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The Investment Process

Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC

     Investing is a process composed of many elements. Unfortunately, many investors simply skip some of the elements because of lack of education or simple naivete. Web sites, books, and advisors that deal with investing in the stock market, but don't address the other critical elements of the process only exacerbate the problem. Many so called "Investment" books and web sites probably should be renamed with the term "stock selection" or "stock picking" because they either briefly address or skip entirely critical elements of the process. In fact, stock selection is likely to be one of the least important elements of investing for many investors (See Asset Allocation). The following summary and links are intended to assist investors in understanding the investment process and achieving their goals in an efficient manner.

1. Determine financial condition, goals and risk tolerance.
a. What are you worth? How much are you saving/spending?
b. What are your goals? How much and when?
c. How much risk are you willing to take to reach your goals?
d. Should you be handling your own investments?

2. Determine the appropriate asset allocation

3. Select investment vehicles and implement strategy
a. Taxable or tax free
b. Active or passive
c. Mutual funds, individual securities, or others
d. Market timing

4. Monitor portfolio, reevaluate goals and constraints and rebalance
a. Rank performance
b. Reevaluate goals and constraints
c. Rebalance portfolio

5. Document your results

Other Investment Process Links

1. Determine financial condition, goals and risk tolerance.

a. What are you worth? How much are you saving?
      Before you can begin planning to invest you should attempt to determine exactly where you stand financially. You can start with (there are plenty of calculators on the internet, these are just a sample) net worth calculators from Smartmoney, CNNfn, and/or Bankrate. Next you should determine your cash flow available for investing or living expense needs with a calculator like one these from Calculatorweb, Mapping Your Future, or Kiplinger. It's important to realize that net worth and cash available to invest are two separate amounts. An income statement will give you an idea of how much money is coming in or going out on a regular basis. You can find a large collection of retirement and other calculators on the Interactive page. By preparing financial statements you'll be able to more effectively determine your needs now and in the future. Proforma statements will help you determine your future needs. You should project inflows and outflows as far out as possible and consider as many alternatives and options as possible.

b. What are your goals? How much and when?
      Before an appropriate investment program can be established, careful consideration should be given to the investor's specific objectives and constraints. Objectives are goals defined in terms of return requirements and risk tolerance. Constraints are limitations, such as liquidity, time horizon, taxes, and legal or regulatory matters, imposed on the portfolio management process. Preferences are constraints that are self-imposed and may be unique. Do you have specific income requirements or minimum rates of return? Is there a minimum value that must be maintained? Are there specific future liabilities? Investors with more wealth than they will ever need may be interested in donating some of their wealth to Charity. Keep in mind that the real value of any dollar amount in the future will be influenced by inflation (which historically has averaged around 3% in the US). Knowing how much you have to invest now and in the future, you can estimate the future value of your investments using these Bankrate or AARP tools. There are various tools available for estimating your savings potential and required rate of return to meet specific targets. If you're goals are too high you may want to rethink you're objectives.

c. How much risk are you willing to take to reach your goals?
      Are you willing to accept volatility to achieve higher returns? Investing should be viewed as a process of making sure that you never have so much risk that your standard of living can be impaired by a negative surprise. There are many interactive tools (risk tolerance and asset allocation tools) you can use to help determine your risk tolerance. Don't be surprised if you get different results from different tools, there are no absolutely correct answers based on the limited information you can supply. Links to calculators and interactive tools are included for informational purposes only and should not be viewed as complete and suitable. Just as you would likely receive different advice from different advisors (even supplying the same information), you should expect the interactive tools to offer varying advice (an example of these tools is Northwestern Mutual's Risk Tolerance).

d. Should you be handling your own investments?
      At this stage in the process you should ask yourself several questions. First, do you know enough about investing (asset allocation, portfolio management, diversification, etc.) to handle your own investments? Follow-ups to that question might be: have you done well with your investments in the past; and, would others who know you and are educated in investments agree with your opinion that you know what your doing? If the answer is no, you should either seek an advisor who is qualified to invest your money (See Choosing an advisor), or become educated (See Education). If the answer is yes, you may want to test yourself to determine whether you really do know as much about investing as you think you do (See Tests). You may also want to read about investor Psychology and consider whether you exhibit any of the common investor irrationalities. See also Is your financial advisor worth it? from Vanguard.

      If you aren't well educated but you enjoy investing, you should ask yourself whether you are willing to accept lower returns and higher risk than you might get by using a qualified advisor? It's not a bad idea to take a serious look in the mirror and ask yourself whether you would hire the person your looking at (as if you were a stranger) knowing how much experience and education in investments, finance, and portfolio theory you have. Your investment decisions and actions can have a major impact on your financial future and they should not be taken lightly.

      Investing does not have to be rocket science, but you should understand the basics of portfolio management and diversification and be familiar with Historical rates of returns and risks for the major Asset classes. Your next question should be do you have the time to handle your own investments and is it the best use of your time? If you are foregoing significant income opportunities with the time you spend on investing, you may be losing money. You might want to also think of what you'd prefer to do with the time you'd otherwise spend on investing. If you have the education, the time, and the willingness to be responsible for your own investment performance (good or bad) its time to move on to determining your asset allocation.

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