How to Pick Your Investments

The classic board game Othello carries the tagline “A minute to learn... a lifetime to master.” That single sentence also applies to the task of choosing your investments. Understanding the basics doesn't take long. However, mastering the nuance of every available investment could take a lifetime.

This piece highlights the most critical points to consider when choosing investments before you can start assembling your portfolio.

The "Pareto Principle" is a helpful concept when embarking on a task that encompasses a lot of information, such as the topic of "how to pick your investments." This principle, named after economist Vilfredo Pareto, is often called the “80/20 rule.” In many aspects of life and learning, 80% of the results come from 20% of the effort. Therefore, in covering the topic of how to pick investments, we’ll follow this rule and focus on the core ideas and measurements that represent the majority of sound investment practices.

As visionary entrepreneur Elon Musk explains, “you boil things down to the most fundamental truths…and then reason up from there." Remember, it is possible to make money from stocks, so learn about the keys to choosing investments that offer good returns.

First, you must determine your timeline. You need to commit to a period during which you leave investments untouched. A reasonable rate of return can be expected only with a long-term horizon. It may be possible to generate a return in the short term, but it is not probable. As legendary investor Warren Buffett says, “you can't produce a baby in one month by getting nine women pregnant.”

When investments have a long time to appreciate, they’re better suited for weathering the inevitable ups and downs of the equities market. This strategy is beneficial not only to investors, but it’s critical to well-managed publicly traded companies. Research published in the Harvard Business Review shows “companies deliver superior results when executives manage for long-term value creation and resist pressure from analysts and investors to focus excessively on meeting Wall Street’s quarterly earnings expectations.” The firms that were considered long-term oriented saw average revenue and earnings that were 47% and 36% higher, respectively, than companies that weren't focused on the long term.

The data is clear: Playing the long game produces significant opportunities. Consider, for example, that over the 10-year period from Jan. 1, 2007, to Dec. 31, 2016, the average annual return of the Standard & Poor's (S&P) 500 Index was 8.76%. Cut the timeline in half to five years spanning from Jan. 1, 2007, to Dec. 31, 2011, and the average return falls to 2.46%.

Another important reason for leaving your investments untouched for several years is to take advantage of compounding. When people cite “the snowball effect,” they’re talking about the power of compounding. When you start earning money on the money your investments have already earned, you’re experiencing compound growth. This is why people who start the investing game earlier in life can vastly outperform late starters because they get the benefit of compounding growth over a longer period.

Asset allocation is the process of choosing which portion of your investment portfolio will go to what kinds of investments. For example, you might put half your money in stocks and the other half in bonds. For greater diversity, you might expand beyond those two classes and included real estate investment trusts (REITs), commodities, forex, and international stocks, to name a few.

To know the “right” allocation strategy, you need to understand your risk tolerance. If temporary losses keep you awake at night, it’s best to maintain a balanced investing approach that includes plenty of lower-risk options, namely bonds. However, if you believe you can withstand setbacks in the pursuit of aggressive long-term growth, a heavier weighting towards stocks is the way to go.

But allocating an investment among various asset classes is about more than just managing risk. It’s also about the reward. Nobel Prize-winning economist Harry Markowitz referred to this reward as “the only free lunch in finance.” You stand to earn more by diversifying your portfolio. Here’s an example of what Markowitz meant: An investment of $100 in the S&P 500 in 1970 would have grown to $7,771 by the close of 2013. Investing the same amount over the same period in commodities (such as the benchmark S&P GSCI Index) would have made your money swell to $4,829.

Now, imagine you adopt both strategies. This is where the magic starts.

If you had invested $50 in the S&P 500 and the other $50 in the S&P GSCI, your total investment would have grown to $9,457 over the same period. This means your return would have surpassed the S&P 500-only portfolio by 20% and be almost double that of the S&P GSCI performance. A blended approach works better.

Markowitz is well-known in the world of finance because he was the first to put forth the idea of “modern portfolio theory” or MPT. The concept suggests that investors can maximize their potential return while reaching a preferred level of risk. It works by carefully selecting a group of investments that, as a whole, balance one another’s risks. MPT assumes you can get the best possible return for whatever level of risk you decide is acceptable. If you choose a portfolio that earns a return that you could have achieved with a less risky group of assets, then your portfolio isn’t considered efficient.

MPT doesn't require you to delve into complicated equations or probability charts. The key takeaway is that you need to: (a) Diversify your asset class to suit your risk tolerance, and (b) Choose each asset considering how it will increase or decrease the entire risk level of the portfolio.

