Whether you manage your own money or hire a professional advisor to do so on your behalf, it is important to understand the investment strategy, even if only at a high level. Quite understandably, many Americans are intimidated or confused when facing the vast universe of financial products available to them. While it is not necessary for every individual to have a complex knowledge of asset management to select funds or understand how investments are allocated, familiarity with the fundamentals is a key component to a successful strategy.
Not all investors will need to know the breakdown between U.S. and foreign equity, never mind their concentration in various sectors. But everyone should have a basic idea of how they’re invested: how much of your portfolio is in cash? Are you invested in single stocks or tracking a market index? Passive low-cost exchange-traded funds or actively managed mutual funds? None of these questions require an exact answer either; the key is understanding the terms and how they’re being applied to your situation.
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If you’re managing your own portfolio, why it’s important to grasp the basics is probably self-explanatory. Again, you can get as granular as you wish on any of these topics, but that usually leads to analysis-paralysis. Knowing the terms and the basic principles behind them can aid investors at any level, especially for those just starting out.
If you’re not managing your own portfolio, absorbing these key concepts can be quite valuable to help ensure you’re on the same page as your investment manager. For example, it is not uncommon for new clients to admit they’re unsure of how their assets are currently being invested — and surprised when we explain how our investment management strategy going forward will differ from how their assets are allocated currently. They may simply not realize the high cash balances across their accounts or were not aware of the risks associated with individual equities.
In no particular order, these basic explanations can be used to refresh your memory or provide the foundation to your understanding of your own investments. (Please note the explanations below are deliberately very high level and do not include all the information that may be required to make decisions on your account.)
Asset allocation. There are many ways that your current portfolio can represent its underlying holdings. The most basic approach divides a portfolio into three different asset classes: equity, fixed income, and cash. The next drilldown would include sector information for each asset class, such as U.S. Large Cap Equity or Foreign Emerging Market Equity.
Mutual fund. Mutual funds allow investors to access to greater buying power by pooling the funds of many. The ability to purchase a greater number of securities across the market may provide more diversification than an investor could achieve on their own. The objective of various mutual funds will differ — some seek to track the broad-based U.S. economy, while others may only focus on a sector such as real estate. Mutual funds are actively managed by a portfolio manager, which means higher expense ratios.
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Target-date mutual fund. Target-date funds are found in many employer-sponsor retirement plans like a 401(k). Target-date mutual funds are different from regular mutual funds due to their focused objective: to provide pre-retirees with a fully diversified age-based investment portfolio, all within one fund. The underlying holdings of each target-date fund will depend on the retirement year selected and will gradually become more conservative as that date approaches. These funds tend to make it much easier for the hands-off investor to achieve diversification and rebalancing automatically, in exchange for a higher expense ratio.
Exchange-traded fund. ETFs are similar to mutual funds but different in a few key ways. Like mutual funds, ETFs are a collection of various stocks and bonds; however, exchange traded funds are considered passively managed and therefore tend to have much lower expense ratios. Mutual funds use active managers to try and outperform their benchmarks while ETFs usually are just designed to track a market index, like the Standard & Poor’s 500 index. ETFs are also typically more tax-efficient investments compared to mutual funds.
Active management. Active managers seek to outperform their benchmark market index by taking advantage of perceived market inefficiencies. Professional fund managers leverage their own research teams, forecasting and other techniques to try and find opportunities in the market. The benefits of active management have been called into question in recent years, especially given the formidable challenge of consistently beating a benchmark on an expense-adjusted basis. According to S&P Indices Versus Active, over the past 10 years, 82 percent of actively managed large-cap funds have failed to outperform their benchmark.
Passive management. Passive investments are also professionally managed, but their portfolio managers have much different objectives. A fundamental principal of passive management is that markets are efficient and prices already reflect all public information. Passive funds often employ a strategy called “indexing” where the goal is to mirror a market index, like the Nasdaq. Expense ratios on passive funds are often significantly lower than active products.
Individual stocks. Sometimes investors will purchase or hold single stocks, such as Tesla Motors (ticker: TSLA), instead of buying a diversified fund or ETF. There are a few main reasons for this: an emotional attachment, often stemming from inheriting the securities, a belief that the company will experience tremendous growth, you received stock from your employer. Holding individual stocks carries much more risk than holding a diversified basket of equities, as you’re taking on the business risk of a company in addition to the market risk. Especially if the stock is your current employer’s, you may run the risk of having a significant portion of your assets and income tied to the success of one company.
Expense ratio. The expense ratio is the annual fee that is deducted from the assets of a fund or ETF to pay for fees and expenses. The expense ratio is paid by shareholders, so it is an important point of comparison when selecting investments. As discussed earlier, active funds will have higher expense ratios than passive.
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Developing a working knowledge on asset management and how you’re invested may take time, but starting with the basics and building from there is a great way to get started. The more you know, the more you’ll be in control of your financial future.
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Know How You’re Invested originally appeared on usnews.com
