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A Lifetime Investment Strategy

By James B. Cloonan

While individuals invest more money in Treasury bills, bank accounts, bonds and real estate than in equities, there has always been a mystique and allure about the stock market. To many investors, it offers an irresist- ible challenge. While the historical returns are high, the volatility of the stock market creates risk.

Sometimes, this risk makes itself very apparent; other times it is more subtle. However, some risk is always present because it is the reason for the higher returns. Those who wish to earn more than the Treasury bill rate must assume risk. This report offers a Lifetime Investment Strategy with guidelines for the long-term successful management of your stock portfolio.

James B. Cloonan Chairman, AAII

Introduction Strategic planning has become a common phrase these days. While everyone may not defi ne strategic planning in exactly the same way, “strategy” deals with the overall, long-term guidelines that are set up in an attempt to ensure the success of an indi- vidual or institution. Tactics are used to implement a strategy, and they relate to activities of shorter du- ration. The focus of this special report is strategy— lifetime strategic decisions made by the individual investor in the course of managing a common stock portfolio.

Sometimes individuals attempt to make decisions while pursuing vague objectives such as “to do well” or “to succeed.” However, such fuzzy objectives make it impossible for investors to successfully choose from the investment alternatives facing them.

An even more common mistake is the failure to specify the time period that the planning will cover. This is critical because what is best for the short term may not be best for the long term. That’s not to say that emphasis should only be placed on long-term results. A young family struggling to get by might have to concentrate on short-term cash generation, even at the expense of long-term investment prof- its. Frequently, decisions must be made with a view to both the long and short term. The point is that time horizons will vary depending upon both the investor and the situation.

In this overview of a strategy for investing in the stock market, a “wealth maximization” objective and a very long time horizon are assumed. These as- sumptions are used because they apply to the situ- ation a large number of investors face when invest- ing in the stock market.

There are two basic requirements for any strategic planning decision: • There must be a clearly

defi ned objective; and

• There must be a specifi ed time horizon.

Part I

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Actually, investment in the stock market for most investors goes through two stages, although these may overlap. The fi rst stage is “accumulation”—the period when earnings exceed expenditures and individuals are building wealth. The second stage occurs when the accumulated wealth begins to be consumed; this is the “withdrawal” stage.

In either stage, some points should be emphasized:

• A long-term strategy means a time horizon of at least fi ve years. No one should embark on a long-term investment strategy if they are go- ing to need their investable assets in less than fi ve years. Instead, a traditional approach similar to that used in the withdrawal stage should be taken for shorter time frames.

• Individuals should not invest all of their wealth in common stocks. This is important because unex- pected events may require that savings be used, even if the investor is still accumulating wealth. Taking money out of the stock market at the wrong time can seriously impair an investor’s long-term strategy. Thus, the investor should possess a suffi cient amount of liquid assets and other investments that can be used for con- sumption in emergencies. In this way, decisions

regarding the common stock portion of an in- vestor’s wealth can be made with a view toward the long term. An investor can expect that— even with a well-diversifi ed stock portfolio—at least once in an investing lifetime there will be a pullback of 30% to 50%. An investor completely in common stocks might panic at that kind of portfolio performance. The latest example oc- curred in 2008, but such pullbacks occurred in 2001–2002, 1973–1974 and the notorious crash of 1929.

• Some investors are always in the withdrawal stage—those living on a trust fund, for example— and the strategic approach outlined here does not apply to them. Other investors will never have to withdraw accumulated wealth and will leave it to their heirs. They may use an accumulation strategy all of their lives.

It is important not only to develop a long-term stock investment strategy, but to understand the rationale of such a strategy relative to current stock market investment research and theory. With this in mind, this report reviews some of the basic concepts of in- vestment theory.

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Background Concepts

Risk Almost all approaches to investing are concerned with risk. But what is risk?

A practical and somewhat simplifi ed defi nition of risk is that it is the likelihood that your investment will be worth less at the end of your holding period than it was at the time it was originally invested. This defi nition could be modifi ed to take infl ation into account, by stating that risk is the likelihood that your investment will be worth less in “real dollars” at the end of your holding period. Another refi nement would be to state that risk is the likelihood that your investment will be worth less than if it had been put into a zero-risk investment, such as U.S. T-bills.

Many investors prefer to turn to a more measurable defi nition of risk. This defi nition involves the use of statistics; it measures variability—the amount by which an investor’s return could vary around the expected average return. Consider the following example. Suppose an investment opportunity is ab- solutely guaranteed to have a 10% return over your holding period. Your “expected return” is 10%. Since the 10% return is guaranteed, there is no other pos- sible realized return and hence there is no variabil- ity. The risk is zero.

Now consider a second potential investment. Suppose that there is a 50% chance that this invest- ment will return 40% and a 50% chance that a loss of 10% will be realized over the holding period.

The expected return on this second investment is (50% × 40% + 50% × –10%), or 15%. However, the actual return may be different than the expected return of 15%—in other words, the return will vary. This implies the existence of risk—the more the potential variability, the greater the risk. Potential

variability can be used to compare the riskiness of different investments, or to make judgments about the suitability of an investment when an investor’s risk preference is known. In statistical terms, variabil- ity or volatility is measured by standard deviation.

There are several important observations that can be drawn from these two examples.