Here’s a list of traditional assets and alternative asset classes:

Traditional Assets:

• Stocks
• Bonds
• Cash

Alternative Assets:

• Commodities
• Real estate
• Foreign currency
• Derivatives
• Venture capital
• Special insurance products
• Private equity

There are plenty of asset classes to pick in the above lists. However, nearly all average investors will find that a combination of stocks and bonds is ideal. Complicated instruments like derivatives, insurance products, and commodities require a deeper understanding of varied markets that are beyond the scope of this piece. The primary goal here is to get started on investing.

If most investors can reach their goals with a combination of stocks and bonds, then the ultimate question is how much of each class should they pick? Let history be a guide.

If a higher return – albeit with higher risk – is your goal, then stocks are the way to go. Consider, for example, that the total return on equities was much higher than on all other asset classes from 1802 to the present. In the book "Stocks for the Long Run," author and professor Jeremy Siegel makes a powerful case for designing a portfolio consisting primarily of stocks.

What’s the rationale for advocating equities? “Over the 210 years I have examined stock returns, the real return on a broadly diversified portfolio of stocks has averaged 6.6 percent per year,” Siegel says. 

In the short term, stocks can be volatile. Over the long term, however, they have always recovered. A risk-averse investor may be uncomfortable with even short-term volatility and choose the relative safety of bonds. But the return will be much lower.

“At the end of 2012, the yield on nominal bonds was about 2 percent. The only way that bonds could generate a 7.8 percent real return is if the consumer price index fell by nearly 6 percent per year over the next 30 years. Yet a deflation of this magnitude has never been sustained by any country in world history,” Siegel says.

These numbers illustrate the risk/reward dynamic. Take more risk and the rewards are potentially larger. Moreover, equity risk over the long term can become more acceptable to most investors. As a guide, consider the historical performance of these different portfolio models over the 1926-2016 period.

No matter the mix you choose, make sure that you make a choice. Investing is necessary because inflation erodes the value of cash. Case in point: $100,000 will be worth just $40,000 in 30 years at 3% annual inflation.

Some people choose their stock/bond balance by using the “120 rule.” The idea is simple: Subtract your age from 120. The resulting number is the portion of the money you place in stocks. The rest goes into bonds. Therefore, a 40-year-old would invest 80% in stocks and 20% in bonds. The formula is designed to increase the proportion of bonds as one ages because the investor has less time to outlast potential market drops.

Now that we can see that stocks offer higher long-term appreciation than bonds, let's look at the factors an investor needs to consider when evaluating a stock.

The number of characteristics is nearly limitless. However, in keeping with the Pareto Principle, we’ll consider the five most important aspects. They are dividends, P/E ratio, historical return, beta and earnings per share (EPS).

Dividends are a powerful way of boosting your earnings. It's a way for publicly traded companies to offer a cash payment from their profits directly to shareholders. The frequency and amount of the payments are subject to the company’s discretion. However, these factors are largely driven by the company's financial performance. Dividends aren't limited to cash. Some companies pay them in the form of additional shares. More established companies typically pay dividends. Why? They’ve reached a scale where they can offer more value to shareholders in the form of these payments rather than add to the already considerable business infrastructure they’ve built.

Choosing dividend-paying stocks is wise for several reasons. First, dividends are a serious driver of wealth. Consider that “going back to 1960, 82% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding,” according to a Hartford Funds white paper. Second, the payments are often a sign of a healthy company.

However, be aware the payments can stop at any time and the company is under no obligation to continue paying. Historically, companies with the highest dividend payout ratio (the yearly dividend per share divided by the earnings per share) underperform those with the second highest ratio. The reason: Especially large dividends are often unsustainable. So consider stocks that have a consistent history of dividend payments.

A price-earnings ratio is the valuation of a company's current share price compared to its earnings per share. A stock’s P/E ratio is easy to find on most financial reporting websites. Investors should care about the ratio because it’s the best indicator of a stock’s value. A P/E ratio of 15, for example, tells us that investors are willing to pay $15 for every $1 of earnings the business earns over one year. A higher P/E ratio, therefore, represents greater expectations for a company because investors are handing over more money for those future earnings.

A low P/E ratio may indicate that a company is undervalued. Conversely, stocks with a higher P/E ratio may require a closer look because, as an investor, you’re paying more today for future earnings.

What is the ideal P/E ratio? There’s no “perfect” P/E ratio. However, investors can use the average P/E ratio of other companies in the same industry to form a baseline. For example, the average P/E ratio in the healthcare products industry is 161 whereas the average in the auto and truck industry is just 15. Comparing two companies, one from healthcare and another from auto and truck, offers no insight to an investor.

