What does baking a cake have to do with investing?
Full disclosure - before I became a financial advisor I was a do-it-yourself investor. I attended one of the top business schools in the country, read all the self- help financial magazines and used an on-line discount broker to keep costs down. I picked my own stocks and mutual funds and thought I was pretty good at it. Then I became a financial advisor and learned that, like most things, there’s a big difference between how a professional does it and how even a talented amateur does it. Essentially I learned to “bake” a portfolio. My grandfather, a professional pastry chef and successful investor himself, would be proud!
Birthday cake or wedding cake?
If you wanted a birthday cake for your spouse, you might bake the cake yourself, but not too many of us would dare bake our own wedding cake. Similarly, if you have some spare “fun money”, you might not hesitate to invest on your own. But if you are investing for something serious like your child’s education or your own retirement where you can’t afford to make a mistake and only have one chance to get it right, I strongly recommend that you seek the advice of a qualified fair-fee registered investment advisor (see my April/May article at www.bostonwomensjournal.com for more information on selecting an advisor). While many do-it-yourself investors think that they are saving money, a talented, reasonably-priced advisor should pay for her/himself in very short order.
Go bake a cake
Constructing a portfolio is a lot like baking a cake. None of us would pour flour, milk, eggs and sugar on a plate and expect our guests to eat it. However, if you bake a cake out of these same ingredients, the result looks and tastes completely different, and better!
Likewise, although there are never any guarantees, the key to a strong portfolio is mixing all of the “ingredients” in the right combination to get the result you desire. Just as a finished cake looks and tastes almost nothing like its individual ingredients, mixed in the right proportion, the “texture” and “flavor” of a portfolio differs significantly from its components.
Contrary to what many investors believe, most research indicates that your asset allocation (the types and weighting of assets you hold) is far more important than trying to pick stock and or mutual fund winners or timing the movements of the market has little to do with your overall investment results. market. A competent professional will take three basic steps in constructing a portfolio:
First, understand your objectives to determine an appropriate mix of four core “ingredients” or asset classes: domestic stocks, international stocks, bonds and other investments like real estate, commodities and currencies. While experts disagree on exact numbers , there is general consensus that 70-90% of your returns will be dictated by this investment mix and only 5-20% will relate to picking individual investments or timing the market. After expenses and transaction costs, there is little benefit realized from market timing or individual security selection.
Second, determine a target and range for the sub-classes of the four asset classes mentioned above. For example, your advisor will establish a target percentage for each sub-class (such as emerging markets in your international allocation), buying additional investments in the category when your mix falls below the minimum required percentage and selling when investments exceed the maximum. This creates an automatic discipline to buy and sell your securities when they are relatively under or over-valued, rather than relying on personal emotion or market prognostication.
Finally, only after going through this detailed analysis should individual holdings be selected. While this is the least important step, it is not unimportant. An investor must weigh several factors including whether to use actively or passively managed investments, the tax ramifications of each transaction, how to reinvest dividends and interest and the underlying costs of each investment.
Don’t open that oven!
The most important role your advisor plays is in assembling a mix that has the best chance of meeting your financial goals. Then, just as you wouldn’t open the oven too often when you are baking, you shouldn’t trade too often in your portfolio. Frequent trading usually devastates long term returns due to transaction costs and taxes. John Bogle, founder of the Vanguard Group, pointedly and accurately states in The Little Book of Common Sense Investing, “The miracle of compounding returns is overwhelmed by the tyranny of compounding costs.”
Research is ongoing, but some of the more recent information available indicates that a classic investment tradeoff exists: frequent trading in a structured portfolio can reduce risk, but tends to reduce returns; while trading less often may increase returns, it can lead to more volatility in the portfolio. Depending on a few factors, most investors should only trade 2-4 times per year and that activity is primarily to reinvest cash that has accumulated from savings, dividends and interest. A properly constructed, well managed portfolio will usually not turn over more than 5-10% of its assets annually.
If you’d like to learn more about professionally “baking” your portfolio, please call us at 617-948-2102.