**A Seven-Step Process for investing in New Assets

Advice for investment accumulators
By Christopher M. Flanagan, J.D.

Published January 1998

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Frequently, people make investment decisions based not so much on what they know or what their experiences have been but, rather, on how they acquire assets. In other words, how investors build their portfolios often is driven by how they acquire their investable cash. For example, one might be a partner in a medical or law firm and receive a partnership distribution. Or, perhaps he or she is a corporate executive who receives a yearly bonus. In either case, assets are received in stages or "chunks," and the individual must now determine an investment route for these new assets. The result of this piecemeal approach now is a collection or accumulation of investments. It is a difficult process if you have a goal of being consistent with an overall plan.


A Flawed Investment Process

After receiving that Christmas bonus, or perhaps liquidating part of a business, the accumulator’s investment process typically takes the following path. First, current market trends are considered, e.g., "Blue chip stocks seem to be doing well," or "There are global opportunities, but market volatility is a concern." Ideas are then checked with a knowledgeable person whom the investor respects (stockbroker or relative). Next, the investor reviews his or her current portfolio and considers whether to add to existing investments, e.g., "I might want to add money to my common stock fund." Finally, the money is invested. The process appears logical to the accumulator, but it is flawed in that it typically takes into account only "this year’s" money and not all of the investor’s assets. The result is a collection of investments, rather than a portfolio with a comprehensive strategy.


A Seven-Step Process


While everyone’s situation is unique and financial needs can be met and addressed in a multitude of ways, the process for identifying what those needs are revolves around the same fundamental issues. At the risk of oversimplification, applying the following seven-step process would enable the accumulator to make smarter investment decisions for the long-term and not just for the moment.


Establish an investment goal. Establishing investment goals amounts basically to writing down, in language someone else would understand, one’s personal investment goals. It can be in very general terms, such as "I want to have enough money for a comfortable retirement," or "I want to make sure I can put three children through college," or perhaps, "I never want to run out of money." That’s pretty plain language, but it certainly does the job of identifying an individual’s financial ambitions and concerns.


Determine the ability to tolerate investment risk. Understanding how much risk someone can tolerate is a very personal thing, but one rule of thumb can help an individual know when they’ve exceeded that comfortable level. Again, it is a basic guideline, but one should "never own any investment that will cause you to lose even five minutes’ sleep at night." Investors frequently ignore this guideline in an "up" market.


Calculate the annual return objective: what kind of performance do you need to get from your investments. The next step is to calculate the average annual return the investor needs or wants, and there are a couple of ways to do this. Begin by looking back at the personal investment goals. As an example, let’s use the goal of a college education for three children. If an individual needs $100,000 a year in today’s dollars—and knowing how much he or she has today and how much will be put aside going forward—you can go through the mathematical calculations of figuring out exactly what annual return on the money is needed to reach the goal. The individual can then get a sense for whether his or her expectations are realistic and whether he or she is setting enough aside to invest for future use. Another method is to take a look at the historical performance data, not over a one-year period, but over a ten-, thirty-, and fifty-year period. Studying long-term performance results will help to keep in line the investor’s expectations for future returns.


Select asset allocation among types of investment vehicles. The next step is determining the asset allocation that best meets investment objectives. Arguably, this is the most critical step and one where individuals could benefit from some professional advice. Asset allocation, the buzz words in financial services today, is how assets are apportioned among various asset classes (stocks, bonds, etc.). The goal is to achieve the highest return at a risk level the investor is comfortable with. Achieving the highest return for any given level of risk is an efficient portfolio mix. Generally speaking, we know that between 65 percent and 85 percent of a portfolio’s performance will be dictated by the structure of the portfolio—the mix of asset classes—rather than the specific individual investments that are held within it. Consequently, it is more important to figure out what portion of a portfolio should be in stocks, etc., rather than which stocks to select. Here is where someone might call on expert assistance. Chart first how much risk exists in the current portfolio (it is often more than expected). Next, determine if it is possible to increase potential returns without increasing your risk and identify the ideal mix of investment types, (stocks, bonds, etc.) necessary to accomplish this.


Choose specific investments. Based on the investment types identified, it is now time to choose the specific investments that are most appropriate. This is where most of the investment "clutter" happens: comparing which stocks did better than others, which funds outperformed benchmarks, etc. And it is here that one needs to have a well-diversified portfolio. Once again, though, while investment selection undeniably impacts the overall performance of a portfolio, it is more important that those investment selections are diversified within the investment types that best support the investor’s long-term investment strategy.


Monitor portfolio performance quarterly. While it isn’t necessary to get mired in every single week’s or month’s worth of statements, it is important to review results on a quarterly basis. Take a hard look at the percentage returns on the entire portfolio during the past quarter. How do those results compare to the annual percentage return objective and to the long-term goal? Were performance expectations met, and were they realistic? Does the investment strategy need to be adjusted?


Revisit steps 1-5 annually. Once a year, walk through the above steps for making smarter decisions. Revisit (perhaps revise) investment goals, as they can and should change over time. With the current appetite for risk in mind, calculate the annual percentage return objectives. Accurately select the asset allocation that will help to meet those goals, and the result will be a successfully structured portfolio.


Ironically, "investment accumulators" usually don’t appreciate how successful they truly are. Because they didn’t inherit their money or win a lottery, but rather just worked for it a little at a time over the years, they don’t think of themselves as "wealthy" or even financially successful. Consequently, they may not be giving their investment portfolio the respect it deserves.


Christopher M. Flanagan, J.D., is a regional manager for Mellon Private Asset Management, a service mark of Mellon Bank Corporation and its subsidiaries.



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Investment, speculation and gambling

It is commonly thought that investment, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates.

It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.

Investment, speculation and gambling (Security Analysis, Ben Graham.):

1. Graham defined investment thus: An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative.

The difference between investment and speculation, when the two are thus opposed, is understood in a general way by nearly everyone; but it can be difficult to formulate it precisely. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation is an unsuccessful investment.

The failure properly to distinguish between investment and speculation was in large measure responsible for the market excesses and calamities that ensued, as well as, for much continuing confusion in the ideas and policies of would-be investors.

2. Graham's addition criterion of investment: An investment operation is one that can be justified on BOTH QUALITATIVE and QUANTITATIVE grounds.

Investment must always consider the PRICE as well as the QUALITY of the security.



Main points:______________

INVESTMENT OPERATION: rather than an issue or a purchase.

PRICE: is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.

DIVERSIFICATION: An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.

ARBITRAGE AND HEDGING: it is also proper to consider as investment operations certain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another. In these rather specialised operations the element of SAFETY is provided by the combination of purchase and sale.

THOROUGH ANALYSIS: the study of the facts in the light of established standards of safety and value, including all quality of thoroughness.

SAFETY: The SAFETY sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experiences indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.

SATISFACTORY RETURN: is a wider expression than "adequate income", since it allows for capital appreciation or profit as well as current interest or dividend yield. "Satisfactory" is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

_______________


For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement.

Speculation, on the other hand, may always properly – and often soundly – derive its basis and its justification from prospective developments that differ from past performances.

GAMBLING: represents the creation of risks not previously existing – e.g. race-track betting.

SPECULATION: applies to the taking of risks that are implicit in a situation and so must be taken.

INTELLIGENT SPECULATION: the taking of a risk that appears justified after careful weighing of the pros and cons.

UNINTELLIGENT SPECULATION: risk taking without adequate study of the situation.