Many money managers really don't use a proven investment process. By that I mean a rigorous, step-by-step process to manage investor's money that has demonstrated success in good and bad financial markets. Conventional money management practices are more focused on investment selection and portfolio construction, not on managing investments and navigating the markets. It is this lop-sided focus on "Offense" and the neglect of "Defense" and Risk Management that explains the big setbacks many investors suffer. Consider the typical money management process to understand more.
The Conventional Investment Approach Generally Follows this Process:
First determine the investor's "Risk Tolerance" to get a general idea of the most suitable mix of Stocks, Bonds, & Cash for the investor to hold. Then also considering the investor's Age, Time to Invest before Income Withdrawals, and Tolerance for Price Swings set their portfolio "Asset Allocation" or overall percentage mix of Stocks & Bonds-- this step typically includes adding Large, Medium, Small, Sector, International, and Emerging Market stocks together with a Fixed Income allocation into Short, Intermediate, and Long term Government and Corporate bonds (to make-up the "Bond" allocation). Common portfolio allocations include 60/35/5, 70/25/5, and 75/20/5 percent mixes of stocks/bonds/cash. Some managers alternatively set Target Percentage Ranges (70-75/20-25/0-5) for each asset class or category. In any case, when target levels are reached the mix is reset back to its original weighting.
The second step, consisting of a "Bottom-up" or "Top-down" analysis begins the actual security selection process. The Bottom-up approach focuses on the price paid for Revenue and Earnings growth of selected companies. A screening process ranks all the available choices identifying the lowest price and/or fastest growing companies for the portfolio. The Top-down approach first focuses on the economy's impact or potential effect on potential investments believing these factors trump security selection. Once the investment climate is assessed, screens are run identify the best holdings for that economic environment. Value and Growth characteristics are final considerations. Managers usually bend to one pole or another.
Security selection screens are employed to filter through a universe of investment opportunities to find desired security characteristics. For example, a "Value" oriented Manager may screen for stocks with high Book Values, low Price Earnings (P/E) multiples and perhaps strong Free Cash Flow while the "Growth" oriented Manager may screen for rising Quarterly Revenue and Earnings growth and defined Price to Sales ratios accepting higher P/E multiples for companies demonstrating above-average Revenue growth. In general, they want to see revenue growth greater than the price multiple.
Some Managers adhere to strict quantitative processes to make their security selections. For greater accuracy they use computer-assisted models to select stocks and construct portfolios. Decision rules then rank and score the opportunities. Judgment calls, considered biased input to a
"Quant" , may be altogether ignored to eliminate human error.
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"Diversification" is the final step of Portfolio Construction and attempts to spread-out risk among many different holdings. Doing so shunts the potential of big losses from any one company in your portfolio adversely impacting your principal value. It eliminates what economists call
"Systemic Risk" leaving the portfolio exposed only to
"Market Risk"
. This risk is assumed to be inherent and therefore unavoidable if one invests in the stock market.
Is Something Missing?
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Yes, the Portfolio Management process should not end here. And while in fairness most managers and financial advisors also consider Tax Efficiency, Income needs, and changing Personal Circumstances while providing a high level of on-going Communication and hand-holding, they fail to consider other crucial factors. Notably the conventional approach relegates
Portfolio Risk Management to after-thought or a passive factor of consideration once 'Asset Allocation' has been set. Its reliance on 'Asset Allocation,' 'Diversification,' and security holdings' past Characteristics permits Risk Management to be placed on
Auto-Pilot. What's more, conventional practices ignore the need for
"Investment Strategy." subsuming it as somehow addressed in the overall investment management process. Indeed its 'Value' and 'Growth' strategies are riddled with defects like the "Value" methodology ignoring the Time Value of Money and both the 'Value' and 'Growth' strategies failing to recognize the
Exponential Dimension of Loss.
A sound investment discipline must include 'Strategy' on the front-end as well as robust 'Risk Management' on the back-end as a check-and-balance system and neither can be passive. The conventional process lately is substituting something called "Automatic Rebalancing" or resetting portfolio holdings back to their original asset allocation on a periodic basis for Active Risk Management. While this automation is expedient because nobody needs to watch the portfolio, the trade-offs for investors are subpar gains and debilitating losses in Market Corrections.
In summary then, sound money management follows a proven investment discipline with "If, Then, Else" rules in place to navigate the financial markets, not just one-time rules to set 'Asset Allocation' and 'Diversify' a portfolio. Because the economy moves through Business cycles, what's best to invest in changes. Sound money management continually looks for opportunities, but also includes "Active" 'Investment Strategy' overlaid with 'Risk Management' techniques to protect principal. Past performance results with big losses underscore this investment axiom of investing. Investors must evaluate the thoroughness of their investment discipline by making sure they understand how their money is being managed. After all, though investing is not an exact science using a proven investment methodology can save you both pain and a lot of time.
