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The Investment Process

Carlos has saved some cash and faces these choices. What would be the best thing for him to do?
  1. put it in his savings account
  2. invest in a mutual fund
  3. buy a U.S. Savings bond
  4. pay off the balance on his credit card that charges 18% interest

     Investing is a process composed of many elements. Unfortunately, many investors simply skip some of the elements because of lack of education or simple naiveté. It’s a good idea to document most of the following for your own use, and potentially for others that may help you along the way (with investing, or with taxes, or legal matters). The term "Investment Policy Statement" (IPS) refers to a document that details and summarizes your investment process.

     Your net worth, or portfolio value is just one component of a well-documented IPS. In this chapter, I'll summarize several critical aspects of that process including detailing your assets and net worth, your current and planned cash flow, your savings plan, your goals, risk tolerance, and other factors that may affect your investing plan. Determining an asset allocation (with specific targets, or acceptable ranges) is the core of a comprehensive IPS and it should also include conditions for changes to that allocation over time, as well as options for adjusting to expected outcomes in the future.

     Web sites, books, and advisors that focus on investing in individual stocks, specific industries, and stocks in general often don't address some of the other critical elements of the process. Many so called "Investment" books and web sites probably should be renamed with the term "stock selection" or "stock picking" because they either briefly address, or skip entirely critical elements of the process. In fact, stock selection is likely to be one of the least important elements of investing for many investors (as previously discussed in chapter 12 about asset allocation).

     The following summary is intended to serve as an outline to assist investors in understanding the investment process and achieving their goals in an efficient and peaceful manner.

A. What are you worth? How much are you spending and saving?

The first step in investing appropriately is determining exactly where you stand financially. You can start with a list of your assets. If you apply for a mortgage or loan, you will likely be asked for a similar list of assets including cash, real estate, debts owed to you, securities, private business ownership, tangibles, furniture, or any other significant assets. Then you should include a list of debts you owe and any other obligations. Your net worth is your assets minus your liabilities.

     In general, you want to pay off debts (especially liabilities with high interest rates, like credit cards) before investing, but sometimes there are advantages to keeping debt and investing. For instance, it’s usually worth allocating funds to some retirement accounts if your employer matches your investment, even if you have some low interest rate debt that you could pay off with the funds. In some cases you may want to take a larger mortgage than you need because the interest rate tends to be low and the interest may be deductible from your taxable income.

     If your net worth is small, or even negative, you should not be discouraged, in fact creating a complete IPS and planning future investments at that time can be critical to putting you in the right frame of mind to take the steps to achieve your financial goals later in life. Even those that are early in their careers that have purchased a house can have a negative net worth, yet still be well positioned and working toward a comfortable financial future. For instance, if you built up substantial debt from education and bought a house, you may still have a negative net worth. If you are expecting significant cash flow for long periods of time, or expect incoming funds, you should still run the numbers to project your future finances.

     The next step is to determine your cash flow, and then how much you have available for investing. Before computers, this was often done by reviewing bank statements and listing your outflows on a simple pad of paper. It’s not a bad idea to do a simple version on paper (partially because, as educators often explain, we know that the process of writing things down helps you learn and remember). But with the software programs and internet tools now available (like Excel, Quicken, Mint, and online banking), creating an income statement and cash flow analysis has become much easier.

     It's important to recognize that net worth and cash available to invest are separate amounts. An income statement will give you an idea of how much money is coming in, or going out on a regular basis. By preparing financial statements you'll be able to more effectively determine your needs now and in the future. Pro-forma statements will help you determine your future needs. You should project inflows and outflows as far out as possible and consider as many alternatives and options as possible.1

     If you find that your cash flow is negative, or much lower than you were hoping (before you ran your numbers), it can be helpful to spend some time researching budgeting and saving. There are excellent resources available on the internet and through various schools, plus there are many interesting and inspiring books, like the classic The Richest Man in Babylon by George Clason. Micro investing services can also help you commit to setting aside money in an investment account, even if you are starting from nothing. According to a 2017 survey from Acorns, about a third of the respondents spend more on coffee than investing.2 I also recommend The Millionaire Next Door: The Surprising Secrets of America's Wealthy by Thomas Stanley and William Danko. The book was originally released in 1996, but recent studies continue to support the conclusion that those that accumulate wealth have a tendency to be frugal with their money.

