The ABCs of Investing

Now that our investments have suffered through two major bear markets in the past decade, it’s time to resuscitate your portfolio.

The Importance of the ABCs

Airway. Breathing. Circulation. It’s the mantra of my specialty -- emergency medicine. If you had to simplify the entire world of emergency medicine, it would boil down to these basic principles. Consciously or subconsciously, with every patient encounter, whether it be a sore throat or a gunshot wound, we address the ABCs first. There’s a good reason for it -- the ABCs provide us with a framework for managing even the most complex patients and organize our thoughts to focus on the most important aspects of the patient’s condition first. So let’s discuss the framework you should build to have a successful investment experience -- a framework built around evidence-based investing and financial science, not financial industry smoke and mirrors.

Asset Allocation: The First Step

Much like the airway in an emergent patient is the first and most important step in taking care of the individual, defining your asset allocation is by far the most important step in managing your investments. Without an airway, you’ve got a dead patient. Without a proper asset allocation, you’ve got a dead portfolio. Asset allocation is the mix of different types of investments, known as asset classes, which form a unified portfolio suitable for your particular risk preferences. An important implication in this definition is that asset allocation really refers to the level of risk you are willing to bear in exchange for the possibility of a future expected return from your portfolio. Ultimately, managing your investment portfolio translates into managing risk.

From a very broad perspective, the different types of asset classes include volatile asset classes and nonvolatile asset classes. Volatile asset classes have higher variation in returns and higher risk than nonvolatile asset classes. Volatile asset classes include stocks, hard assets (real estate and commodities), and alternative investments (hedge funds and private equity). Nonvolatile assets include cash, CDs, and bonds.

Each particular asset class can be further divided into various sub-asset classes. For example, stocks are a broad asset class, but you can subdivide stocks into U.S. equities vs. international stocks, large-capitalization stocks vs. small-cap stocks, value vs. growth, and so on.

You must determine not only which asset classes to include in your portfolio, but also how much of the overall portfolio is devoted to the chosen asset classes -- and ultimately how much of each type of risk to take on. As you might imagine, this can be a daunting task considering the breadth of available investments. Next time I’ll discuss the academic evidence of why asset allocation is the cornerstone of investing.

This week's financial prescription: Determine the asset allocation in your investment portfolio.