First, if we compare the fi rst investment (10% re- turn, no risk) to the second investment (15% return, some level of risk), we do not get an answer to the question of which is the best investment. The sec- ond investment has a higher expected return (if you made such an investment 1,000 times you would average 15%), but it also has a higher risk. The in- vestment choice depends on the trade-off between risk and return that the investor is willing to make. Objectives, which are critical for making investment decisions, must be stated in terms of both return and risk.

Second, in any effi cient market, expected invest- ment returns will be higher for investments that have higher degrees of risk—but only if the risk is unavoidable. The concept of “unavoidable” risk will be discussed in the next section.

Third, the risk and return trade-off will change de- pending on the time frame used. For instance, the risk and return trade-off for a one-year holding peri- od will be different than the trade-off for a fi ve-year holding period; in general, stock market risk declines as the holding period lengthens. This helps explain why setting a proper time frame is essential when making investment decisions.

reduCinG risK: diversifiCATion We have defi ned risk in this report as variations in re- turn. But what causes these variations? In the stock market, two factors will cause a stock’s return to vary: changes in the fi rm or the way investors perceive

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the fi rm, and movements in the overall stock market. Thus, there are two components to the risk that an investor faces: market risk, which is inherent in the stock market itself; and fi rm risk, which is associated with the unique characteristics of any one stock or the industry in which it operates.

Firm risk accounts for up to 70% of the total risk that stock investors face. Yet, this risk can be almost eliminated by diversifying among different stocks— investing in, for instance, 10 different stocks rather than just one. Market risk, on the other hand, ac- counts for about 30% of total risk and cannot be avoided by diversifi cation, since all stocks are affect- ed to some degree by the overall market.

Think carefully about that last paragraph. An inves- tor with a single stock in his or her portfolio is tak- ing on 100% of the risk associated with stock invest- ing, compared with only a 30% risk that an investor with a diversifi ed portfolio would take on—in other words, the single-stock investor is taking on three times more risk. Investors who consider themselves “conservative” but invest in one low-risk stock may actually incur more risk than investors with a port- folio of 10 aggressive growth stocks—and the “con- servative” investors are getting a lower expected re- turn since they are in lower-risk, lower-return stocks.

This illustrates an important concept. The stock mar- ket provides higher returns for higher risks, but it only provides those higher returns for unavoidable risk. Firm risk is largely avoidable. No matter what in- vestment objectives investors may have, no matter

what the intended holding periods are, no matter what kind of stock analysis is performed: If inves- tors do not have diversifi ed portfolios, they are either throwing away return or assuming risk that could be avoided—or both. The discussion here assumes a diversifi ed portfolio when talking about common stock investment.

Investment Approaches There are many different strategies that can be used to invest in the stock market. But most strategies fall under three broad categories:

Let’s start with the third category, since that may seem to many investors a strange approach to investing.

This approach will be referred to often in this re- port, because it is the benchmark against which any other approach to the market should be measured. This strategy provides the returns that would be obtained by buying and holding the stock market, generally defi ned as the Standard & Poor’s 500 in- dex. Of course, no investor would buy all 500 stocks. However, by investing in a large number of well-di- versifi ed stocks, investors can build a portfolio that closely resembles the S&P 500, or they can buy an index mutual fund that mirrors the S&P 500.

“ The stock market provides higher returns for higher risks, but it only provides those higher returns for un- avoidable risk.

• Technical analysis, • Fundamental analysis, • Buy and hold the market.

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The buy-and-hold-the-market approach is used as a benchmark because no analytic investment ap- proach is valid unless it can outperform the market over the long run. If an investment approach does produce a return above the market return with the same risk, the difference between the two returns is called an “excess return,” and it represents the added value of that investment approach. It is often called “alpha.”

fundamental analysis is an approach to investing that is primarily concerned with value. This approach examines factors that determine a fi rm’s expected future earnings and/or dividends and the variability of those earnings and dividends, and it attempts to put a value on the stock accordingly. The approach then seeks stocks that are a good value—in other words, stocks that are priced low relative to their perceived value. Fundamental analysis assumes that the stock market will later recognize the value of the stock and bid up its stock price accordingly.

Technical analysis is an approach that tries to pre- dict the future price of a stock or the future direction of the stock market based on past price and volume changes. The underlying assumption is that stock prices and the stock market follow discernible pat- terns, and if the beginning of a pattern can be iden- tifi ed, the balance of the pattern can be predicted well enough to yield excess returns.

Most academic studies indicate that investing using purely technical analysis does not work. This report does not cover the technical approach.

Instead, the strategy described here focuses on the two remaining—the fundamental analysis approach and the buy-and-hold-the-market ap- proach. The choice between these two will be greatly infl uenced by your attitude toward market effi ciency—how well stock prices refl ect all avail- able information.

is The mArKeT effiCienT? According to investment theory, stock prices in an effi cient market refl ect all publicly available in- formation concerning that stock, and thus are ex- tremely close to the true value of the stock. This does not mean that stock prices at all times refl ect the stock’s true value. The theory assumes that stock prices on average refl ect the true value, but it also assumes that variations about this average price may exist. These variations, however, are unpredict- able—sometimes they are positive and other times negative. And because they are unpredictable, they cannot be used to obtain excess returns. This theory concerning random variation in stock prices, known as the “random walk” theory, is the explanation for short-term price fl uctuations that occur seemingly without cause.

So much for theory. What about reality: Is the stock market an “effi cient” market?

