Whether you are drawing up a financial plan or simply trying to figure out how much money you will need to save to pay for a child’s education or fund your retirement, a key part of achieving financial goals such as these is investment management. The reason is simple: given today’s challenging economic landscape, getting your money to work hard on your behalf is often essential to achieving your financial goals.
With interest rates near all-time lows, gone are the days where you could simply set aside funds in a bank account and buy CDs or invest in a money market as a way of meeting financial objectives. The yields on such investments are simply not high enough to provide the type of growth most people hope to see from their investments.
At the same time, investments that can provide you with better returns such as stocks, mutual funds, ETFs, commodities, etc., tend to be more volatile and thus more risky than simply buying a CD or U.S. government bond. As a result, randomly selecting these types of investments or chasing hot tips from your friends and neighbors can be perilous if you don’t have the financial expertise necessary to thoroughly analyze potential investments.
Rather than chasing risky investments in the form of hot tips, or sticking exclusively to safe but low yielding investments, a better approach for most investors, is to take a comprehensive look at the various elements involved in the investment process and build an investment strategy from there. Doing so includes considering factors such as your risk tolerance and your investment objectives along with your time horizon. Once this is done, you can build, either with an investment professional or on your own, an investment portfolio that takes into account those factors.
The process of building and managing a portfolio is known as investment management. It typically incorporates the following activities:
- Establishing investment objectives and risk tolerance
- Determining investment philosophy
- Investment planning & strategy: how will you invest funds according to your investment philosophy to achieve your goals within your specified risk tolerance
- Building a portfolio by determining asset allocation and selecting investments within the included asset classes
- Managing portfolio risk
Investment management involves structuring a portfolio to optimize an investor’s chance of reaching their goals – whether those goals are general, such as outperforming a market index such as the S&P 500, or specific, such as saving enough money to be able to retire. It involves a variety of factors, including analyzing economic conditions, investment philosophies such as Modern Portfolio Theory, asset allocation strategies, and tax strategies.
While some people serve as their own investment managers, many investors prefer to hire an investment manager or managers, given the time and expertise it takes to manage an investment portfolio. Investment managers manage money both for individual and institutional investors.
Services typically provided by investment managers include:
- Devise strategies and execute trades in client portfolios
- Expert analysis of investments
- Continuous monitoring of portfolio holdings
- Perform risk exposure analysis
- Create mitigation strategies to cope with portfolio volatility
An investment management firm working directly with investors will typically require an investor to establish an account with the firm, whether an IRA, individual, trust or other account type, in order to provide management services.
When building a portfolio, investment managers use assets such as stocks, bonds, mutual funds, and ETFs (exchange-traded funds) containing stocks and bonds, real estate, and commodities. After a portfolio has been built, an investment manager will make trades in the account in line with the investment strategy, track account performance, and provide monthly or quarterly statements to the client.
In some cases, investment managers are also financial planners or investment advisors, offering overall financial planning services in addition to investment management. Investment managers who take this approach will often meet with their clients to ascertain their goals, risk tolerance, and help them come up with an investment strategy.
They may also coordinate with other professionals such as accountants and attorneys when needed and meet with their clients on a regular basis to update progress towards their goals. This type of holistic planning is known as wealth management, as it offers both investment management and a number of associated financial planning services.
Whether you work with a financial advisor or go it alone, the key to successful investment management is setting realistic investment objectives and determining your risk tolerance. Once you’ve identified your financial goals and decided how much investment risk you’re comfortable with taking to reach them, you can move on to the next step of the investment planning process, evaluating different investment approaches and strategies, also known as investment philosophies.
Selecting an investment philosophy typically focuses on evaluating factors such as how an investment manager selects investments, how they manage risk, and the type of assets they typically utilize.
Financial planning software can be very helpful in this evaluation process. The software can take your input with regard to investment goals and risk tolerance and produce reports that show how likely you are to reach your goals given the amount of money you are setting aside and the investment approach you are taking. This enables you to see how different investment philosophies perform based on historical data.
Investment planning is important to the investment management process because it provides a framework an investment manager can use in seeking to optimize the performance of client portfolios.
Next, we will take an in-depth look at the following elements of investment planning:
- Investment philosophy
- Managing Risk
- Diversification & Asset Allocation
Investment managers must, of course, do more than just consider past results when building an investment portfolio. Investing is a forward-looking field by nature, so it’s important to know and understand an investment manager’s investment philosophy before investing with them. This refers to the principles which guide their investment strategy and takes into account factors such as asset allocation, diversification, trading frequency, key economic indicators, and market sentiment indicators they use, etc.
Broadly speaking, the two main approaches to long-term investing can be classified as follows:
- Active investing: An investment manager actively manages your funds by choosing the individual stocks, mutual funds, and ETFs that seem most likely to enable you to attain your investment objectives. Portfolio holdings are adjusted to attempt to take advantage of opportunities presented by changing market conditions at the discretion of the manager. Active management typically aims to do better than broad market indexes such as the S&P 500.
- Passive investing: Your investments are allocated to mutual funds or ETFs that track the performance of broad indexes such as the S&P 500 or NASDAQ, rather than trying to pick individual securities. While in some cases asset allocation may be adjusted, this is not done in response to or as an attempt to take advantage of specific market conditions, but rather to reflect changes to your investment objectives, risk tolerance, or market moves which have changed the asset allocation of the portfolio outside targeted parameters. Passive investing seeks to mimic the return of an index, rather than outperform it.
