Lately, one of the most common questions for investment advisors is the “What if” question. What if the European Union fails? What if Obama is re-elected or Romney is elected? What will happen to investment portfolios if we fall off the fiscal cliff?
In today’s uncertain economic climate, people are worried. Unfortunately, nobody has the ability to read the future, but the good news is that nobody has to. Successes in financial plans or investment portfolios do not require a crystal ball. Using the right investment process helps protect investments and gives better protection from financial disasters, such as the 2008/2009 credit crisis.
Many financial advisors build a portfolio based on the Modern Portfolio Theory developed by Harry Markowitz in the 1950s. The MPT theory assumes that people can predict investment returns, price volatility and the risk/return correlation based on historical data. Using MPT as the foundation, two major investment strategies were developed and widely adopted: asset diversification and “buy and hold.” However, these strategies are problematic, particularly for investors who are close to retirement age.
Portfolio diversification is a common practice and protects investors against “unsystematic risk,” which is associated with investing in a particular stock or industry. Enron employees, for example, who invested the majority of their retirement money in the company’s stock, were hurt by unsystematic risk.
However, “systematic risk” is the inherent risk of the financial system and affects all companies, assets and industries. This hazard comes from large-scale economic events, such as war, inflation and recession. The 2008/2009 credit crisis is an example of systematic risk, since nearly all asset classes, from precious metals to money market funds, lost value. The U.S. stock market lost approximately $6.9 trillion in 2008. Investors asked their financial advisors and stockbrokers what they should do. Oftentimes, the answer was: “buy and hold.”
This “buy and hold” tactic, which has become a mantra for the financial industry, is a “buy, hold and hope” strategy for the average investor, who may be told to ride out the market.
Investors might well consider an investment process that offers more protection against the inherent systematic risk of the market. One such process marries two schools of thought. The first involves fundamental analysis in which an understanding of expected cash flows and fair value help determine if an investment is a good opportunity. The second involves technical analysis in which the analyst gains an understanding of whether it is the “right time” to own a particular investment by examining the relationship between supply and demand for the security. Anyone who has bought stocks knows that it’s easy to find an investment that looks good on paper but fails to perform well because there are more buyers than sellers.
Another technical measure of an investment’s potential is “relative strength.” When the investor understands which investments have the strongest investor demand, he can focus investment dollars accordingly and to the exclusion of investments that have the weakest investor demand.
Nobody has a crystal ball to predict the future of the financial markets and investing has inherent risks. However, a well-devised investment strategy can help you, the investor, achieve long-term financial goals even if the election, the fiscal cliff, or tax law changes don’t go your way.
— Rob Hoxton is the president of HFI Wealth Management, a leading fee-only investment advisory firm. He can be reached at 304-876-2619 or firstname.lastname@example.org