Nick Harroz III
Mark I Asset Management
The stock market has seen an unprecedented stretch, from the financial collapse beginning in late 2008 to the rally beginning in March 2009. What was the greatest challenge investors faced during this period?
NH: During any financial crisis, investors sometimes want to hit the panic button and make a run to cash. Markets go up, markets go down, and there is no way to be absolutely certain on any given day which swing will occur. Investors who engage in market timing - a process of going from stocks to cash, and vice versa - will never be successful.
According to Morningstar Research, if in 1926, an investor would have invested one dollar in the stock market, the investment would have grown to $3,246 by 2007. However, if that same one-dollar investment was subject to market timing, minus the 40 best months of the stock market from 1926 to 2007, the investment would have grown to a mere $19.23; minus the 18 best months, a meager $2.36.
The bottom line is that while the initial panic makes investors want to convert their equity positions to cash. From a long-term perspective, it is simply not the right thing to do, since you cannot predict the market on a daily basis.
Since most investors want to engage in market timing, what is the best way to develop a disciplined investment strategy?
NH: A disciplined investment strategy begins with a detailed investment plan. Central to a detailed investment plan is communication: between the investor and the financial adviser about the investor's goals, time horizon and risk tolerance.
First, at a minimum, an investor should have a time horizon of at least five years. Excluding the Great Depression and the current market cycle, whose recovery is yet to be decided, the longest market downturn lasted 25 months and the longest recovery lasted 49 months. Therefore, an investor with the discipline to set funds aside for a period of at least five years will have the potential to weather the storm during a downturn and participate in the market recovery.
Second, it is important for an adviser to assess and an investor to communicate risk tolerance. Simply stated, risk tolerance is the amount of investment risk, including a possible loss, an investor is willing to take. Risk tolerance is more than a function of an individual's psychological makeup; it is affected by other factors such as age, cash reserves and family situation.
After the investor and the financial adviser have determined the goal, risk tolerance and time horizon, they need to develop an investment policy. An investment policy is a concise statement of an investor's objectives and constraints. Objectives deal with the risk and return desired. The constraints address the time horizon, tax, legal and liquidity needs of the client.
After determining that an investor has some form of risk aversion, how do you develop a detailed investment plan?
NH: Most investors have some form of risk aversion. Even the investor who is fully committed to the plan has doubts during times of uncertainty. In developing a detailed investment plan, a financial adviser should consider diversifying among asset classes in a way that correlates to an investor's risk tolerance through a process known as asset allocation. Asset classes are groups of securities that have similar characteristics, attributes and risk-return relationships.
Diversification reduces the volatility of a portfolio by increasing the number of asset classes. Traditionally, asset allocation between asset classes consisted of dividing a portfolio between stocks and bonds. However, more modern trends in investing in more asset classes beyond stocks and bonds also include international stocks and bonds, real estate and alternative asset classes, such as hedge funds.
After determining that an investor needs diversified asset classes in his or her portfolio, how do you determine what specific asset classes to select?
NH: Each investor is unique, because each investor has specific goals and objectives to achieve through investing. Therefore, every plan should be tailored to meet those specific needs.
However, to achieve a diversified portfolio, the asset classes selected should behave differently. A mix of asset classes such as large cap stocks, small cap stocks, international stocks and government and corporate bonds can help to achieve diversification and reduce volatility.
Diversification does not eliminate the risk of experiencing investment losses, but it does help to mitigate an investor's loss relative to the market as a whole.
In today's current economic environment, toward what asset classes and sectors are you guiding your clients?
NH: Given the current economic environment, an investor needs to look for mutual funds and securities that will stand to benefit from an economy emerging from a recession. Specifically, areas that benefit from job creation and economic expansion should do well. I continue to like sectors such as technology, metals, mining and energy. All of these sectors should benefit from an economy emerging from a recession.
Also, we continue to focus on globalization, since the world is an integrated whole, with each part dependent upon the other. Countries with emerging middle classes - such as China and India, and regions like Eastern Europe - continue to be attractive investment opportunities.