MODULE 2: BUILDING AN INVESTMENT PLAN

For those members wanting to engage in their portfolio and do some personal investing, this video explains how members can build their own portfolios with a three step process

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Transcript of Video

Slide 1:  Hi!  It’s Jim again.  This video is the second video of a three part series on investing.  In this video, I want to show you how building an investment portfolio is not rocket science and that the process is easier than you might think.

SLIDE 2:  Building a portfolio, like most things starts with a plan.  If you think about it, a plan gives you some direction.  I see too many people who don’t have a clear plan.  I call this the WING IT STRATEGY.  So many people have no idea if they are really doing the right thing.  They have no idea if they are on the right road or not.

SLIDE 3: Building a portfolio is kind of like building a house:

  • First you need a set of plans
  • You also need some different parts and materials
  • Then there’s a process to assemble these parts.

Follow the steps and you’ll build that house.  Miss a step and you could have trouble.

SLIDE 4:  When it comes to the importance of building a plan, I think Warren Buffet, one of the most famous and most successful investors of all time said it best.  To be a successful investor does not require stratospheric IQ, unusual business insight or insider information.  What’s needed is a SOUND INTELLECTUAL FRAMEWORK for keeping EMOTIONS from corroding that FRAMEWORK.

Basically what Warren Buffet is saying is you need a plan to keep yourself from making psychological and emotional mistakes.

SLIDE 5:  Developing an investment plan is easier than you think.  You just have to follow a three step process.

  1. Investing is personal so the first step is to take some time to understand what you want from your portfolio.
  2. The second step is to develop a mix of asset classes based on your personal needs.  Some experts have argued that this step accounts for 90% of your investment return.  We’ll talk more about this later.
  3. And then to select the appropriate investments that fit into the mix.

Too many people start with investment selection before looking at the asset mix and their personal needs.  As you can see, this is backwards.

SLIDE 6:  Understanding your personal investment needs can get quite detailed if you want it to.  However, the starting point is to complete a risk profile Questionnaire. Every company has their own version of these questionnaires and it really does not matter which on you use.

Once you finish answering the questions, the next step is to tally up your results and match them to the appropriate Model Portfolios (313 downloads) .

SLIDE 7:  As a standard, the investment industry has 5 model portfolios based on risk.  The Conservative portfolio is the most conservative and generally recommends 80% in fixed income and 20% in stocks.  As you move up the risk spectrum you will allocate more equities to the portfolio.  The most aggressive portfolio is typically 100% equities.

SLIDE 8:  These model portfolios are not arbitrarily created.  They are really based on the science of investing otherwise known as Modern Portfolio Theory.  Modern portfolio theory was pioneered by Harry Markowitz and suggests that you can optimize risk and return by mixing different asset classes together.

SLIDE 9:  Diversification is a key concept in the investment industry but there is a difference between inefficient diversification and efficient diversification.  As you can see from the chart, you can have 5 different investments but if they all do the same thing, you will still feel the ups and downs of the market.  The point of modern portfolio theory and efficient diversification is to mix different asset classes that do different things at different times to reduce risk and optimize returns.

SLIDE 10:  Once you’ve completed the questions you will be directed into the appropriate asset allocation model based on your personal risk tolerance.  Let’s take an example of someone should be an balanced portfolio.

At this point you can use the suggested mix or you can alter it a bit as you desire.  This is really about building your portfolio the way you want it but remember there is something to be said about the science that has stood the test of time.

SLIDE 11:  The third step in the process is selecting the best investments that fit into the mix.

SLIDE 12:  When selecting investments for your portfolio, there are three tips or ideas I can offer you on

  • How to research performance
  • Choosing between active and passive investments
  • Knowing why fees make a big difference in results.