B. What are your goals? How much and when?

Before an appropriate investment program can be established, careful consideration should be given to your specific objectives and constraints. Objectives are goals defined in terms of return requirements and risk tolerance. Constraints are limitations, such as liquidity, time horizon, taxes, and legal or regulatory matters. Preferences are constraints that are self-imposed and may be unique. Do you have specific income requirements or minimum rates of return? Is there a minimum value that must be maintained? Do you have specific future liabilities?

     Keep in mind that the real value of any amount in the future will be influenced by inflation (which historically has averaged around 3% in the U.S.). Knowing how much you have to invest now and in the future, you can estimate the future value of your investments using online calculators or other tools. If you're goals are too optimistic you may want to rethink your objectives.

     There are some great online tools that can help with planning and projections. For instance, try Vanguard’s Retirement Nest Egg Calculator, which will run projections of how long your portfolio will last based on how much you start with, how much you spend, and your asset allocation. T.RowePrice's Retirement Income Calculator estimates how much you may be able to spend each month and how long your savings will last.

C. How much risk are you willing to take to reach your goals?

Are you willing to accept volatility to achieve higher returns? Investing should be viewed as a process of making sure that you never have so much risk that your standard of living can be impaired by a negative surprise. There are many interactive tools you can use to help determine your risk tolerance (for instance, the questions at the start of chapters 3, 5, 12, and 21). Don't be surprised if you get different results from different tools since there are no absolutely correct answers based on the limited information you can supply. Just as you would likely receive different advice from different advisors, you can expect the interactive tools to offer varying advice.

D. Determine the appropriate asset allocation.

Asset allocation is the most important part of the investment process because it will likely determine the majority of both risk and return for your portfolio. There are many free online tools and many other options for recommending an asset allocation of assets (stocks, real estate, bonds, and cash) for your portfolio based on your inputs (see chapter 12). Some recommend allocations to other assets and how much international assets to consider. You should consider many asset classes (including those discussed in chapters 12-18), as well as your own intuition. In the next chapter, I’ll discuss advisors (which can help you with this critical decision) including Robo-Advisors. One advantage of Robo-Advisors is you can open an account with a small amount of money to test the system and get a recommended asset allocation. In fact, many investors prefer multiple sources of advice and there is nothing wrong with managing a part of your money on your own, using funds or Robo-Advisors for part, and using an advisor for another part. Over time, some may find one of those options works out best and adjust accordingly. Once you've determined your asset allocation, you can choose benchmarks which you'll use later to evaluate your results and determine how well your investments have done.

E. Select the investment vehicles and implement strategy

You can generally use the lowest cost option (as long as it’s one of the well-established firms) as the default for investing in each asset class before determining the actual securities or funds you will use.

Taxable or tax free

At this point you should evaluate tax free and tax advantaged investment vehicles. If you are eligible and you can accept the limitations, you should evaluate investing through IRA's, 401K's, and other vehicles that will at least temporarily eliminate, or reduce taxes. Some asset classes are better and more logical choices for taxable accounts and vice versa. For instance, if you are buying municipal bonds it would make much less sense to buy them in a tax advantaged retirement account.

Active or passive

Another important decision to make at this point is one that some investors unfortunately don't evaluate thoroughly. Passive investing (or indexing) involves purchasing diversified portfolios of all the securities in an asset class. Active investing involves overweighting securities and sectors within an asset class believed to be undervalued and underweighting securities and sectors believed to be overvalued. Purchasing a security, a stock for example, is effectively an active investment that can be measured against the performance of the stock market itself.

