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One of the most important parts of your overall financial plan is the investment plan. The investment plan is made up of three distinct parts: present value, projection of future inflows and outflows, and allocation. It is allocation that we’re most interested in with this article.
Allocation is the process of determining the “mix” of your investment assets: stocks, bonds, real estate, etc. as well as domestic and international categories. Allocation is determined by the philosophy that you choose to follow with regard to investment management. Our philosophy is summed up as follows:
- Diversify
- Reduce Costs
- Pay Attention to Economic Signals
- Maintain Discipline – Stick To Your Plan
Now, there are three primary schools of thought that are often relied upon to develop an Investment Philosophy: technical analysis, fundamental analysis, efficient markets hypothesis.
Technical Analysis is the review of charts of stocks and funds, with the belief that patterns within the action of a stock can provide insight into the future actions that the stock will experience. The theory is that investor behavior can be predicted based upon volume and stock price fluctuations, and given the prediction of this behavior, Technical Analysts purportedly take advantage of “knowing” what the future will bring. I’ve always likened Technical Analysis to palm reading…
Fundamental Analysis is where the data about a stock – the price-earnings ratio, expected growth rates, earnings projections, etc. – is studied in order to determine the “correct” price intrinsic within the stock. This intrinsic value is then compared to the trading value (present price) of the stock, and if the intrinsic value is higher than the trading value, this represents a buying situation; a selling opportunity exists if the intrinsic value is lower than the current price.
The third school of thought, Efficient Markets Hypothesis (EMH), explains away the benefits supposed by the Fundamental Analysis theory. With EMH, as the name implies, it is assumed that the market itself is very efficient with regard to the dissemination of information. In other words, when a piece of new information is made available about a stock, that information is quickly and efficiently spread to all interested parties, allowing for little, if any, opportunity for arbitrage. In today’s connected world, this spreading of information occurs at the speed of light.
For example, let’s say that Acme Motor Company is coming out with a new model of car, widely expected to be the savior for the company. As a result, Acme stock is highly valued, compared to recent history, in anticipation of this new model. During the testing of this new model, it has been determined that there are serious flaws in the design – turns out using aluminum foil for the engine block wasn’t such a good idea – and now the new model will not only be drastically delayed, it may be canceled altogether. If this new information were known only to a select few (outside the company), then those folks could take advantage of the situation, and short-sell the stock in anticipation of it’s expected fall in value. The Efficient Markets Hypothesis takes the stance that this kind of information is spread SO quickly that the opportunity for arbitrage is effectively wiped out.
So that explains how EMH addresses Fundamental Analysis – how does this help build our investing philosophy? How does the investor take advantage of the marketplace to their benefit? To answer these questions, we first need to take a walk – a Random Walk, specifically. “A Random Walk Down Wall Street”, by Burton Malkiel, first published in 1973 and now in its Ninth Edition, describes the activity of the stock market as a “Random Walk”. This is due to the observation that short-run changes in stock prices cannot be predicted, but rather are quite random.
Let me say that again: Short-run changes in stock prices cannot be predicted, but rather are quite random. It is for this reason that I often don’t pay much attention to the day-to-day fluctuations in the Dow or the S&P 500 – what I’m more interested in is the long-run direction of the market, which is illustrated by some very sound statistics. Specifically, I pay attention to the broad views of the domestic and world economies, including manufacturing, GDP, and jobs information; interest rates and inflation; as well as money supply and market valuations (for example, the forward view of price-earnings ratios of the broad indexes), among other things.
Against this backdrop of factors, the present momentum of the markets is also considered, since it is more likely that the market will continue in the direction that it has maintained over the previous 18 to 24 months than not.
So, how does all of this fit together? Let’s look at the four points of our investment philosophy again:
- Diversify – by utilizing broad market indexes, covering all points of the marketplace both domestic and international as well as fixed income and equities, we are automatically diversifying across market capitalization, company, industry, and country. It just doesn’t make sense to choose a narrow band of investments when you can take part in the success of the overall economy – the global economy.
- Reduce Costs – index mutual funds are the most cost-efficient investment vehicle in the industry. Expense ratios are well below 0.5% for most of these investments and often is less than 0.1%. In addition, Exchange Traded Funds (ETFs) are also the most tax-efficient investment options available that invest in the unrestricted equity and bond markets.
- Pay Attention to Economic Signals – when viewing forward-looking economic conditions, it is necessary to context the various signals together, considering the impact on your present investment elections. As indicated previously, short-run trends are difficult if not impossible to predict, but longer-run trends tend to have certain signals that indicate they’re on the horizon. Paying close attention to these signals can help with long-term decision making with regard to your investments.
- Maintain Discipline – Stick to Your Plan – this goes hand-in-hand with the view that short-run trends cannot be predicted. In addition, short-run trends typically have little impact on the overall investment plan, provided that you maintain discipline and do not stray from the plan. The worst thing you could do is panic in a short-run market action and abandon your plan. The whole point of having a plan is to help you to get through those panicky times with confidence.