Step 6 of 10 Personal Financial Planning Steps in the Right Direction
This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner‘s personal financial planning and personal investment management process. For a summary of these ten steps, see “Your Family Financial Planning.” To find an in-depth article for each step, just click the Sitemap link at the top of this page. Also, you can reach us by using the contact form below. Please enjoy reading this article. Thank you!
Step 6 – Select investment securities using valid criteria
Without a rational personal investment system based on scientifically verified investment management strategies, individual investors will make inferior decisions based on false assumptions.
Given the extremely large number and variety of available securities, investors need a rational basis to select among them. Without rational selection criteria and a good understanding of which factors are more or less likely to increase risk-adjusted returns, investors will make poor decisions based on false assumptions. Your portfolio investment strategy should focus on broad-based, market oriented financial investments that can be acquired economically and held inexpensively in your portfolio for an extended period. Of course, investment costs and tax implications heavily influence how you structure and manage your investments.
If you cannot find scientific evidence to verify a personal investment management strategy, then just do not do it. To cut to the chase about what tends to work best with investment strategy and retirement planning, I have concluded that all forms of active management that cannot be cost justified should be driven out of personal investment strategies.
The best investment strategy for lifetime personal finance and retirement planning
Individual investors need to choose a comfortable, very low cost, low tax, risk-adjusted market investment strategy and let it run over time. Maintenance should be minimal and low cost, and the urge to chase “beat the market” mirages should be heavily restrained. Investors’ strategies should focus on broad-based, market-oriented investment funds securities (mutual funds and ETFs) that can be acquired economically and held inexpensively for an extended period.
Buy the cheapest, most broad based investment mutual funds and exchange traded funds (ETFs). Buy and hold them. Keep holding them, unless you really need the money for some other purpose. This is what assets are for. You keep them until you need them. Otherwise, get on with your real life.
Key concepts to consider when deciding on the best investment strategy for your personal investment portfolio.
The current price of a security represents the market’s consensus about its potential future value, given the various advantages and disadvantages that all investors see in holding or selling that security. As such, the current security price is a weighted average value forecast of events that might or might not occur. Market prices are the best available assessment of forward-looking, risk-adjusted fair market value.
Through securities market prices, a wide array of investors with differing predictions and varying concerns essentially “vote” on the expected or likely future value of a security through its current price. Investors’ evaluations of the value of securities may vary widely. What one person might see as a great bargain, another might consider grossly overpriced. Without this divergence of opinion over current securities values relative to potential future values, there would be no trading of securities. Given the immense volume of securities trading that occurs daily across the world’s securities exchanges, it is clear that there is no shortage of significant differences of opinion about current market values.
Securities prices represent the current valuation consensus on a risk-adjusted basis. Risk refers to the expected size and likelihood of future up or down price variations or volatility. As such, not only do prices reflect expected returns, they also reflect the panoply of concerns, optimism, risks, and euphoria about how a wide range of factors might affect the price in the future.
Given this highly speculative, future-oriented, and risk-adjusted valuation process, there are bound to be very significant price fluctuations as time goes on. This variability is the natural side effect of the market’s communal, self-interested valuation process, and this variability is neither good nor bad. It seemly means that speculation about future investment value has been, is, and will always be subject to risk and uncertainty.
The problem with trying to predict future securities market values is that the future is fundamentally unknowable, until it arrives.
The problem with trying to predict future securities market values is that the future is fundamentally unknowable, until it arrives. While history can be instructive about what might be more or less likely in the future, history tends not to be predictive. Securities prices exhibit only a very tiny level of predictability within a very large range of random fluctuations. The blending of expectations about future returns and risks into current securities prices means that the situation is subject to a wide range of either insightful to specious predictions. Unfortunately, you can only guess which predictions are insightful or specious, until after the fact.
The volatility of prices across time provides an opportunity for just about anyone to develop a supposedly predictive theory on how the markets actually work and to offer selected data to support their arguments. The only reliable way to sort through what is true or false is to rely upon the investment research studies of highly disciplined academics who carefully test these theories using market price data that is unbiased.
