have.
Choose an asset allocation
An asset allocation is the percentage of assets held within each asset class within each portfolio. For example, you might choose to have 45% equities, 30% bonds, 15% real estate and 10% cash in your portfolio. That 45/30/15/10 represents your asset allocation.
Lots of people struggle with this aspect of investing. Do some research and pick something and stick with it - it is not complicated. Consistency is your key to success and as Graham indicates, once this decision is made it frees you from making frequent decisions.
Wealthy investors want to preserve their wealth and so should you because taking on extra risk by significantly overweighting an asset class, say going 100% equities, goes against this premise. Conversely, a greater risk is being all cash because your money loses value to inflation.
Never waiver because desperate sellers and frantic buyers are taken full advantage of in the markets, so guard against fear and greed. To use Jack Bogle’s favorite expression, stay the course!
Employ diversification
The more of the market you own in each asset class, the less chance you have of making an investment mistake. If you own everything, your returns equal the market less expenses. Today's passive investor can use broad market index funds to get instant diversification, while simultaneously reducing risk. Back in Benjamin Graham’s day, index funds did not exist, but I am sure he would have been a huge fan, especially for the individual investor.
Pick the best funds
Seek out index or broad market funds for each of your asset classes. Avoid load funds and look for those with reasonable expense ratios. As for expense ratios, be aware that you pay your fund company every day because they take their cut prior to publishing the Net Asset Value (NAV), which is very clever because you never see the bill. Think about it, if you had to write your fund company a check each day, you would be prone to find the lowest cost funds offering the best value for your money. As with most things in life, the lowest cost may not represent the best value.
Consistent fund performance is elusive, so do not chase it because you will never get to where you want to be. Performance leaders change daily, but if you have index funds or managed funds – those managed by a team and not one individual, stick with it because performance regresses to the mean.
Stay invested
One of the largest obstacles to investment success is having the courage to remain firm with your asset allocation during extreme market swings because we all feel compelled to do something, anything when the market rallies or declines significantly. A single tool exists to help you during these periods – rebalancing. By rebalancing your portfolio at the proper time, you essentially sell high and buy low, which is every investors dream (aside from reading the Wall Street Journal a day in advance).
It is important to ignore the noise (media, friends and family) and stick to your plan because market recoveries typically follow market declines.
Consistently predicting the market direction in the near term is impossible and those taking credit for calling a market downturn are rarely heard from again. If you feel compelled to do something other than rebalancing, employ what is called a tactical shift in your asset allocation, but never more than five percent over/under weight.
Monitor your portfolios
At this stage, you have done your homework, created portfolios and established asset allocations within each one. If you are like a typical investor, your engagement ends there, but you may be exposing your portfolios to what is termed market drift. Market drift occurs when an asset class within a portfolio increases or decreases, exposing your portfolio to unnecessary risk. Not only does your portfolio face risk, but also comes with an opportunity cost attached – failing to rebalance means you will forgo profits.
Capturing gains and/or buying on discount is paramount and rebalancing a portfolio at the appropriate time increases your wealth and reduces your risk. Visit Track My Portfolios – the leader in portfolio tracking; they watch your portfolios and alert you when opportunities to rebalance present themselves.
In summary, invest wisely to stay ahead of inflation while keeping within your time horizon. Employ broad market diversification and rebalance - to paraphrase Benjamin Graham, buy wisely when prices fall sharply and to sell wisely when they advance a great deal.
Good luck and may you achieve your life goals.
G. Michael Kennedy
Financial Strategist
Family Financials, Inc.