Those who believe that it is would deny the value of a fundamental approach that seeks to fi nd stocks selling signifi cantly above or below their value, since they argue that stock prices vary randomly around their “true” value. Investors who believe the stock market is effi cient would not concentrate on specifi c stock selection but rather on fi nding the most “effi - cient” portfolio. An effi cient portfolio is one that pro- vides returns closest to the market’s return at a given level of market risk (remember, fi rm risk is eliminated through diversifi cation). The level of market risk de- pends on the investor’s own risk/return trade-off de- cision. In other words, the investor determines the amount of market risk he is willing to take on and then builds a portfolio accordingly.

Adherents of the view that markets are ineffi - cient believe that variations in the way people re- ceive and evaluate information cause the prices of some stocks to deviate signifi cantly from their true value. In addition, psychological factors impact

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perceptions of data, thus compromising an essen- tial ingredient of effi cient market theory—a rational decision-maker. This psychological distortion can relate to institutional as well as individual decision- making. The fi eld of “behavioral fi nance” is devoted to studying such factors. With any market ineffi cien- cy comes an opportunity for diligent analysts to fi nd underpriced and overpriced stocks, allowing them to outperform a buy-and-hold-the-market strategy.

There is obviously considerable disagreement over the market’s effi ciency. Our own opinion, as well as the opinion of most practitioners and a growing number of theoreticians, is that the market is often ineffi cient—that there are opportunities for outper- forming a buy-and-hold-the-market strategy. We be- lieve, however, that the market is reasonably effi cient and there are limits to how much excess return can come from exploiting the market ineffi ciencies. But over an investing lifetime, even an additional return of 2%–3% a year could double an investor’s wealth at retirement.

oPPorTuniTies in An effiCienT mArKeT There are special opportunities for individual inves- tors, even in an effi cient market. When discussing investment planning, it was pointed out that the selection of the best alternatives depends on the in- vestor’s objectives and time frame. This means that, to the extent that investors have different objectives and time frames, the true value of a stock—even in an effi cient market—will be the average of all of the various individual values. If you carry this one step further, it means that even if the market is effi cient, stocks will be overvalued or undervalued for many investors whose objectives and time frames are dif- ferent from the average objective and time frame.

What is the average objective and time frame? A look at the composition of stock market investors can provide a clue.

So much for theory. What about reality: Is the stock market an “effi cient” market?

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The stock market is dominated by institutional in- vestors, and it is their objectives and time frames that will tend to dominate. By and large, institutions have objectives that stress low risk, and they have time frames that are very short. Why? Because their performance is evaluated on a daily, monthly, quar- terly or annual basis, and the institutional managers must conform to performance standards in the short run. They are often more concerned with not doing worse compared to their competitors than with op- timizing returns. Also, institutions, which account for a large percentage of trading activity, sometimes have short-term demands on their assets. In addi- tion, large institutions cannot invest in the stocks of smaller companies or in less liquid issues, and these are the stocks that perform best over the long run.

Some individuals will have objectives and time frames that are similar to those of institutions, but many will not. This is the reason for making a distinc- tion between the accumulation stage and the with- drawal stage of individual investors, as mentioned earlier in the discussion. By and large, individuals who will need capital or income from the market in the shorter term—such as individuals in the with- drawal stage—will have objectives and time frames similar to those of institutions. Long-term individual investors—those in the accumulation stage—face a completely different set of objectives and time frames. And they will be able to fi nd stocks that are undervalued because prices are forced down by short-term, highly risk-averse investors.

TrAnsACTion CosTs When comparing the different approaches to in- vesting, the impact of transaction costs should not be ignored. Transaction costs include broker- age commissions and the bid-ask spread, which is the difference between the price at which an indi- vidual can buy a stock and the price at which he or

she can sell the same stock. [Taxes are also part of the transaction cost because a sale has an immedi- ate tax consequence while holding defers the tax consequence.]

Fortunately for the individual investor, commission rates have been steadily dropping. With online dis- count brokers, commissions can be less than $10 per transaction. With a transaction size of $5,000, this comes to 0.2%, and even with a more expensive online broker and smaller transaction size the cost would be less than 1%—much lower than in the past.

Due to innovations by the exchanges, the bid-ask spread has also been reduced. For a high-priced liquid stock, the spread becomes almost trivial, but for lower-priced smaller-cap companies, where we believe more opportunities lie, the spread is still signifi cant.

Suppose you have 100 shares of ABC that recently sold for $25 a share and wish to switch into XYZ, which also re- cently sold for $25 a share. The following factors determine the transaction cost:

1. The average commission from an online bro- ker might be $12 for each side or a total of $24, about 1% of the investment.

2. Next, the bid-ask spread will increase the cost of switching. In the example of ABC and XYZ, which last sold for $25, you may fi nd that the current spread is $24.85 to $25.10: You would receive $2,485 for the stock sold and pay $2,510 for the stock purchased. This is another 1% “charge.”

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In total, then, you are paying 2% of your investment to switch holdings. This is not to say that it shouldn’t be done, just that the new stock must perform suf- fi ciently better to overcome this handicap.

Investors who use investment approaches that re- quire them to turn over their portfolios several times a year must outperform the market by 5% or more just to stay even with a buy-and-hold-the-market approach.

