The investment approach we choose is key toour long-term investment success. But few ofus choose the approach that best suits ourinvestment knowledge and aptitude. Instead,we often choose the wrong approach by default. Thereare two basic investment approaches you can use toinvest on your own: the simple and the sophisticated.Otherwise, you should seek professional help and workwith an investment manager.
For many physician-investors, this may be ideal. Youdivide your portfolio among four asset categories—cashequivalents, intermediate-term bonds, domestic stocks,and international stocks—and use low-cost, broad-basedindex funds for each category. For intermediate-termbonds, you would use an intermediate-term bondindex fund; for domestic stocks you would use a totalmarket index fund; and for international stocks youwould use a developed market index fund.
The approach calls for an equally simple age-basedasset allocation strategy. Dollar-cost-average into themarket during the saving years and dollar-cost-averageout of the market during retirement when you need towithdraw money. If you can stick to this simpleapproach, you'll end up doing better than the vastmajority of investors.
There are some problems with the simple approach.First, when you invest in low-cost, broad-based indexfunds, most often you end up investing a lot of yourassets in large cap growth stocks. This may be fine whenthe market is going up, but this can be a disaster whenthe market tumbles. Second, during a bubble, continuingto blindly put money into those index funds will result ininvesting in overpriced stocks. This can significantlyincrease your portfolio's risk.
To get around parts of these problems, you can sliceand dice your stock portfolio more finely and get awayfrom the market weights built into broad-based indexfunds. For example, you may decide to split your portfolioamong large cap growth and value stocks, smallcap growth and value stocks, and a few other special categoriesof stocks such as real estate investment trusts.You can still use index funds for each of these categories,but now you will have the flexibility to pick the weightin your portfolio for each stock category. For example,you may decide to put more money into value stocksthan growth stocks.
If you choose a reasonable allocation among the variousstock categories and rebalance your portfolio onceor twice a year, you will also greatly avoid the problemof continuing to pour money into the most overpricedstocks during a bubble.
There are many other refinements. But keep in mindthat any foray into the sophisticated approach requires asignificant knowledge of investing and commitment totime. So before choosing this approach, make sure thatyou have the aptitude, interest, and time to become anexpert; otherwise it can become a very expensive experiment.Also keep in mind that the law of diminishingreturns takes over very quickly, and you can easily domore harm than good by trying to be too sophisticated.
If you want to take the sophisticated approach butcan't do it on your own, find the right investment managerto work with. Be prepared to devote a good amountof time and effort to finding the right person. In mostcases, you're better off working with a fee-only advisorto avoid conflicts of interest. Make sure the advisor canclearly explain their investment philosophy. If it deviatesfar from the sophisticated approach, be wary.
Investment management fees should not be higherthan 0.75% for the first $1 million of assets, and shouldgo down for asset levels above that.
Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001)and Financial Modeling Using Excel and VBA(John Wiley; 2004), currently teaches finance atthe Fordham University Graduate School ofBusiness and consults with individuals on financialplanning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.