These key investment principles create the foundation of our investment philosophy:
We believe capital markets are generally efficient, meaning that security prices reflect all available information.
This does not mean prices are always correct. Rather, it means fierce competition among market participants makes it virtually impossible for any single investor to consistently make profits above all other investors. As stock markets worldwide have become more efficient due to rapid technological advancement, almost any investor with a computer now has access to the same information as professional portfolio managers. As a result, global capital markets are far more efficient today than they were only 30 years ago.
For a more detailed exploration of efficient markets, click here to watch an interview with Eugene Fama, the University of Chicago finance professor who introduced this theory to the investment community.
Eugene Fama was quoted as saying, “I’d compare stock pickers to astrologers, but I don’t want to badmouth the astrologers.” For three decades, “reams of academic research” has shown that stock pickers—those investors who are trying to actively exploit “mispricings” in the markets—have been unable to consistently generate investment returns high enough to recoup their research costs. This evidence has lead to a strong increase in passive investing, which is the practice of using index funds to capture market returns. We firmly believe that passively managed mutual funds are the best building blocks for creating globally diversified portfolios.
Asset allocation—the choice of asset classes and the percentage of the portfolio allocated to each—accounts for 94% of a portfolio’s performance, according to academic research. This means that asset allocation is far more important to a portfolio’s rate of return than either security selection (accounts for 4%) or market timing (accounts for 2%). Asset allocation is similar to the concept of diversification, which teaches you to “not put all of your eggs into one basket.” The difference is that asset allocation is concerned about the baskets (or asset classes). Therefore, asset allocation says to avoid putting all of your eggs into “baskets of a similar type.”
Sparrow Wealth Management works with you to develop an Investment Policy Statement that clearly shows how your assets will be allocated among different asset classes. The appropriate asset allocation will be established based upon your goals, objectives, time horizon, and risk tolerance. The first asset allocation decision is how much of your portfolio to invest in fixed income (or bonds) and how much to invest in equity (or stocks). The larger the percentage of equity, the more risk (or volatility) you will have in your portfolio, and hence, the greater the potential return over the long run. The second decision is to allocate the equity and bond positions across different asset classes. For the fixed income portion of the portfolio, SWM primarily invests in short-term bonds and inflation-adjusted bonds. The equity portion of the portfolio should be diversified across the following asset classes—U.S. and international, large and small, and value and growth.
Modern Portfolio Theory
Modern Portfolio Theory says that the investment return of a portfolio is maximized for any given level of risk by using asset classes with low correlations to each other. For example, in a perfect world, you would have two asset classes with high total returns and opposite correlations. So, when the price of asset class A is going down, the price of asset class B is going up. The combined effect is a portfolio with a “risk-free” total return. Since the real world does not have asset classes with completely opposite correlations, our goal is to own asset classes that have high returns and the lowest possible correlation. Harry Markowitz—who developed Modern Portfolio Theory at the University of Chicago in 1952—won the Nobel Prize in economics in 1990 for this “common sense” investment methodology. For a more thorough explanation of Modern Portfolio Theory, we recommend that you read the following article: Investing in the ‘90s: More Gain, Less Pain by Scott Leonard, CFP®
The key to higher risk-adjusted returns is taking advantage of investment opportunities throughout the world. We strongly believe that global diversification will decrease the risk of your portfolios and increase your rates of return over the long run. Even though you may believe that America is the strongest financial country in the world, it could still face recessions and/or depressions in the coming years. To ensure that your portfolio is properly protected against such events, we recommend that you invest 50% of the equity portion of your portfolio into international index funds.
Portfolio rebalancing has the effect of reducing the risk of your portfolio, and it may also increase your long-term rate of return. The basic reason for rebalancing is to maintain your overall asset allocation (as it is written in your Investment Policy Statement). Over time, you will find that certain asset classes will perform better than others in your portfolio. Rebalancing is the process of selling some of those asset classes that have done well, and buying some of the asset classes that have done poorly. Academic research has shown that the returns of asset classes tend to revert to their long-term expected return. Therefore, in addition to reducing risk, rebalancing should result in consistently “buying low” and “selling high” over the long run. Portfolio rebalancing requires tremendous discipline and courage to do the unpopular thing. In contrast, many investors fluctuate between greed and fear—buying as the markets rise and selling as they fall. Obviously, you cannot make money when you are consistently “buying high” and “selling low.” This is one of the many reasons that it’s wise to hire a disciplined financial advisor to manage your money.