Historically, there have been times when one or the other of these approaches has turned in better performance. As a result, many investment managers will incorporate both strategies into client portfolios, either by building portfolios that include both passive investments such as ETFs and securities selected by the manager, or by outsourcing some part of the process, typically the active portion, to outside money managers.
When managing portfolios, investment managers must continuously take risk into account. This encompasses more than just market risk, the risk that the market will decline in value, and should also consider inflation or purchasing power risk and correlation risk, which is the risk that too many of a portfolio’s holdings move in lockstep with each other.
Concentration risk must also be considered. A portfolio that is narrowly focused on just a few securities or one or two asset classes (technology or biotech stocks, for example) carries more risk than a portfolio that is widely diversified. Most investment managers will typically provide investors with broadly diversified portfolios unless an investor requests that a more aggressive, concentrated approach to portfolio construction be used.
One tool for managing the risk of an account in conjunction with maximizing its performance is Modern Portfolio Theory (MPT). This approach holds that by properly diversifying among asset classes based on historical performance data, a portfolio can be designed to maximize return potential for a given level of risk.
Many investment managers use MPT or some variant of it to help build investor portfolios. The theory takes into account how different asset classes have performed over time and uses diversification among them to attempt to reduce volatility while delivering the potential for optimal returns.
Financial planning software, as noted earlier, can be helpful in determining the risk of an investment approach as it relates to meeting investment goals. Such software typically uses what is known as a Monte Carlo analysis to determine the chances of attaining a financial goal over a specified period of time. The software takes into account the amount of money invested, the portfolio approach you plan to take (aggressive, moderate, conservative, etc.), and runs hundreds and even thousands of return projections based on historical performance data.
Generally, if your portfolio delivers the desired results from 70 to 90% of the time it can be said to fall into the Comfort Zone, providing you with the potential of achieving your goals. If the result is below 70%, it may indicate that you need to change your original parameters (invest more, for example, or take a more aggressive investment approach), and if above 90% it may mean that you don’t need to invest quite as much to still have a good chance of achieving your goals.
This type of analysis enables an investment manager to calculate whether your portfolio appears likely to meet your investment goals at any given time and take action to improve the odds that it will, if necessary.
Another aspect of investment philosophy revolves around a manager’s approach to factors such as diversification and asset allocation. A more aggressive manager might attempt to deliver superior performance by building a more concentrated portfolio, as opposed to reducing volatility by diversifying across a greater number of asset classes.
A similar dynamic applies to asset allocation. While many model portfolios are built on a balance of stock and bond investments, for example (60% stocks, 40% bonds, 70% stocks, 30% bonds, etc.), an investment manager who wanted to take a more aggressive approach might minimize the portion of the portfolio placed in bonds, or allocate the stock portion to riskier, higher beta stocks, and vice versa if the manager wanted to take a more conservative approach.
However it is achieved, diversification is a crucial component in long-term investment management. The benefit it offers, the chance to earn above-average returns from inherently volatile assets while reducing overall risk, is key to enabling investors to achieve long-term goals.
Given that the U.S. market is just a part of global investment markets, many investment managers will recommend diversifying portfolios geographically as well as by type of asset (stocks, bonds, real estate, commodities). This enables investors to benefit from global growth during times when the U.S. markets are not performing well.
A key component of robust diversification is a focus on non-correlated and weakly correlated assets. Correlation implies that one asset moves in synch with another – when one asset goes up or down, the other tends to follow suit, and vice versa. Diversifying a portfolio among assets that don’t correlate strongly with each other helps reduce overall portfolio volatility and can improve long-term performance.
While passively managed portfolios typically use a static asset allocation approach based on a particular model, active investment managers proactively adjust an asset allocation when they see opportunities to improve portfolio performance by doing so.
Studies have shown that asset allocation is a key determinant of investment performance. As a result, when considering investment managers, it is important to understand their approach to allocating funds among different asset classes in a portfolio.
The benefit of working with a CERTIFIED FINANCIAL PLANNER™ Professional is that, based on your personal goals and risk tolerance, they can either build a portfolio for you or provide you with recommendations for building a portfolio. Understanding your financial situation gives them the information needed to select investment managers that fit best with your approach to investing and investment objectives. It also makes it easier for you to diversify among investment managers, rather than being limited to just one or two. This allows you and your advisor to make changes in the investment managers you use, if necessary, to improve performance.
A CERTIFIED FINANCIAL PLANNER™ Professional can serve as both a financial advisor and investment manager by helping you plan for investment goals and selecting the investments to help you achieve those goals. In practice, many CERTIFIED FINANCIAL PLANNER™ Professionals will outsource at least some portion of the investment management process to provide you with the opportunity to benefit from a variety of investment perspectives.
While some individual investors do select investment managers themselves or manage their own portfolios, for many investors this is not the optimal approach, given the time, experience, and expertise necessary to manage money well.
To become certified, a CERTIFIED FINANCIAL PLANNER™ Professional must demonstrate knowledge across the spectrum of investment planning and management, including determining investor risk tolerance, and building and managing investment portfolios. They must also demonstrate the highest degree of ethical behavior and undergo regular testing to ensure they are up to date on all the latest rules and regulations regarding investment planning. As a result, having a CERTIFIED FINANCIAL PLANNER™ Professional as your financial advisor can put you in a good position to take the steps necessary to optimize your approach to investment management.