The investment process can be broken down into two key steps:
Step 1: Determine the right long-term asset allocation given the investor’s unique needs and objectives.
“Asset allocation” is a fancy way of saying how much an investor should target in safer investments, like bonds, versus riskier investments, like stocks. The goal is to select a long-term allocation. The best answer depends on the investor’s unique circumstances, specifically his or her ability to take risk and his or her willingness to take risk (see illustration below). The important point is to devise a plan that (a) is appropriate given the intended use of the investment assets and (b) the investor can stick to through the inevitable ups and downs of investing.
Step 2: Implement the decision made during Step 1 by building an investment portfolio.
Once a decision is made in Step 1, it must be implemented. The starting point is a low-cost, well-diversified portfolio consisting of stocks and bonds. Because investments markets have grown increasingly efficient, it is difficult to do much better than this starting point, at least without taking more risk.
Warren Buffett cites the great baseball player Ted Williams, who maximized his batting average by only swinging at pitches in his “sweet zone.” Buffett points out that investors have a leg-up on batters because there are no called strike-outs in investing. Investors can patiently wait at the plate for the “fat pitch.” In other words, stick to the low-cost, well-diversified portfolio and deviate if and only if attractive opportunities arise.
Opportunities can come in a few varieties:
- Investors can try to time their participation in the stock market by periodically overweighting or underweighting the percentage of their portfolio invested in stocks relative to their long-term asset allocation targets. (Click here for our thoughts.)
- Investors can add so-called “alternative investments” to their portfolios. (Click here for our thoughts.)
- Investors can purchase externally managed funds (such as mutual funds or hedge funds) that they believe will outperform the market. (Click here for our thoughts.)
- Investors can select individual stocks or bonds that they believe will outperform the market. (Click here for our thoughts.)
Each avenue has its pitfalls, and should be approached with caution, patience and a disciplined approach to independent, fundamental research.