Think about this: We plan for birthdays, holidays, and even vacations; but we don’t give nearly as much consideration to one of the most plan-required tasks of all: Investing.
Trying to invest your money without an investment strategy is akin to the Carolina Panthers heading into a football game without a playbook. Sure, there’s a possibility that they could win based on sheer talent and prior experience, but having a plan and some direction would significantly improve their chances.
The problem is that choosing an investment strategy is hard! Among other factors, it requires calculating investment returns which can be a highly mathematical, detailed, statistical jumble of numbers best left to PhDs and nerds.
But does that mean you should just blindly follow an investment strategy because your financial advisor says so? Or do you just choose the strategy of the day? (Yes, there are fads within the investing world.)
Being comfortable with your investment strategy is at least, if not more important than choosing the actual investments. There are a number of approaches to managing investments for different objectives. The key is pairing them together to fit your goals.
Before doing that, you must fully understand both.
Let’s take a high level view and explain the concepts of several popular investment theories so you can be confident that the strategy you choose is aligned with the goals you’re looking to accomplish.
Passive / Index Investing
By definition, Indexing is an investment strategy that attempts to track a specific portion of the stock market (ex: S&P 500, the Nasdaq 100, Wilshire 5000) as closely as possible — after accounting for any expenses incurred to implement the strategy.
This passive form of investing has several great benefits, among those is cost-efficiency.
Let’s use a broad-market index fund as an example. Since this type of fund is designed to track the returns of the overall market, the fund simply invests in companies in the same proportion as they occur in the actual index. This means that the operating fees of the fund are much lower because there is less research and analysis required.
A recent (2013) white paper produced by Betterment makes arguably the best case for passive/index investing — that they are rarely outperformed by actively managed investments.
The report took a look into several portfolios that held multiple asset classes between 1997 and 2012. In those, researchers found that index fund portfolios outperformed comparable actively managed portfolios nearly 90% of the time!
Example: Vanguard Total Stock Market Index (VTSAX) – This is a Large Cap Blend index fund covering over 3500 different stocks. It serves as a cost-effective, passive investment option that does a great job of matching it’s benchmark, the CRSP US Total Market Index.
Active Investing
Investopedia defines Active Investing as an investment strategy involving on-going buying and selling actions by the investor.
Active investing requires an investor (or money manager) to be highly involved in the day-to-day activity. The antithesis of the passive investor who typically seeks long-term appreciation, active investors are generally looking for opportunities to achieve short-term profitability.
Actively managed investments are popular in the financial planning community, as many advisors recommend them for a significant portion of their clients’ portfolios. The rationale is that these investments offer the flexibility and risk aversion that other strategies don’t due to the ability to move into and out of specific holdings (or sectors) when risk levels get too high. These funds may involve advanced strategies such as shorting stocks, and hedging with futures.
Example: American Funds Growth Fund of America (AGTHX) – This is a Large Cap Growth fund that pairs itself with the S&P 500. This fund has been around since 1973 offering active management, but at a cost. You may pay a fee up front, and then there are regular expenses as well as 12-b-1 fees for marketing. These fees are higher because the fund trades more often than a traditional index fund. While a popular fund, it’s returns trail those of Vanguard’s Total Stock Market Index over the past three years.
Core and Satellite
Core and satellite investing is a strategy designed to outperform the broad stock market, while simultaneously minimizing costs, tax liability, and market volatility.
Essentially the best of both (passive & active investing) worlds.
The “Core” of this strategy consist of passive investments that track major market indexes, in an effort to reduce costs, taxes, and market risk. Alternatively, the “Satellite” includes actively managed investments designed to earn higher returns.
The challenge in this strategy lies in the ability of the active manager to outperform their benchmarks, while only having only a small portion of the portfolio dedicated toward active management.
Example: Since the Core and Satellite investment strategy is a combination of passive and active management, an example would require the use of more than one fund. That being the case, rather than provide a single example, here is some information from First Ascent Asset Management — a firm with experience designing portfolio’s that align with this strategy.
Smart Beta
When putting together a passive portfolio, traditionally larger companies are given a bigger slice of the ‘pie’ even if analysts consider that company to be overvalued. This causes the fund to purchase more of an investment that may not be worth as much as they are paying.
Similarly, smaller companies are given smaller allocations, even if all signs indicate that they are poised for growth.
Smart beta is an investment strategy that seeks to mitigate these challenges by utilizing a series of rules-based screens to determine which companies should be given a larger piece of the index pie. The ideal result is increased returns or enhanced risk profile.
Example: Goldman Sachs ActiveBeta (GSLC) – Here is another Large Cap Growth investment, however this is an ETF instead of a mutual fund. It is new on the investing scene since 2015, so it has a limited performance track record. The fees are super low, and it follows a Goldman Sachs created index. Holding only 451 stocks, it’s portfolio is much smaller than that of Vanguard’s Total Market Fund, so it is more strategic in its purchases; however, the top 10 holdings are almost exactly the same.
Factor Based Investing
Factor Based Investing, popularized by Dimensional Funds, is an investment strategy in which securities are chosen based on attributes that are commonly associated with higher returns.
This investing strategy takes into consideration traditional methods of diversification, such as 80% stocks and 20% bonds, however, instead of merely stopping at asset class, it goes a step further and evaluates other factors such as style, size, and risk.
One of the keys to the factor based investing strategy is in the ability to look at specific attributes and determine whether securities will move in the same direction, and adjust portfolio holdings to reduce this risk.
This is important because you may think that you’re diversified, but if a large percentage of your portfolio declines during certain market conditions and you’re unaware, you could stand to lose a lot.
While on the surface, factor based investing may seem reserved for the more astute investor, a novice can focus on simpler attributes, such as growth vs. value, large cap vs. small cap, and the like. All of these attributes can be easily found on websites like Morningstar and even Yahoo Finance.
Example: DFA US Large Cap Equity Institutional (DUSQX) – This Large Cap Blend fund is a bit more expensive than the similar Vanguard fund, but still a bargain. It tracks a more narrow benchmark of the Russell 1000 and holds just over 900 stocks, yet maintains a very similar return to Vanguard’s all passive approach.
Now that you have more information on a few of the investment strategies at your disposal, wouldn’t it be nice to have an objective view to guide you on which option makes the most sense for your unique situation? Let’s chat! Click here to schedule a complimentary meeting where we can discuss the specifics of your portfolio and create a plan to get you on the path toward financial independence.
Pamela J. Horack, CFP® of Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.