Many investors understand the need for portfolio management.

Unfortunately, most investment professionals work very hard to make their portfolio management extremely confusing.

• They have a vested interest in creating investor confusion.
• They use jargon designed to intimidate you and make it difficult for you to understand.

But portfolio management is actually not that complicated if you stick to five key concepts for portfolio management success.

Concept One: Utilize Diversification Effectively to Reduce Risk

Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. However, no matter how sophisticated you are, it’s easy to get caught in a trap. Proper diversification is a major key to successful portfolio management.

Concept Two: Dissimilar Price Movement, Diversification Enhances Returns

If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return. You want to design your portfolio so that it has as little volatility as necessary to achieve your goals.

Concept Three: Employ Asset Class Investing

Many investors feel that they could have executed better than they did during the last few years.

Unfortunately, most investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors. The average investor who uses actively managed mutual funds is trying to fix a sink with a screwdriver, when they really need a pipe wrench. You need the right tools.

Almost all investors would benefit by using institutional asset classes due to:

1. Lower operating expenses
2. Lower turnover resulting in lower costs
3. Lower turnover resulting in lower taxes
4. Consistently maintained market segments

Concept Four: Global Diversification Reduces Risk

We’ve all read about the concept of a “global village”—that we’re getting closer and closer together.

Technology is creating a new paradigm in which businesses around the world are tied together, just as markets are now tied together. International investments should be a part of your portfolio.

Concept Five: Design Portfolios That Are Efficient

The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting.  This concept boils down to one simple point: for every
level of risk, there is some optimum combination of investments that will give you the highest rate of return.

Given today’s market volatility, one of the most important things you can do as an investor is to ensure that your investment plan is current. Your plan should examine where you are now and where you need to go to
realize your financial goals, and should also identify the gaps you need to overcome.

The US stock market has taken investors on a bumpy ride in recent years.

Market volatility has tested investor discipline and prompted some people to question their commitment to equities. While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926. The performance years are stacked in ascending order by return range. This chart illustrates that:

• Market performance over the past two years has been severe by historical standards. In 2008, US stocks experienced their second-worst calendar return in eighty-four years. Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.
• Over the long term, the market’s positive return years have outnumbered the negative return years. Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.
• Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.
• The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance. Therefore, the best strategy is to ignore the “noise” and stick to your investment plan.

A recent Wall Street Journal article epitomizes the new “conventional wisdom” that asset allocation failed in 2008.

It is true that correlations among major asset classes have increased in recent years giving the impression that asset allocation no longer works.

During the 2008 financial crisis all major equity asset classes experienced severe declines. Even commodities, which historically had exhibited low correlations to equities, dropped dramatically.

This does not mean that diversification and asset allocation failed.

• High-quality fixed income securities, i.e. U.S. Government bonds, of all maturities were a safe haven and had returns ranging from 1.6% to 25.8% percent in 2008.*
• Financial and economic shocks are rare occurrences, and investors must understand that they are part of the risk of investing in equity markets. Correlations historically have increased during economic shocks but returned to more normal levels as economic conditions normalized.
• Asset allocation depends on individual circumstances. If one has a high overall risk tolerance and a very long investment time horizon, accumulating shares during bear markets may be a wise strategy.

The major problem is, so many articles in the financial press are devoted to attempting to avoid investment losses. These articles make it seem that market timing can work for most investors. Many nervous investors needlessly adjust portfolio holdings, usually to their long-term detriment, in an attempt to grab the current “trend.”

In reality, alternatives like market timing, short selling, and stock picking have historically tended not to work as claimed for most money managers.

Your best bet for financial success is to stick to your plan and your appropriate asset allocation.

*Source: DFA Returns 2.0; One-month T-Bills and Long Term Government Bonds, respectively.

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This question has been coming up a lot lately in the media and some academic journals. Thinking Modern Portfolio Theory died last year is based on the misconception that Modern Portfolio Theory will guarantee against a loss.

That is simply not the case. What MPT believes is diversification to a portfolio, which over the long term can potentially reduce a portfolio’s volatility versus a single asset portfolio.

According to a recent article in Investment News:

• MPT does not guarantee against a loss
• Fixed income helped reduce the amount of loss in many portfolios last year
• Many advisors are finding that their clients had too much equities and not enough fixed income for their risk tolerance

Remember, when investing in a diversified portfolio, you will experience negative returns periodically.

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