Having determined the asset allocation, you can select the vehicles for investing in those asset classes. If you have chosen to use an advisor, they should handle the implementation of investing your money. You should attempt to keep your expenses as low as possible since expenses come directly out of your returns. See Investment Costs.
a. Taxable or tax free.
At this point you should evaluate tax free and tax advantaged investment vehicles (See Taxes). If you're eligible and you can accept the limitations you should evaluate investing through IRA's, 401K's, and other vehicles that will eliminate or reduce the tax bite. If you have access to Financial Engines (created with William Sharpe) and other online tools you should evaluate them as well.
b. Active or passive.
Another important decision to make at this point is one that some investors unfortunately don't evaluate thoroughly. It is the decision to invest actively or passively. 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. When compared to a passive investment in a stock index, the purchase of an individual stock can be viewed as a combination of an asset allocation to stocks and an active investment in that stock with the belief that it will outperform the stock index. If you purchased a stock that was up 100% from the beginning of 1995 to the end of 1997 you actually underperformed the market (the S&P 500 was up 125% over the three year period). You can be right on your asset allocation and wrong in your active security selection and vice-versa.
Arguments can be made for both active and passive investing but a much larger percentage of institutional investors choose to invest passively than do individual investors. The arguments for passive investing include reduced costs, tax efficiency, and the fact that historically, passive funds outperform a majority of active funds. The arguments for active investing are that there are Anomalies in securities markets that can be exploited to outperform passive investments and the fact that some investors and managers have outperformed passive investing for long periods of time. See also
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 half of your stock allocation in an index fund and the other half 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.
c. Mutual funds, 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 and/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 ndividually through Stock Brokers. Private funds are primarily used by institutional investors to invest in Venture Capital and Alternative investments. Tangibles can be purchased through various sources.
d. 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.
"No one on Wall Street has ever figured out how to time stocks' swings perfectly. Most people, in fact, fail miserably at timing."
Tom Petruno, LA Times (4/9/97)
"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."
John C. Bogle as quoted by Burton Malkiel in A Random Walk Down Wall Street
a. Taxable or tax free
Please send suggestions and comments to Investor Home