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Sunday, April 25, 2010

SOUND INVESTING: Artificial Constraints: The Truth About Investing

Sound Investing with Jason Lampa, MBA

DALBAR’s update of its Quantitative Analysis of Investor Behavior (QAIB) study found that while the S&P 500 has returned 8.35% over a 20-year period ending in 2008, the average equity investor earned just 1.87%, which was less than the inflation rate of 2.89%. Bond investors fared no better. They earned returns of just 0.77% compared to 7.43% for the index. Using the rule of 72 (a simple method for finding out the number of years it will take to double your investment), we find the average equity investor would need 39 years to double their investment, while bond investors would have to wait 94 years, respectively. Something has to give.

As part of my mission to help investors generate the returns necessary to make the experience of investing worthwhile, I would like to begin by discussing asset classes, investment styles, and individual securities. Stocks, bonds and cash are the most common asset categories. These are the categories that most investors understand as asset allocation, and hence rely on to generate the returns that will provide them a comfortable retirement. Let's add a couple of more to the asset allocation mix that can benefit investors. Real estate, precious metals and other commodities, and private equity are four additional asset classes that should be added to an investor's wealth building strategy.

For many years, gaining access to these additional asset classes was difficult, only available to the ultra-affluent. Through advances in technology, and a growing interest among the mass-affluent for additional investment choices, the opportunity for investors to take advantage of these options is now a reality.

Investment style refers to the different style characteristics of asset classes within a given investment portfolio.

Active vs Passive
Active investors rely on the belief that they have the ability to outperform the overall market by periodically adjusting their investment holdings and by selecting professional mangers to generate returns. Taking a passive approach, other investors buy into the philosophy that investors can not beat the overall market. It's a philosophy that industry pundits use to convince the general public of their expertise, though this philosophy is a false belief system.

Growth vs Value
In an effort to bring additional confusion to the investment process, the industry has created labels such as growth and value companies. A mutual fund or individual security is either labeled a growth or value play based upon numerous measurements. The following are a few of the fundamental characteristics measured:
  1. Price to Earnings
  2. Sales Growth
  3. Return on Equity
  4. EPS Growth
  5. Dividend Percentage
Small Cap, Mid Cap and Large Cap
Based upon the market value of a publicly traded company, it is assigned an artificial "box." Companies that have a market value of under $1 billion are labeled small capitalization companies, those between $1 billion and $ 5 billion are labeled middle capitalization and those above $5 billion are put into the large capitalization "box." The prevailing belief system is that smaller cap companies are a higher risk than large companies.

Individual securities are placed into sectors in which their firm operates. Companies that make software are placed into the technology sector. Those companies that make items such as refrigerators, washing machines, and tractors are put into the consumer durable sector. Overtime these sectors have exhibited certain return characteristics which the investor community believes is a result of the sector they are in. This is yet another false belief system that restricts investors from looking at what is actually happening here.

In summary, we have discussed asset allocation, investment styles and individual securities. The artificial labels that are placed on individual companies has been a convenient way for large, institutional investors to take advantage of retail investors who are not provided the entire story. In my next article, we will discuss how to ignore these artificial barriers and give yourself the best opportunity to generate wealth utilizing equity and fixed income securities.

For more information, please visit Jason's TNNWC Bio.

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