SLIDE 13:  Let’s start with chasing performance.  Quite frankly, it is the most common strategy people employ when making investment decisions but it is the worst thing you can do.  I have done lots of research on this topic mostly because I wanted to see if chasing performance actually works as a winning investment strategy.  I looked at mutual fund data from 1985 to 2006 and I wanted to see how often funds made it into the top 20 in their respective categories 2 consecutive years in a row.  In other words, how often did chasing performance work.  Pick out of the top 20 and you would be in the top 20 the following year.  My results showed that it happened 14.7% of the time.  Although these results were higher than I thought, the result are also saying that 85.3% of the time chasing performance did not work.  These are not good odds to becoming successful.

The problem with this research is back in 1985, there was only 300 funds and in 2006, there was about 7000 funds.  To get in the top 20 in 2006 was a lot harder than getting into the top 20 in 1985.  To make things fair, I wanted to see if you could pick above average funds based on past performance.  By definition, above average means half the funds are above average and half the funds are below average.

Again, the results suggest that chasing performance does not work.  Only 2.7% of all funds were above average for 5 consecutive years in a row.  That’s crazy low.  Less than 1% of all funds were above average for 7 years in a row and only 1 fund was able to be above average for 10 consecutive years in a row.

The moral of the story is do not chase performance!!  It does not work.  If it were that simple, investing would be a whole lot easier and more successful that it is!

SLIDE 14:  When it comes to investing, we go to great lengths to try to improve and enhance returns.  So what is the most effective way to enhance returns?

Would it surprise you if I said lowering fees is one of the most tangible, direct and easiest ways to enhance returns?  Let me prove my point.

SLIDE 15:  All of the fees in the mutual fund industry are imbedded. The fees on a retail mutual fund are about 2.5%.  The problem is you never see it because you never pay for it directly.  In this example, if your investment produced a 7.5% return, a 2.5% would leave you with a 5.0% net return.  The industry is regulated so that all returns shown to the investor are net returns (the 5%) and not the gross returns.

One of the advantages of a group plan is you typically get a break on fees because of the buying power of the group.  Anytime you lower fees, it means a direct increase in the return to the investor.  As you can see, a 1% reduction in fees means a 1% increase in net returns.

It’s really that simple.

SLIDE 16:  That fee savings not only makes a difference over 1 year but over time, a fee savings can really compound into a lot of money.  As you can see that 1% savings in fees over 25 years on a one time investment of $10,000 means an extra $9,411 in the investors pocket.  That’s a 29% difference in accumulated values.  That’s significant!

When choosing investments, it’s important to be aware of fees and the lower the fees, the better

SLIDE 17:  Next let’s look at the difference between active and passive investing.

Active investing is exactly what the word says.  Active investments buy and sell to try to outperform the markets.  It’s the belief that research, analysis, timing and selection can increase and enhance returns but does anyone really have this edge in investing?

Passive investments are the opposite of active investments in that they do not try to beat the markets but instead they try to be the market.  Passive investment invest in the index.  They are not fancy and as a result have significantly lower fees

SLIDE 18:  So, do active investments out perform passive ones?  Does all the buying and selling based on research, timing and intuition pay off?

Unfortunately, the results for active investments are not good.  The figures show the number of active investments that are able to beat the market.  As you can see for all asset classes for all time frames, passive investments win.  Generally speaking win 65% to 100% of the time.

SLIDE 19:  So passive investments win over active ones but by how much?  If you look at the difference between the average annualized returns of the index vs the average of all funds, there is a 1.08% difference.  The compounding  effect of 1% over a 10 year period is very significant.

SLIDE 20:  In fact, the data is consistent over different time frames.  Here’s data over 5 year periods . . .

SLIDE 21:  So, when it comes to selecting investments, remember these three research based tips:

  1. It’s tough to beat the market so look for passive index investments
  2. Lower fees gives you the edge
  3. And, don’t just chase performance.  Remember, past performance is no indication of future performance.

SLIDE 22:  So there you have the basic steps to building a portfolio.

The next step is to manage your portfolio.  I’ll teach that to you in the next video.

SLIDE 23:  I hope you now understand that investing is not rocket science even when it comes to building a portfolio.  Just follow three simple steps.

If you still need help, we have a team of professionals that can help you.

Good luck!