Transaction costs can vary widely. Looking at my own portfolio, I have a stock trading at $400 with a bid-ask spread of one cent. Trading 100 shares of this and a similar stock would involve a cost of $25 on $40,000 or 0.06%—hardly noticeable. At the other extreme, I have a stock showing a bid of $2.80 and an ask of $3.00. Trading 100 shares of this and a similar stock would cost a total of $44 on $300, or 15%. The transac- tion size and bid-ask spread make a big difference. In AAII’s model portfolio of small-cap stocks (the Model Shadow Stock Portfolio), transaction costs average 2%. Fortunately we have been able to absorb this cost and still have excess returns.

Setting Objectives & Time Frames The importance of setting an objective and deter- mining a time frame should be clear by now. How can investors do this?

The most useful approach is to look at the historical record: What kinds of risk and returns can investors expect, based on what has already occurred? The one important caveat, of course, is that history may not re- peat itself. The historical record can, however, provide

you with some idea of what you can reasonably expect.

Time frAme: shorT-Term vs. lonG-Term Let’s look at the difference in risk as a function of our time frame, or holding period. For this purpose, risk will be defi ned in a practical way—the likelihood that invested wealth will diminish from the time of the initial investment to the end of the holding pe- riod time frame.

Examples of risk differences appear in Table 1. The table assumes that an individual is invested in a port- folio of the indicated asset category, and remains invested for the holding period indicated; the table indicates the percentage of times the individual

TABle 1.

Time frame and losses (1926–2014)

Percentage of holding Periods holding That resulted in losses Period s&P small Corporate u.s. Gov’t. (Years) 500 stocks Bonds Bonds T-Bills 1 27% 30% 20% 26% 0% 3 17 18 9 10 0 5 14 14 4 7 0 10 5 3 0 1 0

The table includes all possible holding periods for the time periods indicated over the past 89 years. For in- stance, the 3-year holding period includes 1926 through 1928,1927-1929,1928-1930, etc. Purchases are made at the beginning of the year and held through the time peri- od indicated. The table indicates the percentage of times the holding period return would have been negative.

Source: Roger G. Ibbotson and Rex A. Sinquefi eld, “Stocks, Bonds, Bills and Infl ation,” 1982 ed., Institute of Chartered Financial Analysts, Char- lottesville, Va.; updated by Ibbotson Associates, “Stocks, Bonds, Bills and Infl ation 2015 Yearbook,” Chicago.

A Lifetime Investment Strategy AAii 9

would have suffered a loss if he or she had invested in this fashion from 1926 through 2014. The statis- tics from which the fi gures are derived include divi- dends and interest payments, but transaction costs and taxes are ignored.

Clearly, though, the percentage of losses declines as the holding period is increased for all of the asset categories.

• If you told your broker to buy a portfolio that matched the S&P 500 at the beginning of the year and to sell at the end of the year, you would have had a loss 24 times over the last 89 years, or about 27% of the time.

• If you told your broker to buy at the beginning of the year and sell after three years, you would have had a loss 15 times since 1926, or 17% of the time.

• If you told your broker to buy at the beginning of the year and sell after fi ve years, you would have had a loss 12 times since 1926, or about 14% of the time.

• If you bought and held the portfolio for any 10 years, you would have had a loss only 5% of the time.

If we had adjusted for infl ation (used real dollars), there would have been a few more losses for each holding period, but that would be true for all other investments as well. The point is, the variability of returns—risk as measured by the chance of loss— goes down as the holding period gets longer.

seTTinG oBJeCTives: reTurns And risK Table 2 presents the returns provided by com- mon stocks, corporate bonds, government bonds and Treasury bills over the past 50 years. Common stocks are broken down into stocks in the S&P 500 and stocks of smaller fi rms, which are generally con- sidered riskier investments.

In general, riskier investments provide higher re- turns. For instance, small stocks have tended to out- perform the S&P 500. However, the table shows that performance for a market segment can vary over different time periods. In addition, while Treasury bills are considered riskless, they have provided re- turns that are only modestly above the rate of infl a- tion over the long run.

Historically, it is evident that common stocks provide exceptionally high long-term returns compared to “safer” investments. And, as noted above, the risk in a practical sense becomes unimportant as the hold- ing period is lengthened.

Historical records provide a strong argument for long-term investors to use the stock market as a base for setting their objectives. But there is also an intuitive argument for the safety of the stock mar- ket for long-term investors. While there certainly are business and stock market cycles, long-term inves- tors can outlast them.

What, then, is the real risk of long-term stock mar- ket investment? It can only be a sustained collapse of private enterprise. If such a collapse occurred, there would be no employment, no corporate or in- dividual income tax payments, no banking system and no solvent government. What would be a safe investment?

If the stock market is not as risky as generally sup- posed, why do we all know people who have lost money in the market? First, the market is risky for

What does the historical record tell us about the stock market, as defi ned by the S&P 500?

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the short-term investor. As we saw, the one-year in- vestor on average would lose a portion of wealth about a third of the time—more often if transaction costs and taxes are considered. Second, there are a great number of investors “playing the market,” or speculating. They try to make large, short-term profits by trading their portfolios regularly or by trying to predict short-term market swings (mar- ket timing). Given the transaction costs and the lack of overall strategies, considerably more than half of these speculators will lose even with the overall upward trend of the market. Third, as we previously indicated, many investors do not diversify. Thus, they take on more risk and incur more losses than the market as a whole.