Individual investors are usually better off, when they ignore concerns about whether the securities markets fairly value investment securities.
Individual investors are usually better off, when they ignore concerns about whether the securities markets fairly value investment securities. If there is a reasonably large and liquid market where investors interact through “arm’s length” transactions, then individual investors should simply accept current market prices and avoid the usually futile temptation to second-guess current values and to try to beat the market. While some securities prices will eventually be shown to have been either too high or too low relative to their subsequent prices, the reasons almost always have nothing to do with market pricing mistakes by the securities markets.
Current securities market prices do a pretty good job of reflecting information that is already know. Statistical studies demonstrate that errors tend to cancel each other leaving little opportunity of investors – especially amateur individual investors – to identify, trade, and profit on these current pricing errors. In effect, especially among individual investors, those who appear to have done better than the market were largely just lucky and those who did more poorly were simply unlucky.
Instead, prices tend to change over time due to unpredictable future events which occur and cause the securities markets to revalue securities. New information continually changes forward-looking expectations about expected future investment values. Since this new information becomes known only if and when it happens, there is no way to have reliably predicted it. Speculation about a range of possible future events will influence current prices, but only time will tell what actually will happen.
Unfortunately, the average professional investment fund manager charges several times his added-value through increased investment fees, costs, and taxes.
Some full-time professional investment managers and professional securities analysts might be able to discern when a security is more likely to be under-valued or over-valued. Before their added costs and taxes are considered, on average active professional mutual fund managers have been shown to deliver performance that is only modestly better than passive index benchmarks. However, across all professional investors there is no evidence that they can consistently beat the markets, after their added costs and higher taxes are taken into consideration.
The costs of trying to beat the market simply overwhelm any professional value-added. Through increased investment fees, costs, and taxes, the average professional investment fund manager charges several times the average value that might be added. The effort to identify and hire only “superior investment managers” is highly uncertain, usually futile, and subject to a great deal of error and dumb luck. In reality, except for cost reduction, there are no reliable metrics to predict superior investment fund performance and to identify superior money managers before the fact.
So, where are all the perennially superior traditional money managers who can be hired economically to manage your money and that of thousands of others for a superior return? They are not to be found. Individual investors spend an excessive amount of time and money looking for investment mutual fund managers who will almost all turn out not to be the next Warren Buffett in the long run.
Choosing the lowest cost investments will always mean adopting a passive index benchmark investment strategy. The logical decision of individual investors is to avoid all activism and not to pay more for a poor chance of winning versus a much larger chance of losing. Instead of trying to beat the market or trying to find a mutual fund manager who will beat the market net of his substantial added costs, individual investors should instead focus their efforts on:
- earning more income and saving more to fund their investment program
- understanding their relative investment risk tolerance and choosing an investment asset allocation that is appropriate for their personal risk profile
- using rational selection methods to acquire a low cost, low tax, broadly diversified, passive market-based portfolio
- applying time and energy to investment activities that tend to increase personal financial welfare, while eliminating time spent on activities that undermine it.
Invest passively in very low cost, very broadly diversified index funds across the world. Save more to build your assets. Save your time and do something else that you actually enjoy, instead of wasting your time and money playing amateur individual investor.
If you can not find scientific evidence to verify a personal investment management strategy, then just do not do it. Do your research and find out what works and what does not. For more information about scientifically based personal investment strategies, see these articles on “Personal Investment Management.” These articles are published on our sister website, The Skilled Investor.
Pasadena Investment Advisors
Larry Russell, Managing Director
MBA – Stanford University, MA – Brandeis University, and BS – M.I.T.
Lawrence Russell and Company Pasadena, California 91103
A California Registered Investment Adviser — Certificate 133101
KNOWLEDGE — OBJECTIVITY — HONESTY — DILIGENCE — SATISFACTION
A truly independent financial planner and fee only investment advisor
(Regarding how I am compensated, I provide financial planning services only on a hourly fee or fixed fee for service basis, and only under a contract that we agree upon. You will not have to pay any asset fees. Furthermore, to avoid all conflicts-of-interest, I do not accept compensation or commissions of any kind from the industry.)
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