Investors who decide to pursue passive equity index strategies still have a few very important strategy decisions to make. They can choose to buy the whole stock market or to adopt a “strategy skew,” when choosing stock index investment funds.

If an investor buys the whole stock market, they seek the market’s return without selecting any particular subset of the market or any investment strategy skew. Doing so is consistent with investment theory and the research evidence. The total stock market is expected to deliver an optimal risk-adjusted return less, of course, whatever minimal costs are associated with the passive broad market index funds chosen to implement this total market strategy. When winners are not identifiable beforehand, this strategy is optimal and efficient.

Without the details, certain factors or investment skews have been demonstrated in the research literature to have the potential to improve modestly upon the market’s risk-adjusted return. Sometimes known as the Fama-French factors, these investment strategy skews are:

• value versus growth,
• large capitalization versus small capitalization, and
• momentum.

These factors may enable investors to improve upon the risk-adjusted performance of the overall market and deliver slight to modestly improved returns. However, to implement these skews or strategies is not costless, and therefore the incremental costs and taxes associated with these strategies also need to be taken into consideration.

A section below will address the value versus growth and large-cap versus small-cap factors or skews. This is because it is practical for passive index investors to adopt such skews through index funds, if they wish and if they are willing to take on the additional risk and costs associated with these skews.

Momentum, which is the sometimes slight tendency of stock price trends to persist, cannot practically be invested in by individuals. If there is any persistence or price momentum, professional traders with very low trading costs, substantial capital, and ample computational resources are the only market participants who are likely to be able to capture this factor economically.

Selecting a broadly diversified investment portfolio WITHOUT any investment strategy skew

The first step in achieving a fully diversified investment portfolio is to choose from among only very broadly diversified and low cost mutual funds and ETFs. The second step is to choose a mix of investment funds that tends to approximate the broadest markets. The funds lists provided in my “Low Cost Mutual Funds and ETFs” book focus entirely on broadly diversified, low cost investment funds.

Various market participants and advisors advocate that investors favor one or more of a multitude of investment selection factors, when assembling an investment portfolio. Unfortunately, these selection factors often involve higher costs, lower diversification, greater risks, and more activity – without a reasonable assurance of improved total returns net of taxes and investment costs.

I suggest that investors own a proportional share of the global public securities markets by buying and holding passive, low cost, and very broadly diversified investment fund vehicles. To do so you would make investments in proportion to the capitalization or total market value of individual securities within the markets.

This is known as capitalization weighting. You can easily assemble a capitalization weighted portfolio by buying low cost, no load index mutual funds and ETFs. Such fund track broad market indexes closely by buying and holding securities in proportion to the capitalization-weighted strategy of the benchmark index. This is where you will also find investment funds with rock bottom fees and costs.

Selecting a diversified investment portfolio WITH an investment strategy skew

To adopt a portfolio skew toward some alternative portfolio weighting factors will require paying higher fees, trading costs, and taxes. To the extent that you “skew” you portfolio or deviate from a very broad and very low cost capitalization-weighted strategy, you should ask whether you are likely to be compensated on a risk-adjusted basis for the added costs of an alternative “skew” to your portfolio. Are you likely to be compensated with sufficient “excess” performance that is disproportionately higher than the additional investment risk that you will incur – after costs and taxes are taken into account?

My reading of the investment literature makes me skeptical on this point from the point of view of the individual investor. In general, the lowest cost and most broadly diversified investment strategy tends to have a better opportunity to come out ahead.

However, as an overview, the following are brief summaries of major skews that a portfolio might have:

 
• “Value versus Growth” — In general, value strategies beat growth strategies over the long-term, although there can be extended periods (think years) when one or the other is in relative ascendancy or relative decline. A growth or value skew can lead to results that deviate unpredictably for sustained periods from the overall market return during the course of market cycles. Furthermore, growth and value investment vehicles often have substantially higher costs. Therefore, I suggest that people select total market investment vehicles with the lowest costs that cover the broadest range of securities.
   
