How Should You Choose Assets? - Part 2

May 14th, 2008 at 12:34pm Amy Barrett

   Amy L. Barrett MBA, CFA, CFP®, CDFA™

Since active investing leads to inferior returns when compared with passive investing, the key steps to building a successful passive portfolio are below. 

 Choose stocks, bonds, and other assets based on Modern Portfolio Theory (MPT) - There is a trade-off between risk and return so select investments to gain the maximum expected return for a given level of risk.

Purchase broadly diversified baskets including a wide range of asset classes - A diversified basket includes
U.S. stocks (large and small), Foreign Equities (with Emerging Market stocks), Real Estate, Commodities, and perhaps high quality Fixed Income.

Hire investment managers that have low asset turnover - Turnover is buying and selling of assets. The turnover costs include a bid-ask spread (selling to the bid and buying the offer), market impact (big traders can cause the market to move), and higher trading cost (paying a commission on sales and purchases).

Keep your costs down - Mutual funds with high expenses reduce return.  Buy only no-load, low cost funds (i.e., passive index funds).

Manage your taxes - Taxes reduce return so purchase tax-efficient investments for your taxable accounts.  Tax-efficient investments control the amount of income distributed in order to reduce investors’ tax liability.

Systematically rebalance your portfolio - Rebalancing instills discipline by selling assets that have grown above the target.  This reduces risk and adds return over time. 

To answer “How Should You Choose Assets?” I recommend that the do-it-yourself investor visit The Vanguard Group website.  Vanguard and other low cost index mutual fund companies offer a variety of broadly diversified index funds.  For investors who are not the do-it-yourself kind, a good financial advisor can help you decided on a strategy and choose assets that can help you reach your long-term goals.                                      

Entry Filed under: Asset Allocation, Financial Planning, Investments