ConClusions Part One of this Lifetime Strategy stressed that for the long-term portion of invested wealth, common stock investing offers an outstanding opportunity for wealth accumulation through growth at relative- ly low risk. It should be emphasized that the stock market is risky for short-term holding periods, but as an investor’s time frame goes beyond five years, this risk is greatly diminished. It should also be empha- sized that an expected holding period can change due to unforeseen circumstances, and this possibil- ity leaves an element of risk. For that reason, even individuals who do not plan on using their assets for many years should not commit all of their wealth to stocks.

long-Term long-Term s&P small Corporate Government Treasury inflation 500 stocks Bonds Bonds Bills (CPi)

AverAGe AnnuAl ComPound rATes of reTurn (%) Last 10 Years 7.7% 7.8% 7.2% 7.5% 1.4% 2.2% Last 20 Years 9.9% 12.0% 8.4% 8.6% 2.7% 2.3% Last 30 Years 11.3% 11.7% 9.4% 9.7% 3.7% 2.7% Last 40 Years 12.2% 16.1% 9.2% 9.0% 4.9% 3.9% Last 50 Years 9.9% 13.4% 7.7% 7.6% 5.0% 4.1%

GrowTh: whAT $1 invesTed would hAve Grown To Last 10 Years $2.10 $2.12 $2.00 $2.06 $1.15 $1.24 Last 20 Years $6.61 $9.65 $5.02 $5.21 $1.70 $1.58 Last 30 Years $24.82 $27.64 $14.81 $16.08 $2.97 $2.22 Last 40 Years $99.93 $392.00 $33.80 $31.41 $6.78 $4.62 Last 50 Years $112.17 $537.84 $40.81 $38.96 $11.47 $7.46

TABle 2.

long-Term returns (Through Year-end 2014)

Annual returns and growth figures include dividends and/or interest, but exclude taxes and transaction costs. Source: Roger G. Ibbotson and Rex A. Sinquefield, “Stocks, Bonds, Bills and Inflation,” 1982 ed., Institute of Chartered Financial Analysts, Charlottesville, Va.; updated by Ibbotson Associates, “Stocks, Bonds, Bills and Inflation 2015 Year- book,” Chicago.

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Determine the “comfort level” of low-risk, short- term liquid assets you require before embarking on a long-term plan.

Stage One Stage One of our Lifetime Investment Strategy be- gins with the fi rst dollars available for long-term investing.

Exactly when any individual has money that is free from short-term emergency demands depends on individual circumstances. A common rule of thumb is that a long-term investment program can begin when income exceeds expenditures and after hav- ing set aside in low-risk liquid assets (such as mon- ey market funds) enough capital to equal three to six months’ income. For the average investor, this seems reasonable, but individual circumstances may dictate a somewhat different approach. While the long-term stock portfolio should not be used for short-term needs, individuals should realize that it will be liquid enough to withstand short-term emer- gencies because an investor can borrow against it rather than being forced to liquidate it and this in- terest is generally tax deductible. The same is true of an investment in a home: Under short-term emer- gency conditions, a second mortgage can be ob- tained without having to sell the home to retrieve the capital.

Determine the “comfort level” of low-risk, short- term liquid assets you require before embarking on a long-term plan. When your savings exceed that amount, Stage One begins.

Because diversifi cation is so essential, the fi rst dol- lars to be put into a long-term common stock pro- gram should be put into no-load or low-load com- mon stock mutual funds. These dollars should be invested there until capital is at least in the $15,000 to $20,000 range. While the diligent individual can outperform mutual funds, the advantage of diver- sifi cation more than offsets the investment disad- vantage, and thus mutual fund investment should

Part II

A Lifetime Investment StrategyAAii12

provide a better risk/reward structure initially. After that level has been reached, an individual may still prefer the mutual fund route, or a combination of mutual funds and individual stock selection—that is fi ne. However, individuals should not start invest- ing in individual stocks until they reach at least that level of investment capital.

No-load funds and low-load funds are suggested because a load is simply a sales commission and does not go toward better investment manage- ment. There is no evidence that load funds can per- form suffi ciently better to offset the load, and when the load is taken into consideration, the average

TABle 3.

The lifetime strategy

Pre-stage 1: Establish a Short-term Low Accumulate short-term Money market Income begins cushion for low-risk investments funds to exceed emergencies equal to at least 3 to 6 expenses months of income

stage 1: Wealth Long-term Moderate Build a diversifi ed, At this stage, stick with Savings above accumulation growth-oriented mutual funds or exchange- your cushion: portfolio traded funds to assure $0 to $20,000 adequate diversifi cation; emphasize no-load and low-load mutual funds

stage 2: Wealth Long-term High Add individual stocks If adding individual stocks, Savings above accumulation to your mutual fund focus on these cushion: $20,000 portfolio (if desired)* characteristics: and up • Outstanding earnings growth potential • Undervalued, especially low price to book value • Small market capitalization

stage 3: Live off Short-term, Moderate Gradually shift a Portfolio consists of: Begins 5 years accumulated long-term to low portion of your port- • Money market funds prior to wealth for blend folio to low-risk, short- and/or short-term bond retirement, and signifi cant term investments funds, and continues through portion of • Growth-oriented stock retirement expenditures mutual funds and individual stocks

* While individual stocks should not be added to your portfolio before this stage, some individuals may prefer to stay solely with mutual funds or exchange-traded funds at all stages.

Time risk Goal horizon Tolerance strategy Type of investments

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load fund tends to underperform the average no- load fund by at least the amount of the load.