     Arguments can be made for both active and passive investing, but a much larger percentage of institutional investors than individual investors choose to invest passively and in most cases passive options will be the best choice, because they tend to be more diversified and cheaper. The arguments for passive investing include reduced costs, tax efficiency, and the fact that historically, passive funds outperform a majority of active funds (as discussed in more depth in chapters nine through eleven). An argument for active investing is that there are anomalies or risk factors in securities markets (discussed in more depth in chapters 20-24) that can in theory be exploited to outperform passive investments, plus the fact that a modest percentage of investors and managers have outperformed passive investing for long periods of time.

     The active versus passive decision does not have to be a one or the other decision. In fact, a common strategy is to invest passively in asset classes considered to be very efficient, and invest actively in asset classes considered to be less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively (for example you can invest the majority of your stock allocation in an index fund and a modest amount in active funds). Investors can also invest actively in sectors in a passive manner. For example, you can invest in an index fund of small stocks if you think small stocks will outperform large stocks, or you can invest in a passive country fund if you believe a particular country will outperform the rest of the world.

     As I discussed in chapter five, indexing in many asset classes (like stocks) effectively allows you to separate investing activities from arguably speculative activities.

Mutual funds, ETFs, individual securities, or others

In many cases the simplest way to invest in stocks (domestic and international), bonds, and real estate is through mutual funds or ETFs. A major advantage of mutual funds is that they provide diversification within the asset class. Stocks, bonds, and real estate investment trusts can also be purchased individually through brokers. Private funds are primarily used by institutional investors to invest in alternative investments like venture capital and private equity. Tangibles can be purchased through various sources.

Market timing

     Active strategies typically involve both security selection and timing the market (buying and selling) based on the belief that securities and markets are over or undervalued. While there are some individuals and firms that have been successful in market timing over certain periods, most studies show that attempts to time the markets are counterproductive (as discussed in Chapter 11).

"In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely, not only not to add value to your investment program, but to be counterproductive."
Jack Bogle, as quoted by Burton Malkiel in A Random Walk Down Wall Street

     A recent article about market timing also summarized the difficulty in trying to successfully time the markets, citing among others research by Elroy Dimson, Paul Marsh and Mike Staunton that found no consistent link between valuation and subsequent returns in 23 stock markets.3

Reinvestment strategy

     It’s a good idea to have a predetermined strategy for available cash flows. One of the differences between mutual funds and ETFs is that ETFs don’t have a reinvestment option for dividends and other cash flows they generate. So ETFs tend to result in cash flow periodically in your account. Mutual fund outflows are often (but not always) set to automatically reinvest in the same fund, but they can also be set to pay in cash, or reinvest in another fund. For instance if you want to gradually invest in an asset class over time, you can usually set other funds flows in your account to invest automatically in a specific fund.

Monitor your portfolio, reevaluate goals and constraints, and rebalance

Rank performance

The portfolio and all variables should be monitored and valued continuously but specific time periods should be chosen to evaluate the performance of a portfolio, as well as reevaluate goals and constraints. The specific time period for evaluation should be determined by each investor. At that time you can compare your returns against your benchmarks to determine whether your decisions have resulted in returns better, or weaker than your benchmarks.

     Your investments in each asset class can be compared to respective benchmarks and your overall portfolio should be evaluated against appropriate benchmarks. Several sources provide benchmark information quarterly. For instance, Morningstar has “Quarter End Insights” with quarterly fund benchmarks online that include categories by percentage of allocation to equities.4 For instance, most investors can start by comparing their overall portfolio to an appropriate category like the following.

     Keep in mind that these Morningstar benchmarks include passive and active funds so if you have a very low cost portfolio you should have a slight advantage versus benchmarks that include other comparable funds with higher costs. Morningstar also provides data on target date funds in 5 year increments and one of the target date benchmarks roughly matching your target retirement age can serve as a useful benchmark.