  • If you feel compelled to adopt a value or growth skew to your investments, the investment research literature supports implementing a value skew rather than a growth skew in a portfolio. If you are willing to accept sustained deviations from market index returns, a value skew tends to win over the long-term. Since the costs of value strategy can be significantly higher than a passive full market, capitalization weighted strategy, adopting and managing a value skew might turn out not to be worthwhile.

   

  • Simultaneously, you need to be prepared to maintain faith in your value strategy and accept deviations from a market return. Value strategies tend to win when things get ugly or the markets move laterally. The hardest periods for value investors are when everything seems peachy and the stock market is rocketing ahead, because that is when value strategies tend to trail the broad market and growth strategies.

   

  • While it is beyond the scope of this book, you should also note that discussions about how to implement stock selection methods for passive value strategies have become more heated recently. For example, the best method to select a value-based subset of stocks from the universe of stocks is not clear. Nevertheless, the greater the investment management cost differential, then the higher the cost hurdle that a value strategy must overcome. This is a primary reason that I suggest simply sticking to whole market funds without any particular skew.

   

  • Note that, while the name “growth” may sound good, the actual long-term results of a growth skewed investment strategy might not be as appealing. This is akin to the naming of the “delicious” apple. Many people are under-whelmed by the taste of delicious apples, and they prefer the flavors of many other apple varieties. However, naming apples delicious is a great marketing strategy. The same might be said about growth investment strategies – good naming, but better long-term risk-adjusted out performance? Not so much.

 

• “Large versus Small Capitalization” – Investors gravitate toward investments in large companies, while perceiving them to be less risky. Perhaps the securities of larger firms are somewhat less risky, but small capitalization stocks sometimes have exhibited better returns historically.
   
  • In general, if you chose to invest across all sizes of firms and you can invest at very low costs and in proportion to securities market capitalization, then you will be more broadly diversified and you can participate is the relative ascendancy and relative decline of all size groups. (However, you should also read the section in the chapter above on diversification that is entitled: “Choose the broadest available, whole market diversification.” Skewing your portfolio toward small or large companies is not a reliable recipe for gaining superior risk-adjusted returns when compared to a passive, whole market investment strategy.)

   

  • Within the US equity securities markets, large capitalization stocks, measured by the S&P 500 represent about 70% to 75% of total market capitalization. Roughly speaking, “mid-cap” stocks represent 15% to 20% of total market capitalization and “small-cap” stocks represent 5% to 10% of market capitalization. This information is provided for those who wish to assemble a US equities portfolio using large-cap, mid-cap, and small-cap investment funds in rough proportion to overall market capitalization.

 

• “Domestic versus International” The total market capitalization of non-US equities markets is now greater than 60% percent of total world markets. If you hold at least 50% international equities in proportion to the capitalization of equities securities markets across the world, then you are also quite diversified from a global geographical standpoint.
   
  • Note that when you hold both domestic and international equity mutual funds, for some years you may see relatively dramatic, even double digit percentage increases or declines in the value of international stock holdings. This does not necessarily mean that there is a similarly large disparity between domestic and international economic growth rates or local stock market returns.

   

  • When you own international stock holdings, returns are denominated in a wide variety of foreign currencies, which must be converted back into US dollars for investment fund reporting purposes. Currency exchange rate fluctuations can amplify or dampen returns percentages both positively and negatively. To understand what really has happened, you need to compare stock market return percentages denominated in local currencies prior to the exchange rate conversion of foreign returns into the local currency of the investor.

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The complexity of personal investment management is driven by the nature of investing in securities that have uncertain and unknowable future values. Nobody — amateur or professional — has a working crystal ball that can predict future asset values. Anyone can have a more or less well-informed outlook and operate with an evolving set of theories as to what might happen.

However, it is what actually unfolds in the future in terms of positive and negative economic, technological, competitive, political, and other developments that will determine the evolution of securities values. And, even as new information becomes known in the future, the value of a particular securities will be always be an amalgamation of currently known information and a forward looking market consensus about the murky future.

In general, it is this very uncertainty that provides investors with opportunities (however unpredictable) to earn over time more or less than a market return on their invested assets. Investing involves varying degrees of risk and participants in real time securities markets buy securities at what they perceive to be a discount against their expectations for higher future values. They sell when they think current market prices exceed the future opportunity.