While it’s unwise to make any attempt to time the market, it is possible to infer some assumptions about future returns from the market P/E ratio. Research from The Journal of Portfolio Management found that “real returns are appreciably lower for decades following high levels of the market P/E ratio.” In early 2018, the S&P 500's P/E ratio hit 26.70 while the median over the past 147 years was 14.69.

This numeric measurement indicates the volatility of a security in comparison to the market as a whole. A security with a beta of 1 will exhibit volatility that’s identical to that of the market. Any stock with a beta of below 1 is theoretically less volatile than the market. A stock with a beta of above 1 is theoretically more volatile than the market.

For example, a security with a beta of 1.3 is 30% more volatile than the market. If the S&P 500 rises 5%, a stock with a beta of 1.3 can be expected to rise by 8%.

Beta is a good measurement to use if you want to own stocks but also want to mitigate the effect of market swings. 

EPS is a dollar figure representing the portion of a company’s earnings, after taxes and preferred stock dividends, that is allocated to each share of common stock.

The calculation is simple. If a company has a net income of $40 million and pays $4 million in dividends, then the remaining sum of $36 million is divided by the number of shares outstanding. If there are 20 million shares outstanding, the EPS is $1.80 ($36M / 20M shares outstanding).

Investors can use this number to gauge how well a company can deliver value to shareholders. A higher EPS begets higher share prices. The number is particularly useful in comparison to a company's earnings estimates. If a company regularly fails to deliver on earnings forecasts, then an investor may want to reconsider purchasing the stock.

Be warned. EPS, like so many other metrics, can be manipulated. A company can repurchase shares, which will increase the EPS by decreasing the number of shares outstanding (the denominator in the above equation). Examine the company’s historical buyback activity if the EPS numbers look unrealistically high.

Investors often get interested in a particular stock after reading headlines about its phenomenal performance. A problem can arise if the performance is short term. Sound investing decisions should consider context. A surge in share price over the course of a day or even a week may indicate a level of volatility, which can lead to investor disappointment. Therefore, it’s important to look at the trend in prices over the previous 52 weeks or longer.

Moreover, people need to consider an investment’s real rate of return. This number represents the annual percentage return realized after adjusting for the mitigating factor of inflation. Remember, past returns are not a predictor of future returns.

For example, technical analysts often pore over the details of stock price fluctuations to design a predictive model. However, research shows that technical analysis is “not better than the purely random strategy, which, on the other hand, is also much less volatile.”

Simply put, historical performance is not a great predictive tool but it does illustrate how well the company can maintain momentum.

You can pick investments for your portfolio through a process of technical analysis or fundamental analysis. Let’s look at what these terms mean, how they differ and which one is best for the average investor.

Picture traders sitting in front of four computer screens that show an array of complicated charts and streaming numbers. This is what technical analysts look like. They comb through enormous volumes of data to forecast the direction of stock prices. The data consists primarily of past pricing information and trading volume. In recent decades, technology has enabled more investors to practice this style of investing because data is more accessible than ever.

Technical analysts are not interested in macro-level influencers like monetary policy or broad economic developments. They believe prices follow a pattern, and if they can decipher the pattern they can capitalize on it with well-timed trades. They use an arsenal of formulas and assumptions.

Conversely, fundamental analysts consider the intrinsic value of a stock. They look at the prospects of the company’s industry, the business acumen of the management, the company's revenues and its profit margin.

Many of the concepts discussed throughout this piece are common in the fundamental analyst’s world. They also would be appealing to the everyday investor, who wouldn't find it practical to analyze endless data as a technical analyst does. Even with the power of technology, the esoteric models require much of the trader’s time to monitor, interpret and act. 

Moreover, the success of the technical analysis approach is not clear. A study published in the Journal of Economic Surveys found that “among a total of 95 modern studies, 56 studies find positive results regarding technical trading strategies, 20 studies obtain negative results, and 19 studies indicate mixed results.”

Technical analysis is best suited for someone who has the time and comfort level with data to put limitless numbers to use. Otherwise, fundamental analysis will fit the needs of most investors because it can be a relatively simplified approach. For example, many people meet their long-term goals with an S&P 500 index fund, which offers diversification and low costs.

Aim to keep costs low. Brokerage fees and mutual fund expense ratios pull money from your portfolio. Such expenses cost you today and in the future. For example, over a period of 20 years, annual fees of 0.50% on a $100,000 investment will reduce the portfolio's value by $10,000. Over the same period, a 1% fee will reduce the same portfolio by $30,000. Fees create opportunity costs by forcing you to miss the benefits of compounding.

Many mutual fund companies and online brokers are lowering their fees while competing for clients. Take advantage of the trend and shop around for the lowest cost.