How I Approach Investing With My Clients

In addition to financial planning and financial coaching, a significant portion of my work with my clients is investment management. A lot goes into this, including assessing risk and time horizon, choosing suitable investments, monitoring those investments, rebalancing, and keeping investments aligned with my clients throughout their lives.

With a universe of almost 10,000 mutual funds available (as of the date of this article), it can seem like a daunting task to try to figure out which ones you should be using in your retirement accounts or investment vehicles.

To add to this, there is a lot of noise out there telling you how you "should" invest. A simple Google search on investing can lead to a mountain of information, much of it conflicting.

Here's the bottom line: there is not necessarily a "right" or a "wrong" way to invest. There are guidelines and possibilities and some are more suitable than others but there are many paths to success.

Along with all the investment options available, there is also more than one investment philosophy. Those who subscribe to one particular philosophy are often fiercely defensive of their point of view to the point that they dismiss all other perspectives.

Let's face it. The stock market is a messy game. Plenty of people try to time the market and predict the future, but the numbers prove that this is virtually impossible to do consistently with any success. There is no way to be certain of the outcome when it comes to investing. We don't know when we hit a bull market or bear market or encounter a recession.

What we can do, is put together a financial plan, stay focused on that plan, and create an investment plan that aligns with our goals while also managing risk.

With all that said, I like to explain exactly what my investment philosophy (and what the specific investing styles are within) is so that my clients (and prospective clients) understand the "why" behind my recommendations and feel informed about where their money is going.

Diversification in Both Investments and Styles

You may have heard the term "diversification" when it comes to investing. It's the notion that rather than putting all your money in one place (like a single stock) it may make sense to spread out your money across many different stocks, bonds or other investments. This helps reduce the risk that comes with tying your money to one source. Think of it as "not putting all your eggs in one basket."

Example: if you have $100, you could invest it all in a single stock with a single company. If the company does well, the stock's value might go up. It it does poorly, the value might go down. Either way, you are tied to the performance of one company. This may sound a bit risky. However, if you wanted to diversify, you could put $10 into 10 different companies so that you spread the risk out more.

This is what a mutual fund is. A mutual fund typically has a large assortment (sometimes hundreds) of different stocks and/or bonds inside of it so that the risk is spread out across many different companies or entities. Sounds less risky, right?

Beyond that, there are many different types of mutual funds. You can find mutual funds made up of large companies, small companies, tech companies, health care companies, real estate, biotech and just about any sector of business. Additionally, you can find mutual funds that are U.S. based, international or a blend.

It's wonderful to have so many choices because it allows us to customize our investments, but of course, it can also be overwhelming. This is why I work with my clients individually to create an investment plan that aligns with their goals and their lives.

Aside from all the diversification built into the landscape of mutual funds, there are also investing philosophies or styles that can lead to heated debates among those who like that sort of thing.

I align with three investing styles: active management, passive management, and Dimensional. I will explain each one next.

Active Management

Active management is an investing style that ties to a belief that you can time the market to some degree and choose investments that are likely to be winners. Actively managed mutual funds are overseen by fund managers who take an active role in updating the stock and/or bonds inside of the fund.

An active manager may study trends, research specific companies, analyze data and generally attempt to buy investments that they feel are going to do well while selling off investments that they feel will perform poorly.

This sounds great in theory, and many people believe that is it. Analyzing the performance of active mutual funds in various time periods does show that they sometimes do better than the market averages overall.

This investing style is popular with many financial educators including Dave Ramsey.

Many actively managed mutual funds have outperformed the overall market and so there is always a chance that an active fund may continue to perform well. Like all investing, it's a risk. But many people feel that if they do enough research and evaluate funds based on criteria that they feel comfortable with, that they can find good candidates. This may include analyzing the specific companies inside the funds, looking at the fund's track record, or even learning more about the fund manager(s).

One potential downside to be aware of with actively managed mutual funds is that they tend to be more expensive (noted by a higher expense ratio) than passive funds (more on that later) because the fund managers are taking an active role in management.

Passive Management

Passive mutual funds are the opposite of active funds. A common phrase used to describe the difference is "active funds try to beat the market while passive funds try to be the market." Passively managed mutual funds make no attempt to buy and sell stocks to find winners and losers. They simply align with a market index and follow it.

A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. Some examples of market indexes include the S&P 500, the Russell 2000, the Russell 3000, and the U.S. Aggregate Bond Market. There are also specific sector indexes like technology.

Passive funds subscribe to the belief that it's not practical to try to beat the market. Many sources say that active funds only beat the market about 20% of the time and so it makes more sense to simply invest in the market as-is.

Because passive funds (also called "index funds") do not require a lot of management, they tend to be lower cost. Since there is very little buying and selling going, the expense ratios of passive funds tend to be a lot lower.

Passive investing was made popular by Jack Bogle, the founder of Vanguard. He believed in low-cost index funds and started a movement in passive investing that is very strong today.

Exchange-traded funds (ETFs) also generally fall into the category of passive funds or index funds.

Many people strongly believe that passive investing is the best way to achieve your goals and there is data that supports this belief. The primary driver of interest in index funds is the low cost.

Dimensional

So we've discussed active and passive management. However, there is a style that is not necessarily all one or the other. Dimensional Funds offers an alternative to either end of the spectrum with a unique process and perspective.

Dimensional Fund Advisors is a mutual fund company that manages a set of funds that take a scientific approach to achieving returns. From the Dimensional website:

"Dimensional’s investment approach is grounded in economic theory and backed by decades of empirical research. Our internal team of researchers works closely with leading financial economists to better understand where returns come from.

Research has shown that securities offering higher expected returns share certain characteristics, which we call dimensions. We structure broadly diversified portfolios that emphasize these dimensions, while addressing the tradeoffs that arise when executing portfolios.

Every day our Portfolio Managers and Traders seek to balance costs against expected returns and diversification. We work for the slightest expected gain, as every incremental improvement can add up over time."

Many view Dimensional's approach as a hybrid between active and passive investing. It's based on passive investing as a foundation but it does take a more active approach than the typical index fund. Additionally, many view it as a more scientific and research-backed method than the typical active fund management approach.

Dimensional's track record seems to support this approach. Over the 20-year period ending December 31, 2018, only 17% of actively-managed mutual funds outperformed the market. In comparison, 85% of Dimensional Funds outperformed the market during this same time period.

Additionally, Dimensional Mutual funds tend to have lower costs than actively-managed funds and often have expense ratios that are more in line with index funds.

Dimensional Funds are not available to the public and are only available through approved financial advisors.

For more information, you may want to download this brief overview called "Transforming Lives through Financial Science".

Diversity in Philosophy and Styles

So how should you be investing? Active? Passive? Dimensional? There is no definitive answer (sorry). Everyone has unique needs, goals, challenges, opinions and life situations. There is no one size fits all.

So how do I approach investing with my clients?

I prefer to include all of these styles in the conversation and the planning process. There are a lot of things to consider when creating an investment plan. Time horizon, life situation, goals, opinions, preferences, attitudes and financial numbers all play a part in creating an investment plan.

For many clients, a blend of styles often makes sense so that you achieve diversity across more than one style of investing and can take advantage of the positive aspects of each. For others, their preferences and opinions might dictate a stronger tilt toward one style over another.

Ultimately, it's your money. You have the final say on what you do with it. My goal is to help add clarity to the conversation and to provide guidance and recommendations that are designed for your specific situation.

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