Thus, the uncertainty about the future drives much of the inherent complexity of investing. Everybody wants a magic system to beat the market and to do better than the other guy, but when you take the time to think about it, you realize that the future cannot be known until it arrives and that there can be no magic bullets, reliable systems, or sure bets with investing.

Nevertheless, the inherent complexity of investing is greatly exacerbated by the proliferation of investment products and services aggressively promoted by a securities and financial services industry that purports to serve your best interests. However, this proliferation of complex investment products most often seems only to serve the financial self-interests of the securities industry itself. Averaged across all retail investors, the high fees of the financial service industry dramatically reduce rather than help to increase retail investors’ net assets.

Personal investing can be simplified greatly by focusing only on valid strategies that have support in the investment research literature. This personal investment planning summary is intended to help you to understand that you can manage your investments using strategies that have a demonstrated basis in the research literature.

When one pursues strategies that are designed to focus solely on the fiduciary interests of individual investors, the vast majority of investment products promoted by the industry can simply and easily be eliminated from consideration. They cost far more than they are worth. Aggressive investment cost control is not a magic bullet to beat the market, but it is a very effective way to avoid being the rube who gets fleeced by the fast talking slick suit.

Once you have committed to a durable long-term investment strategy, you can manage by yourself relatively easily the details of investment implementation. You do not need to pay high costs for something you can do yourself.

You can build an easy-to-manage, do-it-yourself, lifetime investment strategy based upon these principles:

• To improve your long-term investment returns, move fully toward the completely passive, globally diversified, and extremely low cost end of the investment securities products spectrum. Invest only in a variety of passive, very broadly diversified, and low cost investment funds.

• Understand better your investment risk tolerance relative to the larger population of investors and decide how much you are willing to be exposed to investment risk. Your investment risk tolerance leads to your asset allocation strategy, which sets the balance of overall expected investment risk and return in your personal portfolio.

• Get invested and stay invested in the global securities markets according to your asset allocation — through thick and thin. Never attempt to second-guess the markets or to time the markets by moving assets around hoping to beat the markets. When you hold securities with an asset allocation that is commensurate with your tolerance for risk, you can ride out market panics without panicking, so you will also be in the markets when they rise toward new highs. The academic research shows clearly that nobody really knows how to time the markets and jumping in/out when you are confident/scared usually leads to inferior results.

• Buy and hold and hold and hold. When you own broadly diversified, passive index investment funds, professional investment portfolio managers will make all the needed adjustments within these funds for you over time.

• Maintain your asset allocation within the percentage policy variance that you have pre-determined. Do so in as low cost a manner as is reasonably possible. Use asset purchases during your accumulation periods and asset sales during your divestment periods to maintain your target asset allocation. This reduces the need to make changes and incur costs solely to maintain your asset allocation percentages.

• Only buy investment mutual funds from mutual fund companies that deal directly with the public. Only buy exchange-traded funds (ETFs) through discount brokers. Only a small fraction of either mutual funds or ETFs are low cost, broadly diversified, passive funds with low turnover. Buy them and ignore the rest with middling or higher fees. And, if you do not have a clear understanding of ETF trading, buy only mutual funds. After the May 6, 2010 stock market flash crash, it should be clear that naive traders fooling with ETF market orders and stop loss orders that automatically convert to market orders unwittingly could do real damage to their portfolios
• Never pay any broker or any other commissioned financial advisor another dime during your lifetime to tell you what funds you should buy. They do not know what will happen to future asset values, because they have no information to make such judgments. Instead, their high advisory costs will be extracted from your assets up front and along the way. Purchasing investment funds through an advisor is far more likely to reduce rather than increase your wealth. Investment cost are not “just a few percent.” For the average investor, average investment costs consume about one-third of average annual investment returns — year after year after year after year. The cumulative losses with even average investment costs are huge and simply horrendous across the lifetime of the average investor.

• Improve your overall net investment portfolio returns by consciously managing the asset “tax location” of your investment assets, which can reduce the investment taxes that you pay. Federal capital gains investment tax rates vary by holding period and different types of assets have returns that are treated differently under the federal tax code. Take advantage of the opportunities that you have to arrange your assets for minimal taxation.

