Investment Articles

On the surface, index investing seems like a perfect fit for do-it-yourself investors. The simplistic buy-hold-rebalance mantra of index fund proponents combined with the abundance of help from investing authors and online forums leads scores of informed investors to take on the task of personal portfolio management each year. Many DIY investors never look back; they treasure their newfound fiscal autonomy and the challenge of overcoming future financial hurdles. Others, however, discover that they lack the time, interest, knowledge or discipline to successfully negotiate the dangerous DIY terrain, and they ultimately seek help from an investment advisor. The purpose of this article is to clearly present the rationale for each approach so that index investors can decide which tactic best suits their needs and abilities.

Why Investors Do it Themselves

According to a 2006 study by the Investment Company Institute, the primary reason that DIY investors manage their own portfolios is that they want to be in control. There is a sense of empowerment that comes with making your own investment decisions, and DIY investors, especially men, like holding the reigns. The study also found that the majority of DIY investors believe that they have the necessary information and intellectual ability to make well-informed, prudent financial decisions without the help of a professional. In the minds of these confident investors, advisory fees are an unnecessary expense. Finally, many individuals find personal finance to be a rewarding hobby. According to the study, the majority of DIY investors enjoy conducting their own financial research, crunching numbers and closely monitoring their investments.

Others choose the DIY path not because they love the idea of managing their own investments, but because they dislike the idea of hiring an advisor. You may fall into this category if you place a high value on your financial privacy, believe that most financial advisors are incompetent or untrustworthy, or simply want to save money by not paying advisory fees. The fact that all investment advisors aren’t created equal provides little solace to those whose opinions have been shaped by the numerous investor scandals of the past year or by a poor past experience with an advisor.

Finally, there is a group of investors who acknowledge that they would benefit from professional help but lack an investment account large enough to capture the attention of an advisor. First-time investors often fall into this category and tend to seek advice from public sources, relatives or friends.

Why Investors Hire Advisors

A good investment advisor can add value to your portfolio in a number of ways. First, he acts as a gatekeeper, preventing you from making common return-reducing mistakes. Numerous studies have shown that individual investors routinely give up as much as 7% in annual returns due to frequent trading, attempting to time the market and chasing past performance. Even the most seasoned index investor needs the occasional reminder to avoid distractions and stick with his investment plan.

A good advisor also provides access to research, techniques and investment choices that have the potential to boost returns. By understanding complex issues like tax management, estate planning and retirement forecasting, an advisor can help you better understand the likelihood of reaching your retirement goals and suggest steps that you can take to tilt the equation in your favor. Additionally, he may be able to expand your investment choices by providing access to exclusive fund families or share classes.

Finally, a good advisor performs laborious tasks like portfolio monitoring and rebalancing so that you can devote your time to other pursuits. An advisor who monitors your portfolio frequently can ensure consistency with your risk profile while potentially squeezing excess returns from rebalancing activity.

Conclusion

Many investors want a quantitative answer to the question of whether to hire an advisor; they want to know definitively whether an advisor would provide them with higher investment returns after fees. In order to answer this question, you must first ask yourself whether you have been able to develop and consistently implement a low-cost, disciplined investment plan on your own. Many investors don’t have enough interest, knowledge or ability to develop a sensible plan; even more lack the necessary discipline to follow one. If you find yourself veering off the path to chase a hot new sector or time the market, there’s a good chance that an advisor would bring some return-boosting discipline and objectivity to your investment decisions.

If you do possess the mental and physical fortitude to develop a sound plan and consistently stay the course, you should probably look to qualitative factors to make your decision. For instance, would you rather spend the time that you dedicate to investment management on other things, like visiting family or pursuing other interests? For many investors, the answer to this question changes later in life as financial situations become more complex, the consequences of poor decisions become more severe, and time with family becomes a bigger priority.