The basic criterion of “long-term wealth maximiza- tion” applies even in Stage One, and thus aggressive- growth-oriented and growth-oriented stock mutual funds should be considered. The method for choos- ing the best fund is a tactic that will not be treated in depth, but it will be discussed later.

At this point it is necessary to look at the meaning of the term “growth” when related to stocks and stock mutual funds. In general we think of a growth stock as being one with a better-than-average chance to increase in value. We will use “growth oriented” to describe this kind of stock or mutual funds invest- ing in these stocks. When the term “growth stock” is used to differentiate between growth and value stocks, it has a different meaning. This is also true of so-called growth mutual funds. All existing stocks are ordered by some value measure—usually the ratio of stock price to book value. Stocks in the lower half of the list are called value stocks. The upper half, instead of being properly called “low value” stocks, are called growth stocks on the assumption that their high price relative to their current book value must mean that growth is ahead. In fact, history has shown that value stocks are more likely to increase in price than growth stocks as defi ned this way, and diversifying between that type of growth stock and value stocks is of little value in risk reduction.

Since mutual funds are themselves diversifi ed, it is not necessary to split your initial capital among a large number of funds if they are general stock funds. However, there is no penalty for using as many funds as you wish if no-load or low-load funds are used.

Stage Two When the value of the long-term portfolio, which up until now has been exclusively in mutual funds, grows to about $20,000, individuals who want to invest in individual stocks can begin develop- ing a stock portfolio. Diversifi cation tactics will be discussed later, but you want to eventually have at least 10 different stocks that are not highly cor- related (we will discuss correlation later), with ap- proximately equal dollar amounts invested in each, included in your portfolio. Because of fl at-rate com- missions, transaction costs go down as the amount invested in each stock goes up. So you may prefer waiting until you have signifi cantly over $20,000 to begin Stage Two, particularly if you do not intend to liquidate your mutual fund holdings.

It is not essential to invest in stocks of your own choosing all at one time. Since the balance of your assets is in mutual funds that are diversifi ed, you can accumulate individually selected stocks one at a time. Individual stocks can be purchased using funds withdrawn from the mutual fund portfolio, or using additional funds. Of course, constructing a portfolio of individual common stocks over time does not preclude holding mutual funds in addition to the individual stocks.

The methods you use to choose stocks are not part of this discussion of strategy, but the overall selec- tion strategy is important.

The basic strategy should be to choose the stocks of fi rms that appear to offer the greatest chance for future earnings expansion. While all factors that may affect a company’s future growth should be taken into account in estimating expected future earnings, you should not be concerned with factors that only affect the fi rm over the short run. Short-term inves- tors, particularly the institutions, spend considerable

A Lifetime Investment StrategyAAii14

time worrying about short-term variability, dividend protection and other characteristics relating to fi rm risk. As a long-term and diversifi ed investor, most of this risk is avoided, as was explained earlier.

Stock investors also should be concerned about the price of a stock relative to its prospects. An un- dervalued stock—one whose price does not fully refl ect its growth potential—has a greater price ap- preciation potential than a fairly valued stock or an overvalued stock.

One of the more promising areas for fi nding long- term growth potential is among the stocks of smaller fi rms. In fact, long-term success will come from pro- viding an opportunity for your portfolio to include at least one stock of a company that will go from being a small company to a successful giant. If you buy stock in only large companies, you eliminate the chance for that kind of growth. While large com- panies may continue to grow, they are beyond the super-growth stage. These fi rms are also observed closely by many analysts, and there will rarely be an opportunity to fi nd an undervalued stock.

Research also indicates a high return potential as- sociated with smaller fi rms whose stocks are trading at low price-to-book-value (P/B) ratios. Price divided by book value (common stockholder’s equity) has long been used by value investors as one measure of a stock’s potential; the research found this ratio to be a better indicator of high return potential than other value indicators, such as low price-earnings (P/E) ratios. And as mentioned earlier, value stocks, on average, are the true growth stocks.

Individuals in most cases should avoid develop- ment-stage stocks or those with high speculative interest. Many times, companies or industries that have received much attention in the fi nancial press are not good investment candidates, at least not at the time of the coverage.

Investors should also keep in mind that it is not nec- essary for every single stock in their portfolio to do well. In almost every long-term diversifi ed portfolio, time will bear out that the overall return is support- ed by one or two stocks that did extremely well.

In summary, the long-term strategy is to buy stocks in companies that have outstanding future growth potential and to make purchases at reasonable prices. This will mean investing a substantial por- tion in the stocks of smaller fi rms, which have higher short-term risk. Remember—in a diversifi ed portfo- lio, long-term investors need not be too concerned about short-term risk factors.

Diversifi cation is the effort to choose portfolio ele- ments that are not highly correlated, which means they will not all go up or down at the same time to the same extent. Diversifying between primary in- vestment areas (equities, real estate, bonds, cash) is usually referred to as asset allocation and is a critical step in investment decision-making. Diversifi cation is also important within each primary area. Within the equity area, diversifi cation can be carried out us- ing the popular approaches for choosing stocks or mutual funds so they are not highly correlated. The usual rules include: choose stocks in different indus- tries, choose some value stocks and some growth stocks, choose some large-cap, some mid-cap and some small-cap stocks (cap refers to the capitaliza- tion value of the corporation, or share price times number of shares), and choose some stocks of for- eign companies. All of these approaches should lead

“ Remember—in a diversifi ed portfolio, long-term investors need not be too concerned about short-term risk factors.

