While investing can at time seem overwhelming, the academic research can be broken down into what we call the Five Key Concepts to Financial Success. If you examine your own life, you’ll find that it is often the simpler things that consistently work. Successful investing is no different. However, it is easy to have your attention drawn to the wrong issues.
Concept One: Leverage Diversification to Reduce Risk
Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. That’s a very simplistic view of diversification, however. It can also get you caught in a dangerous trap – one that you may already have fallen into.
Concept Two: Seek Lower Volatility to Enhance Returns
If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return.
Concept Three: Use Global Diversification to Enhance Returns and Reduce Risk
Global diversification in your portfolio reduces its overall risk. American equity markets and international markets generally do not move together. Individual stocks of companies around the world with similar risk have the same expected rate of return. However, they don’t get there in the same manner or at the same time. The price movements between international and U.S. asset classes are often dissimilar, so investing in both can increase your portfolio’s diversification.
Concept Four: Employ Asset Class Investing
An asset class is a group of investments whose risk factors and expected returns are similar. Originally, institutional asset class funds were not available to the great majority of investors. Often the minimum investment for these mutual funds was in the millions of dollars, effectively keeping them beyond the reach of all but large pension plans and the wealthiest individual investors. Fortunately, these institutional asset class funds are now accessible to all investors. You can gain the same advantages previously enjoyed only by large institutional investors.
Four major attributes of asset class funds make them attractive:
- Lower operating expenses
- Lower turnover resulting in lower costs
- Lower turnover resulting in lower taxes
- Consistently maintained market segments
Concept Five: Design Efficient Portfolios
How do you decide which investments to use and in what combinations? Since 1972, major institutions have been using a money management concept known as Modern Portfolio Theory. It was developed at the University of Chicago by Harry Markowitz and Merton Miller and later expanded by Stanford professor William Sharpe. Markowitz, Miller and Sharpe subsequently won the Nobel Prize in Economic Sciences for their contribution to investment methodology.
The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting. It’s important to remember that math is nothing more than an expression of logic, so as you examine the process, you can readily see the commonsense approach that is takes – which is counter-intuitive to conventional and over-commercialized investment thinking.