• Focus the time that you spend on financial affairs during your lifetime on increasing your income and/or managing your consumption to increase your savings rate. In addition to reducing your investment costs, saving more is the single most effective way to accumulate assets for retirement and other personal finance goals.

• Enjoy your life and resist the compulsion to act as an amateur investment portfolio manager. By ceasing their amateur investment management activities, most people can free up substantial amounts of time to spend on far more pleasurable activities. Don’t you have other things you would rather do than spend your life playing futile investment games?

Most people waste a great deal of time on investment activities, tactics, and strategies that are more likely to reduce rather than increase their investment portfolios.

Very low cost, professional index fund managers can manage your money far more efficiently in terms of much lower costs, far greater diversification, better returns, lower taxes, and significantly less time than you can ever realistically hope to do as a personal investment portfolio manager. Do yourself a favor and decide to fire yourself as a personal investment manager in favor of a handful of index fund managers running very broadly diversified, low cost funds.

Despite these factors, some people just cannot resist the personal investment management game. If you simply cannot resist the temptation to play personal investment portfolio manager, then understand clearly that this is likely to be one of the most costly hobbies that you could have. If you are anything like the average investor (and you probably are), then your self-managed personal investment portfolio is highly likely to cost you money through inferior returns, higher costs, and inadequate diversification. Moreover, this hobby is extremely likely to waste a significant amount of your valuable time over your lifespan.

However, if you must play investment manager, then never play with the rent money, the baby’s milk money, or the money that you are relying upon for your retirement, your kids education, or other important obligations. Since investment portfolio self-management is not likely to be a value-added activity, never allocate more than 10% of your overall investment assets to this hobby. Invest the remaining 90+% in accordance with the investment methods summarized above.

In addition, learn how to track carefully and accurately your investment performance relative to appropriate passive benchmarks, so that you do not fool yourself into thinking you have more skill than you actually do. Everybody is an investment genius in a rising market, if they do not track performance relative to appropriate passive market benchmarks. Academic research clearly demonstrates that individuals most often achieve significantly sub-optimal investment results relative to passive benchmarks, while simultaneously they carry higher and unnecessarily risks due to non-diversified self-managed portfolios.

You investments should work for you rather than you working for them. Avoid all the financial industry games designed to make money off of your assets and to keep you moving assets around chasing performance gains that have already passed you by. Instead, simplify your investment program, and use your financial assets to enrich and protect your life and the lives of those you love.

OK — So How Does One Go About Doing This?

Here are some ideas to get you going:

1) On the “Retirement Investment Calculator” front page of this website, you can read about VeriPlan, which is an automated personal financial planning and retirement savings calculator software tool that individuals and families can use to do their own lifetime financial plans. This lifetime savings and investment calculator is the most sophisticated and high quality financial planning software that you can buy at a great bargain price. VeriPlan automates all of the tedious calculations needed to do fully integrated lifetime financial planning in a manner that is customized to reflect your particular financial situation, all your financial resources, and all your financial life goals and objectives.

Furthermore, VeriPlan also provides very extensive and absolutely objective personal financial planning documentation that helps you to understand the lifetime financial planning process and how to use VeriPlan’s automated and fully integrated IRA investment calculator, 401k investment calculator, mutual fund investment calculator, and saving for retirement calculator functionality. While VeriPlan hides the complexity of millions of inter-related financial investment calculator operations, it also treats you like an adult!

VeriPlan was designed with the firm belief that smart, well-educated adults need and want well-designed financial decision support tools with sophisticated future value investment calculator functionality. If you are going to invest the time needed to plan your family’s financial future, you need a financial planning software “power tool” to help you. It must be highly functional and robust, while it also provides useful and entirely objective financial information.

