Sandra L. Bragar, CFP(R), Managing Director – Planning Strategy & Research, Partner at Aspiriant.
I often hear from prospective clients that they simply don’t understand a lot of the language investment advisors use, particularly when it comes to investment strategy. They sometimes tune out the jargon and, therefore, don’t really comprehend the decision-making process that drives their portfolio. There are many investment advisors out there, and it’s important to know their approach to investing to make sure it’s the right fit for you.
There are four common approaches. Each can be conservative or aggressive; they just have different levers to pull to change the risk.
A market capitalization approach typically invests in assets with the largest market cap — calculated as the number of a company’s outstanding shares multiplied by the current price of a single share. The asset allocation is mainly a percentage of stocks and bonds based upon your risk appetite, maybe 80% stocks/20% bonds if you’re younger and have more time to make up eventual losses, or 60%/40% if you’re nearer retirement and need to preserve capital. If you need all the assets in less than five years, say for a down payment on a home purchase, then you would look to being even more conservative.
You will probably not hear an advisor or investor say they use a “market capitalization” approach to investing. This strategy is more commonly described as index investing. The simplest way to invest using the market-cap approach is through index-tracking mutual funds and exchange-traded funds (ETFs), and therefore, you tend to pay less in fees. As a result, over the long term, the portfolio grows consistent with the mix of the stock and bond markets you’ve adopted in the portfolio (i.e., 60% stocks/40% bonds).
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With this approach, investors often experience the full effect of market highs as well as the full depth of market corrections and periodic crashes. Additionally, this approach often tilts purchases toward companies with the largest market cap and bond issuances, which could mean “buying high” in expensive markets and facing lower returns going forward.
A lifestyle immunization approach is just as it sounds — it’s meant to preserve your capital so you can continue living your life the way you enjoy for as long as possible. The idea comes from pension funding and is meant to match the timing of cash flow received from your investments to when it’s needed to be spent.
The lifestyle immunization approach is often used by investors who have more financial resources than they need to fund their highest priority goals and, therefore, don’t have pressure to optimize investment returns. It’s also used by investors with a particular financial goal that has a near-term end date, such as college, and who need to reduce risk of loss and save the money as it approaches.
Lifestyle immunization portfolios will typically be weighted toward the more stable returns of bonds and experience less growth because of the lower allocation to stocks.
At a high level, risk parity seeks to maintain balanced risk allocations across the portfolio and generate returns that are more resilient to a variety of changing economic conditions. It’s generally implemented by allocating similar risk weights to three or four asset types: stocks, bonds, currencies and inflation assets, such as commodities.
Additionally, risk parity managers use leverage (debt) to manage the level of overall portfolio risk. The resulting asset allocation that tries to match the risk of a 60% stocks/40% bonds portfolio might use leverage on an allocation of 16% stocks/62% bonds/22% commodities. Investors who want to reduce exposure to equity volatility are most attracted to this approach.
Proponents of risk parity highlight the increased diversification of risk among all asset classes. Risk parity helps to dampen equity market risk and has worked well during the bond bull market of falling interest rates as bonds have provided strong risk-adjusted returns compared to equities. There is a concern, however, about how this approach will perform if there is a sustained, long-term increase in interest rates.
Valuation driven is a long-term, active investment approach that aims to outperform passive benchmarks over time. Here, the investment manager is focused on “buying low and selling high” by choosing to buy investments when their price is near or lower than their inherent fair value and then selling when the investment becomes expensive.
This means buying stock when it’s priced cheaply across a variety of ratios, such as price to earnings (P/E), price to sales, price to book and other factors. For example, if a market’s average P/E is 22x and is now trading at 15x, and its price is 1.5x its sales versus other markets, which are trading at 3x sales, it might be a good time to buy.
This method requires a great deal more research and analysis to be able to understand how relatively cheap or expensive various investments are at any given time. It also requires patience, because it can underperform benchmark indexes during extreme bull markets.
But a valuation-driven approach also reduces sharp losses during down markets, allowing you to remain invested through full market cycles. Over the long term, history shows valuation-driven investing outperforming the indexes as investor emotions cause the market to overprice popular companies and undervalue slow growers.
Invest Based Upon Your Goals
When you sit down with an investment advisor, your personal values and your financial and life goals should be the main priorities. The portfolio approach you adopt should allow you to achieve your goals while you remain comfortably invested through periods of market volatility.
Most importantly, the advisor should clearly explain their overall philosophy and strategy orientation and how they would apply it to your portfolio. Do not be afraid to ask questions. This is your money. And if you feel they are not listening to you or explaining their methodologies and fees in a way you understand, then consider another investment advisor. There are plenty out there who want you to feel comfortable and confident about your financial decisions.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.