Investing 102: Understanding Our Investment Philosophy

Building on our discussion of basic financial concepts in “Investing 101,” the following reviews slightly more advanced concepts, which are integral to understanding our firm’s investment philosophy and best practices for investing over the long-term.

Asset Class. An asset class is a category of investments that behave in a unique fashion as compared with other investments. Asset classes divide up the markets by geographic locations, size and relative value measures (see below). They include U.S. large growth stocks, U.S. small value stocks, international large value stocks, real estate securities, emerging market stocks, bonds, etc.

• Large vs. Small Stocks. When investors categorize companies as “large cap” or “small cap,” they are referring to the company’s capitalization, i.e. the value of the company’s outstanding stock (market cap = # of shares outstanding x price per share). Large companies are generally defined as having a market cap of over $10 billion, small companies under $2 billion, and mid caps in between.
• Growth vs. Value Stocks. Growth companies are generally those that reinvest a higher proportion of profits into the company in pursuit of future growth. Unlike value companies, growth companies do not generally pay high dividends to stockholders. Most of the returns earned on growth stocks will come from price appreciation (i.e. the price of the stock increasing over time). Value companies include companies that are “out of favor” with investors, in some cases because their initial business or product line has dried up and they are attempting to reinvent themselves, as well as companies that produce steady but unremarkable profits, such as utility companies.

The concept of asset classes is essential to understanding the benefits of diversification.  If, for example, you hold five different mutual funds, but they are all “balanced” funds that invest in U.S. large growth stocks, international large growth stocks, and bonds, then your portfolio is not very diversified.  Despite holding five different funds, you are only invested in three types of assets.  These funds are likely to perform similarly over time.

Active vs. Passive Management.  Active managers try to pick the “hot” stocks that will do particularly well (i.e. “outperform the market”) in a given period of time, and they try to avoid expected losers.  Passive managers try to simply match the returns of a market index or capture the returns of a specific asset class.  Both methods carry risk, however, in that they involve investing in the market, an inherently risky business.

Market Index.  An index is a broad compilation of stocks or bonds, which is used to gauge the direction of the market as a whole or segments of the market.  Examples of market indices include the S&P 500 (which is comprised of 500 large U.S. companies), the Dow Jones Industrial Average (30 large U.S. companies), the Russell 2000 (2,000 small U.S. companies), and the MSCI EAFE (approximately 900 large and mid-size non-U.S. companies).  (Note that you cannot directly buy shares in an index.  Some investments may try to mirror an index, e.g. the Vanguard 500 mutual fund tries to mirror the S&P 500, but they will likely underperform at least slightly due to the costs of buying, selling, and maintaining the investments in the portfolio.)

At PFS, our investment strategy focuses on using passively managed mutual funds.  Each fund invests in one asset class, giving us the tools to create fully diversified portfolios at a low cost.  We then tilt client portfolios toward the asset classes that have been shown to outperform over time and capture the benefits of diversification through regular rebalancing (which will be discussed further in a future post!).