Because of the Efficient Market Hypothesis, nobody knows what stocks are going to go up or down. Not your cousin, not your broker, not your advisor. Over time, the performance of 99.9% of stock pickers is indistinguishable from luck. That’s why I advise investors not to try to time the market.

A stock’s price is based on the earning potential of the company that issued shares. The way the market views a company’s earning potential depends upon several factors, including the company’s ability to earn profits, the state of the company’s sector, and changes in the economy.

Often, in examining a portfolio’s performance over time, it becomes clear that a fund manager is trying to time the market. For example, if your fund was invested in Large Value Stocks in 2010, but by 2012 it had shifted to Large Growth Stocks, the fund would be experiencing “style drift.” The manager is trying to time the market and predict whether it will go up or down. He is speculating and gambling with your money.

Alternatively, we often see the amount of cash holdings fluctuating. This can also be a sign that the fund manager is jumping in and out of stocks. Alternatively, it can mean there is a large outflow of investors in the fund.

Diversifying is easier said than done. It’s easy to own stocks across different market sectors, such as a tech company and an oil company and a clothing company plus a food company. But there are more layers to diversification. You should diversify in terms of size and geography, in addition to market sector.

If you own mutual fund shares, assessing your diversification can involve some work, because the true scope of your investments is hidden. By drilling down into the funds you are invested in, we will learn how many funds hold the same stocks. We call this Portfolio Overlap. That redundancy can reduce your true diversification and add complexity to managing your investments.

Asset allocation and diversification are the most important factors in a portfolio’s long-term performance. Most people know that diversification is important and believe that their portfolio is diversified. In reality, most people fall far short of achieving true portfolio diversification. Even people invested in one or more mutual funds often hold fewer than 4,000 unique stock or bonds in their portfolios, yet wrongly believe they are well diversified. In the modern financial world, many mutual funds hold over 10,000 different stocks. (The one I currently favor holds over 12,000.) More importantly, while a wide spread of stocks is important, the total number of unique holdings alone doesn’t actually tell you anything about how diverse those assets are. They could all be in foreign banks or fast food companies for all we know.

When we meet to conduct a Portfolio MRI on your investments, we will break down your asset allocations in detail, and make sure the mix meets your investment objectives. Then, using indices for different investment categories, we will compare the performance of your portfolio’s asset mix to the historical performance of other mixes. That way we can make sure you are truly and properly diversified.

We’ve reviewed how mutual fund expenses can eat away at your portfolio. In fact, total fund expense is the most important variable to consider when comparing funds because it’s the one that actually makes a difference.

The Portfolio MRI will uncover what you are paying in “total fees” – not just the fees you know about. If you don’t know what your fees are, there is no logical way to find less expensive ones. So we simply drill down into your portfolio to reveal all of the fees that affect your returns.

Since turnover within a portfolio can significantly affect returns due to transaction costs, we will also learn what percentage of your portfolio is turning over in a year. We can then assess that turnover in comparison with an index, like the S&P 500, as well as one or more institutional mutual funds. Once we know your actual costs, we can advise you how to lower those costs to keep more of your money working for you.

The easiest way to increase your return is to reduce your fees.

The Portfolio MRI is part report card and part recipe book. It breaks down information about your investments and stacks them up against inflation-adjusted historical data reflecting different asset mixes, funds, indices, etc. I like to walk through the Portfolio MRI with my clients step-by-step. I want everyone to understand the logic behind the investment choices they are making, and how their portfolio fares in terms of the five rules of investing. By looking at your portfolio over time, we can see how closely it adheres to the fundamental rules of investing. Let’s review them:

1. Don’t Try to Time the Market
2. Buy and Hold
3. Diversify Broadly
4. Reduce Your Costs
5. Don’t Buy High and Sell Low

The Portfolio MRI will also measure the historic volatility of your portfolio and give you an idea of the historic volatility and performance of different asset classes. That allows us to estimate the risks you are taking relative to the returns you’ve seen, and compare your portfolio’s performance to the performance of other benchmarks over similar time periods. Not only can we assess how well the volatility we see matches up with your risk tolerance, but we can also determine whether alternatives asset mixes would be likely, based on historical data, to reduce volatility or yield higher returns (or both!).

