Step Three - Monitoring the Investment Portfolio

On Friday and Saturday we looked at asset allocation models - for the American Association of Individual Investors and Schwab, respectively. Asset allocation models specify targeted percentages of asset classes. They are the framework investors use for investing. The breakdown of the percentage to invest in stocks and bonds is the most important step in the investment process. The model is what we need to be able to stick with as the market goes through its fear and greed cycle. Having the right model is crucial in preventing us from succumbing to the emotional ups and downs of the market.

Yesterday we examined Step Two on how to choose investments. We considered sources of exchange traded funds - iShares and broker commission free funds. We also touched on buying individual securities for the small cap sector.

Today we look at Step Three - monitoring the portfolio. I have seen many investors who have an ad hoc investment process primarily because they don't have a means of monitoring their overall portfolio. They have numerous accounts at multiple brokers that they try to track using spreadsheets. In effect, they are using a paper-and-pencil approach that was appropriate 20 years ago but, IMHO, is cave-era stuff in today's age of technology. What is being done by pencil and paper can more easily and efficiently be done with tools provided by brokers.

To see this, let's extend the example used in the previous posts, mentioned above, whereby we picked a model with the Charles Schwab platform and we've made our investments. Where do we stand now?  This is easily answered by using their "portfolio analysis" tool. Here is a  portfolio relative to its model ("Moderate Conservative") showing the actual percentages relative to targeted percentages: CLICK TO ENLARGE

(Source: Charles Schwab)
 
The beauty of all of this is that accounts can be combined. If you have, for example, a taxable account, a traditional IRA, and a Roth IRA etc., all can be combined and analyzed as one portfolio relative to the asset allocation model you have chosen. Forget spreadsheets and data entry. Once a trade is entered, it is automatically put in its asset class and the analytics are available.

As shown in this table, the "International Equity" sector is below target. By buying the appropriate international exchange traded fund, it can be brought back on target in a matter of minutes. The seasoned investor will quickly see the utility for rebalancing purposes.

Note that the discrepancies can easily be viewed in dollar amounts, which is useful in quickly calculating the number of shares to buy or sell.

Another important part of monitoring portfolios is performance. Schwab provides performance up to the previous trading day for various time periods along with the performance of the benchmark: CLICK TO ENLARGE

(Source: Charles Schwab)

I believe that at least 80% of retirement money should be indexed using low-cost index funds. For those, however, who want to try to beat the market with up to 20% of their investable assets, the performance analytics are highly useful. All they need do is segregate their "play account." Then they will have the performance of their "play account" relative to whatever model they want to choose (including the "Aggressive" model which is 95% stock). It won't take long to see if you're the next Warren Buffett!

With these three steps--choosing a model, selecting investments, and monitoring a portfolio--those willing to make a small time commitment can become a DIY investor and keep a great portion of their nest egg  instead of handing it over to high-priced advisors. Voluminous, unbiased research shows that at least 75% of professionals underperform the market, after fees, over longer periods of time.

For those interested in additional detail , I recommend:

Other more advanced recommended books can be found at the "RW Investing Bookstore" link on the right.

Disclosure: I am not affiliated with Charles Schwab, although I do recommend to clients and potential clients that they consider switching to Schwab because of their excellent analytics.

Step Two - Choosing Investments

On Friday, we looked at the American Association of Individual Investors (AAII) asset allocation models. This was followed by yesterday's post on the Schwab asset allocation models.

The process of picking an asset allocation model is the first step in the investment process.

So by "hook or crook", as they say, we've arrived at an asset allocation model. Now is the time to take Step 2 in the process: choosing investments.

The model we've selected lists various asset classes and gives a targeted percentage to invest in each asset class. For example, the Schwab "Moderate" asset allocation model shows 10% targeted to "small cap equity."

CLICK TO ENLARGE

(Source: Charles Schwab).