     The Wall Street Journal historically also posts quarterly reviews and benchmark data (from Lipper) online, although it is usually posted about a week after the end of the quarter.5 These sources calculate returns including reinvestment of dividends. Just looking at price changes from time to time does not necessarily reflect reinvestment of dividends and other cash flows, which can underestimate benchmark returns.

     If your performance hasn’t been better than, or close to your benchmarks, it may be time to reevaluate your strategy. It's also a good idea to determine whether your portfolio has fluctuated more or less than you had expected and to adjust your expectations and portfolio accordingly.

     As an example, it’s not uncommon for an investment or specific stock to double over several years, yet that could still be an underperforming asset. From the beginning of 1995 to the end of 1997 the S&P 500 was up 125% over the three year period, so doubling your money in a stock during that period is actually underperformance (and the broad U.S. stock market roughly tripled from the start of 2010 to the start of 2018). You can be right on your asset allocation and wrong in your active security selection and vice-versa.

Reevaluating goals and constraints

     Goals and constraints should also be reevaluated on a regular basis and whenever unique circumstances or events occur that may affect your investments.

Rebalance portfolio

     Price increases and decreases, dividends, income payments, inflows and outflows of cash as well as other events will naturally cause the asset allocation of your portfolio to fluctuate. For instance, a rising stock market can cause a portfolio's allocation in stocks to rise above predetermined ranges. Therefore it’s helpful to have a regular schedule for rebalancing the portfolio.

     Keep in mind any tax consequences of rebalancing and any trades in taxable accounts. For most investors it makes sense to schedule time near the end of the year to evaluate possible trades in taxable accounts. If you have securities valued below their cost basis it can make sense to sell to generate tax losses and in most cases if you want to maintain your asset allocation, you can buy similar securities at the same time (you may need to have cash available if your custodian requires it) and you should consult your tax professional (if appropriate) in advance as well.

Document results

     You should always maintain appropriate documentation and records of your investments for tax purposes and future use. Consult your tax professional regarding how long you should keep physical records. Digital records are much easier to maintain and back-up, preferably in a safe location with some kind of password that you will not forget, or lose.

     The question at the start of this chapter is from the SEC’s “Test Your Money $marts” web site.6 The vast majority of sources would recommend paying off high interest rate credit card debt before investing. You would have to earn 18% after taxes to do better than paying offer the credit card debt in that scenario.

Investment Policy Statement Outline (See also Bogleheads IPS Wiki)

     Most investors will find it useful to have a formal document outlining and summarized their investment process. In 2019, a Northwestern Mutual survey found 92% agreed with the statement “Nothing makes me happier or more confident in life than feeling like my finances are in order."7 73% of Americans rank their finances as the No. 1 stress in life according to a 2019 study by Capital One.8 Yet, according to a 2019 Charles Schwab survey, only an estimated 28% of Americans have a written financial plan (63% of those that have a plan feel financially stable).9 Your plan should be updated at least once a year. The following is a check list of items to include in a basic investment policy statement.

-Portfolio Assets & Net Worth (with and without home)
-Cash Flow Projections (monthly and/or annually)
-Time Horizon – (Short-Medium-Long) Term
-Risk Tolerance – (Low-Moderate-High)
-Objectives (examples)

-Rebalance strategy including frequency and under what conditions (examples)

-Current Asset Allocation
-Target Asset Allocation (Equities, Real Estate, Fixed Income/Bonds, Cash)
-Maximum and minimum percentage for major asset classes
-Target International Percentage
-Target Return

1. See the Social Security Administration's retirement estimator and "How much do you need to retire?" and Terrance Odean's Youtube Channel
3. The perils of trying to time the market: In practice, is surprisingly hard, Economist December 13, 2018
4. For instance 1Q2019
4Q2018 and
5. Examples can be found at and
9. Modern Wealth Survey May 2019

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Last update 12/23/2019. Copyright © 2019 Gary Karz. All rights reserved.
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