We believe that an investment portfolio should be built on a sound foundation of research, a strategic and closely adhered to financial plan, and rational expectations. Speculation or hunches, and the perpetual buying and selling of stocks, are costly and inefficient. There is no single “right” answer for how much risk is appropriate for a portfolio; each investor has his or her own unique circumstances dictating the level of risk to assume. For that reason, after speaking with you and understanding your goals and concerns, we will evaluate your portfolio to see how it meets your investment needs.

Mutual funds hold thousands of different stocks, and have many hidden costs (expense ratios, turnover, load fees, etc.) that can significantly reduce your returns. There are countless ways to allocate our assets and diversify a portfolio. Additionally, we have seen that portfolios must be rebalanced to maintain the proper asset mix. So how do you know if your current portfolio is right for you? How do you know how close or far you are from where you need or want to be? The answer is that you must take a comprehensive assessment of your portfolio and compare it to the relevant benchmarks as well as other potential options.

Rosen Investment Management uses a proprietary diagnostic tool called a “Portfolio MRI” to analyze your investments and assess its volatility, total fees, turnover, and diversification. This personalized investment analysis will help you better understand your investments, as well as the costs and risks associated with them. We begin with understanding your personal goals and needs. Armed with this information, we can then analyze how different mixes or styles of investment portfolios may have performed in the past. That enables us to calculate the expected return for your portfolio, and gives us an idea of how well your portfolio meets the goal of providing broad diversification that delivers market returns with reduced risk.

When and how often should you rebalance your portfolio? You can do it based either on the calendar or on your investment ratios. Many financial experts recommend that investors rebalance their portfolios on a regular basis: every six or twelve months. The advantage of this method is that the calendar reminds you when to rebalance.

Others recommend rebalancing when the relative share of an asset class increases or decreases more than a certain percentage that you set in advance. The advantage of this method is that your investments determine when to rebalance. In either case, rebalancing works best when done on a regular, but relatively infrequent, basis to minimize transaction costs.

You can direct your investment advisor to rebalance your portfolio accordingly to either of these methods. At Rosen Investment Management, we automatically rebalance our investors’ portfolios every quarter, after considering the tax implications of selling off assets, unless the asset ratio has not changed very much.

For example. if your investment strategy is 50% fixed income and 50% stocks, and at the end of the quarter the proportion is 48% fixed income and 52% stocks (because the stock value grew faster than the bond value), it probably doesn’t make sense to rebalance. But if, in the following quarter, stocks rally and your portfolio mix is now 39% fixed income and 61% stocks, we would rebalance to 50:50 by buying more fixed income securities.

Once you decide on your asset mix, one thing you must do to keep your portfolio working for you is rebalance it periodically. Rebalancing means bringing your portfolio back to your desired Asset Allocation mix. It is important to rebalance because some investments will grow faster than others, which will cause the ratios of different asset classes within your portfolio to be out of alignment with your investment goals. Periodically rebalancing your portfolio brings it back into alignment with your investment goals and keeps your portfolio within your risk-reward comfort zone.

For example, let’s say you determined that stock investments should represent 60% of your portfolio. After a market rally, stocks grow to represent 80% of your portfolio.

There are three ways to bring your portfolio back into alignment with your chosen Asset Allocation strategy:

1. Sell off investments from over-weighted asset categories and use the proceeds to purchase investments in under-weighted asset categories.
2. Add capital to make new investments in under-weighted asset categories.
3. If you make continuous contributions to your portfolio, alter your contributions so that more investment goes to under-weighted asset classes until your portfolio is back in balance.

In the example above, where stocks have rallied, it can be psychologically difficult to force yourself to rebalance your portfolio. It’s hard to rationalize shifting money from an asset that is performing well into one that isn’t. But don’t think of it as giving up on well-performing assets; think of it as locking in some of your gains. Cutting back on the current “winners” and adding more of the so-called “losers” allows you to accomplish one of our Investment Rules: Buy Low and Sell High

A well-diversified portfolio spreads your investment among different types of investments, and within different asset classes. Asset Allocation is how you accomplish this.

Asset Allocation refers to the composition of your investment portfolio. You can divide your investment in many ways, including stocks, bonds, cash, and cash equivalents. An Asset Allocation-based strategy aims to balance risks and rewards by adjusting your portfolio’s makeup based on your risk tolerance and time frame – two things that vary depending on your personal investment objectives.

