By Craig D. Allen
This is a great time to evaluate investment portfolios, strategies, and advisors. The markets in 2011 were certainly challenging, but there were also significant opportunities to earn strong returns. The beginning of the year is an excellent time to take some time to review what happened in the previous year, to decide if any changes are needed. In this week’s column, I will discuss five important criteria every investor should use to evaluate their portfolio and investment strategy. After the investor has completed this review, they should have some actionable information with which to make any necessary changes that are appropriate.
Performance isn’t everything, it’s the only thing
Often in the investment world we use sports analogies, quotes, and the like. Sorry for that! With performance, for many investors, the truth is that achieving high returns is not the only thing. Firms in the industry have conducted many surveys of investors and, almost without exception, the most important issue with investors is not performance, but rather trust and honesty. Investors want to know that they can trust their advisor and that their advisor is giving them good advice, and not selling them something just to earn a commission or fee.
Performance is also a tricky thing to measure. Most individual investors (as opposed to institutional investors) would define good performance in dollar terms—how much did my portfolio increase in value during a certain time-period. Industry professionals often measure their performance against a benchmark, such as the S&P 500. In periods where the S&P 500 is down significantly, if the portfolio manager did better than the S&P 500, even if they lost money, they will feel that they have done well.
Perhaps the best way for investors to judge performance is to match the returns they are receiving with the amount of risk they are willing to take in their portfolio. For example, if the investor’s portfolio is invested in a very conservative way, so that he holds only U.S. treasury bonds, and the stock market performs very well in a given period, while the investor’s portfolio only generates a modest return, the investor should not be unhappy with their return, since they are taking far less risk that an investor who owns nothing but stocks in their portfolio. Return is a function of risk—one cannot have a return without taking some amount of risk. It is a good idea for investors to understand the amount of risk that they are comfortable with, as well as the actual amount of risk they are taking in their portfolio, when judging performance (more on risk below).
It is a good idea for investors to match their expectations about returns with the amount of risk they are taking in their portfolio. Return expectations should also be clearly communicated to the advisor, so that both investor and advisor are on the same page. Investors can avoid a lot of frustration, and possibly poor performance, by making sure that they clearly convey their expectations and discuss various possible return outcomes with their advisor, right up front, before assets are invested, and also throughout the investing process, as conditions change.
Fail to plan; plan to fail
Investing is a very complex business. Without a clearly defined investment strategy in place, it is virtually impossible to achieve appropriate results for the investor. Each investor should have a well-defined investment strategy that matches their individual investment objectives—exactly what the investor is trying to accomplish—with the investments to be held in the portfolio. The amount of risk that the investor is comfortable assuming should also match the risk of the overall portfolio, taking into account all investments to be held in the portfolio.
Investors that take the time to establish a well-conceived investment strategy can stay the course when markets are volatile. Having confidence in the process of developing the investment strategy—that it is the appropriate plan to get the investor where they need and want to go financially—can prevent the investor from panicking out of the market during tough times. The most common mistake I see with investors who do not have a well-defined investment strategy is selling when markets are down, and then buying right back in after the market has rebounded. This behavior is the direct result of the investor panicking because they do not have a plan in place. The investment strategy is like a safety line on a ship that sailors hold on to in stormy seas. If they didn’t have that, they would fall overboard.
Expert advice only matters if the advisor is an expert
By now you can probably see that all five of these recommended criteria are interrelated. If the advisor the investor is working with is not educated, credentialed, experienced, and skilled in investing, it is unlikely that their advice or actions will result in positive performance. Likewise, they will not have the expertise to help the investor formulate an effective investment strategy that is appropriate to their individual, specific needs. As with hiring any professional, it is a very good idea to inquire as to the background, experience, education, credentials, and regulatory record of your advisor. Ask the right questions! How long have they been working in the industry? Do they have any customer complaints? Do they have a degree? Are they a CFA (Chartered Financial Analyst) Charterholder, CFP (Certified Financial Planner), CLU (Chartered Life Underwriter), or other credentials?
Don’t be afraid to ask these questions and others. You have the right to know who is advising you on your investments! Only someone with a depth and breadth of experience can help you develop an appropriate strategy and then help you implement that strategy. This is important! You work hard for your money, and have sacrificed to save. You should invest the same effort and time into the process of selecting your investment advisor as you do in choosing a doctor, lawyer, or any other professional. One final piece of advice—do not assume that just because someone works at your bank or at a brokerage firm that they are educated, experienced, or credentials, or that they have any experience. I have been working in the industry for over 20 years, and I can tell you from direct experience that there are many, many individuals working at the best banks and brokerage firms that are completely unqualified. Protect yourself, your family, and your assets, and ask the questions!
The best blue suit in the world won’t work if you need a black suit
When evaluating investments for your portfolio, make sure they are appropriate, given the amount of risk you want to take and the objectives you are trying to achieve. Each investment that you consider for your portfolio should complement the other investments to be included, and should work with all of your investments, so that collectively they represent the appropriate mix that will give you the best chance for success—success meaning achieving you stated goals as outlined in your investment strategy. Investments should not be evaluated in isolation, but in the context of all other investments in the portfolio, and with the risk tolerance and investment objectives of the investor in mind. An investment could sound like the best opportunity in the world, but if it doesn’t fit with your investment strategy, it is not appropriate for you. (This is another reason why it is so important to have a strong investment strategy in place.)
Time isn’t on your side
Many investment approaches look great on paper, but may not be a good fit for a specific investor. For example, Warren Buffett is widely recognized as a highly successful investor, and he has produced some tremendous result over time. His approach may work great for someone who is younger, and has many years to leave their money invested. However, for other investors who have shorter time-horizons, a long-term buy and hold strategy may not work at all.
It is very important to have a good understanding of the amount of time you have available for your investments to work for you. If you plan to retire in 5 years, your portfolio will look quite different than it would have 20 years ago, when you had 25 years to invest for retirement. Understanding your time-horizon as you formulate your investment strategy will help you to match the investments to be included in your portfolio with the time you have available for those investments to work for you. Over time, as your life situation changes, your investments must also change, so that things like the appropriate level of risk in your portfolio, liquidity, income generation, etc., match your needs.
While there are many things to consider when investing, this quick listing of five criteria should set you on the right path towards achieving your financial goals. By understanding things like appropriate performance expectations and measurement, having an appropriate investment strategy in place, making sure your portfolio matches that strategy, working with an experienced advisor, choosing investments that are appropriate for your personal situation, and understanding your time-horizon, you will be in a better position to navigate the treacherous waters of the investment world!
Craig D. Allen (CFA, CFP, CIMA) is founder and president of Montecito Private Asset Management, LLC. For more information, call 805.898.1400 or visit www.craigdallen.com.