A Lifetime Investment Strategy AAii 15

to better diversifi cation, but they are rather vague. Today there are tools available to measure the cor- relation between different stocks and approach di- versifi cation in a more scientifi c way. These tools are generally available, as are historical stock prices for those more statistically inclined.

I cannot emphasize the importance of diversifi ca- tion enough. As an example, AAII’s Model Shadow Stock Portfolio consists of about 30 stocks, each one of which is extremely risky. The average stock in the portfolio is over three times as risky as the market in general, but the portfolio is less risky than the S&P 500 index. Diversifi cation eliminated 75% of the in- dividual stock risk.

Stage Three Stage Three begins about fi ve years before an indi- vidual will become signifi cantly dependent upon invested capital for current expenditures. Five years is used because that period will generally include an entire business cycle. The situation that an investor must avoid is having to sell an entire stock portfolio at the bottom of the economic cycle.

Of course, individual needs will vary. In some cases, accumulated wealth will be needed all at once, as in the case of accumulation for a down payment on a house or a child’s education. In other cases, such as retirement, the need will be stretched out, although there may be a need for at least part of the capital in

less than four years.

The individual who needs all of the wealth on a specifi c date should consider liquidating one-fi fth of the stock portfolio in each of the fi ve years pre- ceding the time of the need. The liquidation pro- ceeds should be reinvested in shorter-term, low-risk investments (such as money market instruments) that will mature prior to the date that the capital is needed.

For individuals who perceive a future need for capi- tal or income at a certain time, but who do not need it all at once, there are two possible approaches. The fi rst approach is to gradually switch the port- folio from the growth-oriented stocks of small and medium fi rms selected under Stage Two criteria, to less risky (short-term risk) stocks—primarily those that pay signifi cant dividends. One thing to keep in mind, however, is that although dividend consid- erations may become more important, selling off shares of stocks that are appreciating in value is no different than receiving dividends on stocks that are not appreciating. While this approach is often recommended, I have problems with it because so- called “extra safe” stocks often turn out to be just as risky as growth-oriented stocks.

A second approach—and one favored by this strat- egy—is to maintain a portion of capital in the high- er-short-term-risk stocks selected in Stage Two, but control the overall portfolio risk by shifting a sub- stantial portion of capital into low-risk, short-term interest-paying investments. Given equal overall portfolio risk, the portfolio made up of growth-ori- ented stocks and short-term, interest-paying invest- ments (such as money market funds or short-term bond mutual funds) will most likely outperform the portfolio consisting of only low-risk stocks. This is because there are excess returns for the risk of the growth stocks of small and medium-sized companies and because short-term money market

I cannot emphasize the importance of diversifi cation enough.

A Lifetime Investment StrategyAAii16

instruments will often yield high returns when the stock market is weak.

It is also possible to create a portfolio that is a com- promise between the two approaches described. And it is possible to vary the time frame of the con- version from Stage Two to Stage Three based on in- dividual circumstances, such as retirement in stages.

Overall, the difference between Stage Two and Stage Three is the investor’s time horizon. In Stage Two, the investor’s outlook is long term: You will live through market downturns (when your invested capital may decline in value), and you will live through market upturns. Over the long term, however, the trend will be up, and you should receive a return based on your level of market risk. In Stage Three, short-term market downturns can be harmful, and short-term risk becomes a signifi cant consideration. Stage One is similar to Stage Two, but requires immediate rec- ognition that diversifi cation is essential and that fi rm risk is avoidable and unrewarded.

Tactics This report concentrates on the overall Lifetime Investment Strategy of investment. However, the implementation of such a strategy requires certain tactical approaches. The major tactical areas of con- cern in the Lifetime Investment Strategy are:

• Tactics for selecting the no-load and low-load mutual funds and exchange-traded funds for Stage One;

• Tactics for effective diversifi cation in Stage Two;

• Tactics for selecting stocks with the best long- term appreciation potential for Stage Two;

• Tactics for timing investment infl ows and

variations in asset mix; and

• Tactics for minimizing taxes.

While complete discussion of these tactics would take several volumes and is the ongoing mission of AAII, the following section gives a general overview of the major tactics and possible follow-up sources for further information.

muTuAl fund seleCTion Stage One involves a long-term wealth maximizing approach. Individuals in this stage should concen- trate on selecting growth-oriented no-load or low- load mutual funds and/or exchange-traded funds (ETFs).

A very comprehensive review and evaluation of no- load and low-load funds, The Individual Investor’s Guide to the Top Mutual Funds, is sent free to AAII members each February and can be purchased by non-members.

In the Model Portfolios column in the AAII Journal, I maintain a model portfolio of equity mutual funds and exchange-traded funds that have performed well and also have an excellent risk profi le. These funds should provide an excellent start for the new investor.

Mutual funds in the categories of interest will send prospectuses upon request (most are now available online from the fund family’s website). Make sure you read the prospectus before investing.

ETFs can be used instead of conventional mutual funds. Most exchange-traded funds track tradi- tional indexes, but some track specially created in- dexes that follow specifi c strategies and are similar to some managed mutual funds. The AAII Journal publishes a complete guide to ETFs each year in the August issue. In addition, in my Model Portfolios col- umn in the AAII Journal, I report on the Model Fund

A Lifetime Investment Strategy AAii 17

Portfolio four times a year; as mentioned, this port- folio includes ETFs and mutual funds.

effeCTive diversifiCATion It was stated earlier that adequate diversifi cation can be achieved by purchasing 10 to 15 stocks, randomly selected. Most investors, however, don’t randomly se- lect stocks for their portfolios, but rather use specifi c criteria for stock selection. This method introduces the possibility that the investor will select a number of stocks whose risk is similar—they are in the same industry, same markets, have the same interest rate sensitivity, etc. In other words, this investor’s portfolio would not be adequately diversifi ed even though it contains 10 or more stocks.

