Do you ever wonder how to invest money? We all would like to have a pleasant retirement. Knowing how to invest money effectively gives you the financial freedom to do so.
Working with an Advisor
Investing is clearly an important part to one’s financial picture, but for many people investing is intimidating and confusing. Hopefully many of these people choose to work with an advisor whose incentives are aligned with their own. On this topic it is important to understand the difference between a broker dealer and a registered investment advisor. Broker dealers must meet a suitability standard. This means their advice does not have to be in the client’s best interest. Registered investment advisors, on the other hand, must act in their client’s best interest. It is important to understand this distinction and know which one the advisor you are considering actually is. Steven Lockshin discusses this as well as other topics involved with the selection of the right advisor in his book Get Wise To Your Advisor. We’ve been recommending this book to clients and prospects for years.
If you are considering work with us, you should know that we are a fee only registered investment advisor. You can get more information on the types of approaches we offer on how to invest money in this paper.
Some people will choose how to invest money themselves. Others just want at least a general sense of what their advisor might be doing for them. Either way, here is a basic framework everyone should understand. Investors generally like to earn as much mean or average return as possible. Typically investors must accept more risk or volatility to earn higher returns over the long-run. Volatility is a measure of the degree to which returns over any given period of time deviate from their average. More volatility is riskier than less volatility. Generally, people are risk-averse. This means they would prefer to have less risk rather than more risk as long as all else is equal. Although, they would also like to have more expected return. In order to get that, they likely need to accept more risk. Thus, there is a trade-off.
Asset allocation should be the first and most important decision any investor makes. This will be the biggest determinant of one’s mean return and volatility over time. The two traditional asset classes are stocks and bonds. Stocks are generally expected to deliver higher returns than bonds over the long-run, but they are also more volatile. Thus, allocating more to stocks and less to bonds leads to higher expected returns and more risk.
One can invest directly in individual stocks or bonds, but investing in commingled funds is more practical. Commingled funds give investors access to several stocks or bonds all through a single investment. Investors can use mutual funds and ETFs for this purpose. It is important to understand that, mutual funds, ETFs, and even hedge funds are NOT asset classes. They are legal structures or vehicles that give investors access to a group of individual securities.
Diversifying is extremely important because it gets back to that trade-off between risk and expected return discussed earlier. Let’s just say a broadly diversified group of stocks typically delivers about 9% returns per year on average with an annualized standard deviation of about 16%. Any one random stock would also deliver about 9% per year. This is no better or worse than the diversified portfolio of stocks. However, the average stock will be more volatile than a 16% standard deviation and, in many cases, much more volatile. This means you get the same expected return with more volatility. That is not an attractive proposition.
Why would you only have one stock? You must be extremely confident that stock will have a substantially higher expected return than the average stock. This reminds me of those studies that ask people if they believe they are above average. Just about everyone claims that to be the case. Many people tend to think there is good reason why some stock they really like is above average when, in fact, it is not.
Having many stocks that are all less than perfectly correlated with each other reduces the volatility of the return stream of the whole group. This is why the average stock is more volatile than the whole stock market. I discuss the mathematics behind this concept in great detail in The Magic of Diversification.
If you ask others how to invest money, some will tell you it is all about dividends. More dividend yield is better. I would suggest you read this short white-paper to get more insight into dividend stocks. Diversification is really more important than dividend yield at the end of the day.
While you can diversify within asset classes, you can also diversify across asset classes. This is where alternative investments become interesting. Within traditional investments, stocks and bonds are the only two asset classes. However, “alternative investments” is a term used to broadly describe every asset class that is not stocks or bonds. Interestingly, there are many different alternative asset classes. Equity long/short, global macro, managed futures, merger arbitrage, and convertible arbitrage are just a few that are mainstream. However, alternative managers are constantly seeking to find more unique and uncorrelated strategies. There is really no limit to the number of alternative strategies or asset classes that managers could create. Even presently, there are certainly many more than the few I just named. White Oaks is constantly evaluating the alternative landscape seeking the best opportunities available. If you ask us, this is how to invest money.
Alex Duty, CFA®, CIPM is a Portfolio Manager at White Oaks. He performs investment research, asset allocation of various strategies, assesses client portfolios, and assists with overall client communication.