Some people decide not to diversity for reasons that depend on their investment goals and time horizon. A twenty-year-old who starts investing for retirement may choose to invest solely in stocks. By contrast, a family saving for a down payment on a new home might want to have that money in cash equivalents, which are short term and highly liquid. These two Asset Allocation strategies do not spread risk across different asset classes and, hence, are not diversified.

If you are well diversified, you don’t have to try to predict what type of asset class will do well, or when it will increase in value. In other words, you don’t have to time the market. Different asset classes move independently so gains and losses in one asset class can offset gains and losses in another. That mitigates losses when the stock market turns bearish. Having a cornucopia of different assets reduces your portfolio’s overall level of risk without costing you anything extra.

It’s virtually impossible to predict which asset class will do well over a specific period of time. Sometimes different asset classes move together; sometimes they don’t. Some tend to move in the opposite direction from others. For instance, when the dollar weakens, international stocks tend to do better.

There have been long periods where certain categories of stocks experienced extraordinarily high returns. In the late ’70s and early ’80s, Small International Stocks really shined, boasting 70-80% returns each year. Then in the late ’80s, when Japan was booming, Large International Stocks did extraordinarily well. Next, in the early ’90s, Small U.S. Stocks did very well. In the late ’90s, it was Large U.S. “Blue Chips” Stocks. (“Blue Chips” are nationally recognized, financially sound companies. They are stable, and their growth tends to mirror that of the S&P 500.) The best way to diversify your portfolio is by investing in different financial instruments, and differently sized and valued companies.

Then the tech bubble burst in 2000. Then in the mid-2000s, the U.S. dollar dropped in value, and International Stocks (including emerging markets) did well. More recently, the housing bubble burst in 2008 and the market nosedived, but began making a comeback in 2009.

Many investors use Asset Allocation as a way to diversify their investments among asset categories.

To emphasize the importance of diversification and asset allocation over long periods of time, let’s look at a hypothetical example.

Imagine that you had one dollar to invest in 1926 that you would cash in in 2015.

● If you had invested it in Large Growth Stocks, that dollar would have increased to $3,530 in 2015.
● If you had put it into Large Value Stocks, it would have grown to $12,910.
● Investing in Small Growth Stocks would have yielded $14,580.
● In Small Value Stocks, that dollar would have grown to a whopping $139,000.

There’s a big difference in returns depending on how you invested that dollar.

Eugene Fama and Kenneth French, professors at the University of Chicago Booth School of Business, expanded on the research into diversification, identifying three key factors that affect a portfolio’s returns. You can think of each of these factors as a type of investment risk: Market Factor, Size Factor, and Value Factor.

Market Factor: The Market Factor tells us it is inherently riskier to invest in the stock market than in fixed income instruments, such as U.S. Treasuries (bills, notes, and bonds). Stock purchases demand a higher return because more risk is involved. If stocks didn’t offer a higher return than Treasuries, everyone would invest in the much safer T-Bills. But stocks have the potential to provide a higher rate of return than fixed income instruments. So the market risk factor informs your decision as to how to divide your portfolio between stocks and bonds.

Size Factor: The Size Factor takes into consideration the size of the companies in which you’re investing. Small companies generally have the potential for higher returns than do large companies, but are a riskier investment. Larger companies are less likely to experience tumultuous business changes, making them appear more stable. In addition, they’re typically more capable of weathering adverse economic conditions and unexpected events. Because of their lower level of risk, the market demands less return on investments in large companies.

Value Factor: The Value Factor refers to the extra risk exposure, and the extra risk premium, of investing in high book-to-market or “Value” stocks. High book-to-market stocks refer to companies with a lower market price than other companies of similar size. These types of companies are usually ones that are experiencing lower earnings and some kind of financial distress. As a result, they’re riskier and offer investors the potential for a higher return.
Research suggests that it is sensible to shift money into companies just when they are having a hard time. That may seem counterintuitive, especially when comparing a “Value” company to one that has better growth and better returns.

In contrast, a company that is doing well has already been rewarded with a higher stock price (also as per the Efficient Market Hypothesis). So if there’s a marked improvement in the distressed company, the upside will be much higher relative to a proportional improvement in the healthy company. That’s why people on reality shows buy run-down houses, fix them up, and then “flip” them at a significant profit. It’s also why no one really knows when a stock is “undervalued.”

The Three-Factor Model shows us that by systematically exposing a portfolio to the three risk factors – Market Factor, Size Factor, and Value Factor – it is possible to increase expected your returns without increasing risk.