Basically there are three ways to satisfy this specification: buy a small cap stock fund, select individual small cap stocks, or use a combination of the two. A good place to start when selecting a fund is at the iShares site and, in particular, their "core solutions":

CLICK TO ENLARGE

(Source: iShares)

As shown, there are 6 funds to choose from, including small cap growth and small cap equity. I would suggest the broadest fund - IWM, which is indexed to the Russell 2000. Another source of funds to consider is with the broker. Competition has led many brokers to offer their own commission-free, low-cost indexed funds. If you are using Schwab, Fidelity, or a similar broker, check out their commission-free offerings.

If you like to pick individual stocks, one place to start is by examining the holdings of a small cap stock exchange traded fund. You can find the top holdings by going to Yahoo! Finance, putting in the fund symbol, and then clicking "holdings" on the left hand side:

CLICK TO ENLARGE

(Source: Yahoo! Finance)

The final step in the 3-step process is to monitor your investments. We'll look at how this can be done tomorrow.

Some books that can help the beginning investor in the asset allocation process are:

Picking an Asset Allocation Model

Yesterday's post discussed Step One - Pick an Asset Allocation Model. Many brokers have similar models to choose from. Here are 2 of the 6 models offered by Schwab:

CLICK TO ENLARGE

(Source: Schwab)

Again, the main point is to look at the broad allocation between stocks and bonds. If you are in a position to take on risk because you have the capability, capacity, and need then, other things equal, you would choose a higher stock allocation. As is typical, Schwab has an online questionnaire to help select the appropriate model. There are also many tools online to kelp in this endeavor.

Note that Schwab has 6 asset classes and their targeted percentages.

Keep in mind that the objective is to choose a model that you can pretty much stick to over an up or down cycle. Don't just look at the best year's performance--look hard also at the worst year return. It is highly likely that you will experience such a return sometime within the next 10 years.

Picking the appropriate model is a big step in the DIY investing process. Tomorrow, we go to Step 2 for the DIY investor: selecting specific investments to fit the model.

Step One - Pick an Asset Allocation Model

The very first step in DIY investing is to come up with an asset allocation plan. Today this is pretty straight forward because suggested models are easily accessible online with all of the relevant parameters.

Today we'll look at the American Association of Individual Investors (AAII) models and tomorrow we'll consider Schwab's. These are just two of the many available.

Keep it Simple

The first thing to know is that there is considerable value to keeping the whole asset allocation business simple. It isn't as scientific as is sometimes presented by financial advisors.

The objective is to arrive at a targeted percentage to invest in various asset classes.

The simplicity of the process is illustrated by the three models proposed by AAII:

CLICK TO ENLARGE

(Source: American Association of Individual Investors).

As you can see, the AAII models suggest 3 categories: aggressive, moderate, or conservative. The aggressive model has 90% stocks, 10% bonds. The conservative model is split 50/50. Note that there are 7 asset classes.

Here are the historical returns of the 3 models:

CLICK TO ENLARGE

(Source: American Association of Individual Investors).

As shown, the longer term performance of the Aggressive model exceeds that of the other two. This illustrates the reward for taking on more risk.

Which model should you choose? To help, AAII provides "Broad Allocation Scenarios." This tells you the relevant points to consider:

(Source: American Association of Individual Investors).

Notice that age, investment horizon, and volatility are listed. Notice that the worst year return is given. These are all important in choosing a model. Still, overall, I'm sure you'll agree that the process is fairly straight forward.

Additional Points

A couple of additional points should be kept in mind. First, the model isn't set in concrete. If the market gets you nervous and you are having trouble sleeping at night, by all means get more conservative. What you don't want to do is continually switch back and forth and, thereby, let your emotions dominate the investment process. Secondly, this is where you have some control. I know from experience that many people have a difficulty working with an advisor simply because they feel they are losing control of their money. In my view, this is where to keep control - make sure the allocation model is well specified and that you are able to track it. Then you can have the advisor do the nitty-gritty work of buying and selling of the securities. Finally, recognize that over time you'll likely get more conservative (i.e. increase the bond exposure)in your allocation.

Tomorrow we'll look at Schwab's models. After we're comfortable with model selection, we'll go to step 2 of choosing investments.