The bottom line is that managing your own index portfolio may be simple, but it’s not easy. If you decide to oversee your own investments, defend yourself against the tendency to stray from your investment plan by drafting an Investment Policy Statement. If you decide to hire a professional, choose a fee-only advisor who agrees with your passive investing philosophy, embraces his fiduciary responsibility to act in your best interests, and is willing and able to add value in the ways described above. Whichever path you choose, you can maximize your chances of investing success by accurately assessing your risk attitude and capacity, designing a diversified, low-cost portfolio, and sticking with your plan.

George Watkins is President of West Wind Wealth Management, an independent investment advisory firm that specializes in index portfolios. He has a BS in Economics from Duke University and an MBA from Harvard Business School. To download helpful tools and tips for DIY investors, purchase a personalized index portfolio recommendation, or inquire about full-service wealth management solutions, visit http://www.invest-it-yourself.com.

“When you fall off the horse” you’re told to get right back on. After the last financial market episode, known as the credit crisis of 2008, you may be wondering how you will ever achieve financial security after seeing your 401k drop by more than 30% in one year. Even though the market has had a remarkable recovery since the bottom was struck in March, 2009, there is fresh data that shows the individual investor is not fully participating in the rebound so far.

According to the Investment Company Institute, since April of 2009 no net new money has been added to equity based U.S. focused mutual funds; the money is being allocated to bond funds instead, whereas the level of money market funds has remained steady. Perhaps these individual investors are saying to themselves “fool me once shame on you, fool my twice shame on me”. This behavior is understandable, even expected. Maybe the general investor population knows something the professionals do not about the future of equity returns in America. One can only wonder.

Below are 17 guidelines to consider when investing or reinvesting for your future to achieve financial security and reduce personal financial risk. The underlying premise is to remain fully invested through out your life and connect your investments to a purpose, such as retirement or paying for your kids college education. Another premise is to use your entire life to finance your life’s liabilities, not just the middle 30 or 40 years while working. This reduces personal financial risk.

A summary of this guidance follows:

1. Use your full “century of life”, not just your middle 40 years; start accumulating assets and managing liabilities as early as you can; optimize the long compounding period in front of you; remember the value of lump sum deposits, even small ones

2. Prepare an accounting of your life’s liabilities as of today; take regular check points to make sure your funding plans are on track and reduce exposure to longevity risk – address serious funding gaps as soon as you can

3. Define your investment purpose and do not invest without a purpose; prepare an investment policy statement, particularly if you work with an adviser

4. Trading is not investing and investing is not gambling;

5. Maximize compounding benefits by using funding compartments – make the difficult choice between spending today and saving; less time means more risk and more anxiety

6. Have conviction. Stay invested in the market at all times, otherwise stay out entirely and find some safer investments; diversify and don’t concentrate your investments

7. Be religious about taking and securing your gains by placing them into your safe deposit account

8. You cannot beat systemic risk, but be alert to significant changes often telegraphed well ahead of time – control your response to it so check your emotions

9. Use insurance to protect against risks to your quality of life – even if you think you can self fund risk – why would you? Insurance is a much cheaper way to go

10. Have sufficient liquidity at all times

11. Secure your income for later in your century of life; cash flow keeps your life flowing the way you want

12. Get rid of unproductive assets – if the house is a burden and you could use the equity then do it

13. Remember only you can be accountable to you; all others may not put your interest first unless they are obliged to by law

14. Make changes to your investments when you decide they no longer fit your investment purpose – do not let anyone force you into a change you do not understand

15. If you have to trust someone, there are many advisers out there who really want to help you finance your century of life; if you want to do it on your own make sure you have the time, tools and the temperament

16. Be careful with web sites, blogs and trendy financial columns, that profess to know what is going to happen in the market beyond today – NO ONE knows. Avoid the get rich quick trading systems and strategies – it usually involves investment concentration

17. Investing mistakes are seldom fatal, except when you concentrate; do not get scared away; remember the parable about “when you fall off the horse…”

You can take charge of achieving financial security. It is your quality of life – you earned it.

Thomas Warren is a Certified Financial Planner(R) practitioner. He resides in Oceanside, N.Y.

Comments about this article can be sent to ACenturyoflife@gmail.com

The majority of advice given to individual investors relates to developing an investment plan: evaluating risk tolerance, choosing an appropriate mix of assets, controlling costs, etc. While these considerations are all important drivers of investment success, a singular focus on plan development often causes implementation to suffer.