2) In parallel with checking out VeriPlan, you might also want take a look at this “Financial Planning Reading List.” This reading list compiles the top 60 or so personal financial planning and personal investment management articles from the many hundreds that the designer of VeriPlan has published on various personal finance websites across the web. All of these “Financial Planning Reading List” articles were personally researched and written by the designer of VeriPlan. If you want to judge whether VeriPlan could be right for you, then these articles might help you with your decision. Furthermore, the more articles on this reading list that you read, the better prepared you will be to manage your own family financial planning and personal investment portfolio over your lifetime.

3) I do believe that it is a virtue to engage in a lifelong effort to understand economics and investments, because of the significant impact of economics and investing on our lives. Personally, I believe that this knowledge provides a very long-term economic perspective and allows one to rise above the constant pressure from the industry and the media to change something – change anything – with ones investments, without any rational reason other than to generate more revenue and profit for the industry, yet not for you.

The more one learns, the less one is inclined to jump from one currently popular investment strategy to the next. Stability, constancy, passivity, broad diversification, risk control, and very low costs have been the hallmarks of the most successful personal investment programs of the past. I have found nothing that makes me believe that these viewpoints should ever change.

Given these viewpoints, I have also determined that I will not pay additionally for any “special insights” from industry professionals. Paid insights are no better that the abundance of free insights. However, since they cost more, one is likely to end up poorer for having paid.
Therefore, I have decided that I will only use free resources. Everything I do relies upon free public information or at least information that is very, very low cost. One just has to learn how and where to look. Of course using only free or extremely low cost public economic and investment information, means I may have to wade through a lot of rubbish to find things that are useful and valid. However, that is far better than wading through a lot of rubbish for which I have paid very dearly.

4) Recommended journals and books

In addition to materials that I have published, here is a short list of my investment reading recommendations concerning other sources that I consider worthwhile. The online sources are all free. You could buy the books inexpensively on Amazon.

A) Journal of Indexing — http://indexuniverse.com/index.php/publications/journalofindexes.html  Back issues can be read online.

B) John Bogle’s book “The Little Book of Common Sense Investing” Go to “John C. Bogel’s Blog.” You can read the first chapter of his book online on his blog. http://johncbogle.com/wordpress/

C) “Capital Ideas: The Improbable Origins of Modern Wall Street” (1993) or “Capital Ideas Evolving” (2007) by Peter Bernstein. These books chronicle of the intellectual development of modern investing.

D) Investment research papers via Google Scholar (To find investment research papers via Google Scholar, go to Google, click “more”, click “Scholar” and enter a search term. This takes time, but researching personal finance via Google Scholar can be very informative. For example, if you want to learn about forex trading online, just type in that phrase. With this example, you get about 2,700 research papers on foreign exchange and related forex topics. Once you get results, you can use Advanced Scholar Search to specify searching within particular subject matter categories and you can select particular authors who have many citations, among other search refinements. Look for most cited papers. Read abstracts, intros, and conclusions.)

After these recommendations, I have few additional recommendations, although I track and read a very wide variety of sources. The next book I would recommend is Ben Franklin’s Autobiography. I do not recommend many investment books, because I think that much more objective materials can be found in research papers on the websites of financial academics.

Comprehensive investment calculator and personal financial planning software is needed to develop a fully personalized family financial strategy

This free “financial freedom guide” on how to invest is just a part of our web site about how to develop a personal family financial plan. The personal finance plan essays on this free site supply important ideas to individuals and families about financial planning program and financial strategy subjects that should taken into consideration. These postings help in understanding how to establish a life time personal finance planning strategy. Also, to generate a really useful long-term money management strategy depends upon you using the best retirement savings calculator and personal financial planning software with a high quality stock investment calculator and the leading long term investment calculator software features.

Also, our financial freedom web site enables you to find the top all-in-one saving for retirement calculator software program for home PC use, and it includes the best retirement investment calculator tool, the best personal budgeting software, and a high quality mutual fund investment calculator for your personally customized lifetime financial planning. It also automates the long-term analysis of debts that you have, which could include mortgage debts, educational loans, credit card debt, business credit, or whatever other credit obligations you wish to analyze individually or jointly. Furthermore, it has an automated tool to assess an interest rate for your choice in situations where your financial assets are projected to have been exhausted, and you would use your other real estate or business assets as collateral for the personal or business credit loan you would need.

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