As discussed earlier, this problem can be overcome by using the mathematical formulas developed for minimizing fi rm risk. For the investor with the time, programs for home computers exist to apply these formulas. However, the data requirements may be so great as to be prohibitive, given the time the average individual has to devote to investment management.

For portfolios that contain a minimum of 15 stocks, however, diversifi cation may be fairly effi cient if a variety of selection approaches are used.

sToCK seleCTion TACTiCs This is an extremely complex area and cannot be treated in-depth here; the following, however, are some brief thoughts.

It was noted that long-term investors should con- centrate on stocks with potential for high returns. Often these stocks have considerable short-term risks, and thus their prices are bid down by the in- stitutions and others with short-term risk-averse at- titudes; but with effective diversifi cation, the long- term investor can reduce this risk. In addition, there may be opportunities for increased excess returns from effective fundamental analysis.

Adequate diversifi cation can be achieved by pur- chasing 10 to 15 stocks,

randomly selected.

A Lifetime Investment StrategyAAii18

In terms of fundamental analysis, a complete analy- sis should include a qualitative evaluation of a com- pany’s market opportunities, product development, management capability, merger potential and other considerations that indicate the potential for future profi t, as well as possible undervaluation of its stock. Major emphasis, however, should be given to the more easily obtained quantitative measures such as company size, past earnings and revenue growth rates, cash fl ow, balance sheet debt and liquidity, price-earnings ratio, and price relative to book value.

There are an almost infi nite number of investment books and theories regarding methods for select- ing common stocks. The AAII Journal continues to publish articles on this topic, and AAII.com inves- tigates various strategies on an ongoing basis. We also maintain a model portfolio of micro-cap value stocks, the Model Shadow Stock Portfolio.

TiminG TACTiCs There are two primary reasons for timing the market. The fi rst relates to individuals who expect to remain fully invested through time; the second relates to in- vestors who wish to vary the percentage of wealth committed to stocks based on economic conditions.

In the fi rst case, individuals are concerned with tim- ing only when investing or withdrawing signifi cant amounts of money. The concern is to avoid putting in or taking out a large portion of wealth at a sin- gle point in time, since long-term investors want to avoid the risk of investing at a market peak or with- drawing at a market bottom. Basic advice is that an adequate period of time be chosen for the percent- age invested or withdrawn—for instance, spreading the purchase or withdrawal over at least a two-year period.

The second reason for timing has to do with a strat- egy of attempting to leave the market during down- turns and reinvesting when the market begins to

head back up. If investors could actually accomplish this, it would lead to higher returns. However, there is no satisfactory evidence that market upturns and downturns can be predicted with enough preci- sion to offset the increased transaction costs, not to mention the adverse tax consequences. In fact, most evidence points to the opposite. Timing the market may generate costs as high as 10% of port- folio value a year. Too much trading stands with a lack of patience as a major reason for lack of invest- ment success.

There is some evidence, however, that the stock market cycle, which generally runs from three to fi ve years, can be tied to business cycles. Stocks are, in fact, leading indicators of the economy. If individu- als feel they can predict such turns in the economy, they can vary their commitment to stocks over time. One very important consideration, often over- looked in the discussion of such tactics, is the alter- native investment returns for funds when they are not in stocks. If returns for low-risk investments, such as bonds, are competitive with returns on stocks (in- cluding dividends), then the relative advantage of committing funds to these other areas is enhanced; if returns for alternative low-risk investments are lower, the advantages are reduced. For the inves- tor wishing to use timing, some study of cycle the- ory and the history of stock market movements is advisable.

TAX TACTiCs Tactics to minimize the tax impact on accumulated wealth will vary over time, depending on current tax regulation. This report will not go into specifi cs but will point out that “aftertax” return is all that any investor will wind up with, and any tactics that re- duce or defer the tax are desirable—as long as there is no substantial change in the investment strategy. A long-term approach to investing will ensure that taxes on a large portion of return are deferred for a

A Lifetime Investment Strategy AAii 19

substantial period of time and taxed at the lowest rate. There should always be plans to defer tax liabil- ity within an overall strategy through various forms of retirement plans, and these should be utilized to the greatest extent possible. Which investments should be in any retirement plan will vary with the tax laws, and these can be counted on to change periodically—which may require repositioning of investments in different accounts. When making in- vestment decisions, the investor must always weigh any tax savings against any potential loss of return that may be due to the tax strategy.

Summary The purpose of this report is to create an overview of a Lifetime Investment Strategy for stock market in- vestment. Implementation of this strategy involves various tactics. Individual investors should carefully investigate the various tactics and understand them before they invest. Such tactics will always be an important topic in the AAII Journal and other AAII programs.

Although tactics are important, remember that the game is biased in favor of the long-term inves- tor. Even if your tactics for selecting stocks with the greatest growth potential are imperfect, your long- term diversifi ed portfolio will likely outperform most professionally managed portfolios and the market over the long run.

A Lifetime Investment StrategyAAii20

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