In order to promote the disciplined execution of a portfolio’s investment strategy, pension plans, foundations and trusts often draft an Investment Policy Statement (IPS). This document formally outlines the investment objectives, philosophy, boundaries and procedures for managing the portfolio so that plan advisors don’t stray from their clients’ intentions. Individual investors can get a similar benefit by drafting their own Investment Policy Statements. A brief, well thought out IPS can help an investor stay focused on his goals and systematically resist the natural human tendencies that seriously harm investment returns.

Investors Behaving Badly

There’s an abundance of research on individual investor behavior, and very little of it is encouraging. Barber and Odean’s landmark study, in which 66,465 household accounts were examined from 1991-1996, found that individual investors trade too frequently, thus destroying returns. The most active traders in the group underperformed a buy-and-hold portfolio by over 7% annually, while the average investor’s returns lagged an inactive portfolio by over 2% per year. According to the study, the root cause of this behavior was overconfidence, a trait that was especially pronounced in men. Specifically, investors were confident in the future movements of the overall stock market or a particular sector, and they invested accordingly. Unfortunately, they were frequently wrong.

Similarly, Dalbar’s 2009 version of its Quantitative Analysis of Investor Behavior study examined the returns of mutual fund investors from the beginning of 1989 through the end of 2008. The study found that the average US equity investor earned an annual return of 1.87% compared with the 8.35% annual return of the S&P 500. The stark difference in performance, according to the study, could be attributed largely to investors abandoning equity mutual funds during declining markets (selling low) and reinvesting following a market rebound (buying high). The study doesn’t pinpoint a solitary causal factor, but this phenomenon usually occurs when investors overestimate their risk tolerance, misunderstand the risk-return tradeoff, or seek safety in numbers through “herd” behavior.

How an Investment Policy Statement Can Help

Fortunately, there are steps that DIY investors can take to counteract their destructive behavioral tendencies. First, it’s important to develop an investment plan consistent with your risk attitude and capacity. When unsure whether a certain level of portfolio volatility is acceptable, it’s prudent to err on the side of conservatism. The worst time to discover your risk tolerance is during a market decline. When determining your target asset allocation, it’s also a good idea to specify events that would trigger a portfolio rebalancing. Without specific rebalancing criteria (e.g., acceptable bands for each asset class), the door is left open for impulsive trading.

Next, formalize your plan in an Investment Policy Statement. An IPS should include your investment objectives, account balances, current income and future liquidity needs, risk profile, target allocation and rebalancing bands, investment philosophy and fund selection criteria, and plans for periodic IPS reviews. Drafting an IPS may seem burdensome, unnecessary or redundant, but without the ongoing help of an investment advisor, this simple document performs the vital role of a bad behavior gatekeeper. When you’re tempted to abandon your risk-appropriate allocation during a market downturn, your IPS will remind you of your investment plan’s rationale and encourage you to stay the course. When you get a “can’t miss” stock tip from a friend, your IPS will tell you to keep your distance. And when you get your investment account statement at the end of the year, your IPS will provide a valuable performance measuring stick. Your IPS could be all that stands between you and your return-reducing behavioral tendencies; don’t pass up this opportunity to add discipline to your investment plan.

Conclusion

Legendary investor Benjamin Graham said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.” There’s plenty of research confirming Mr. Graham’s hypothesis, but fortunately, there’s hope for the individual investor. By understanding the impact of human behavior on investment returns and devising a disciplined plan of attack in the form of an Investment Policy Statement, DIY investors can overpower damaging behavioral forces and increase their chances of achieving their financial goals.

George Watkins is President of West Wind Wealth Management, an independent investment advisory firm that specializes in index portfolios. He has a BS in Economics from Duke University and an MBA from Harvard Business School. To download George’s sample Investment Policy Statement (IPS), view other tools and tips for DIY investors, or to purchase a personalized index portfolio recommendation, visit http://www.invest-it-yourself.com.