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 group of investments that share similar characteristics and behave in a unique fashion as compared with other investments. Equities (i.e. stocks), fixed-income (i.e. bonds) and cash are common asset classes you may recognize from your portfolio, but other asset classes include real estate, commodities like gold or silver, cryptocurrencies, and even rare collectibles like fine art.

Asset classes can be further divided into categories based on specific attributes, such as geographic location, size and relative value measures. For example, stocks can be identified as U.S. large growth stocks, U.S. small value stocks, international large value stocks, emerging market stocks, etc. Below is a breakdown of some common characteristics used to differentiate asset class categories for stocks.

• Large vs. Small Stocks.  When investors categorize companies as “large cap” or “small cap,” they are referring to the company’s market capitalization, which is 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, and in other cases because they produce steady but unremarkable profits, such as utility companies.  In the auto industry, one example of this distinction is Tesla (growth company) versus Toyota (value company).
• Domestic vs. International Stocks.  Domestic stocks represent companies based in one’s home country – in our case, the United States – while international stocks represent companies based outside of one’s home country. However, a fund labeled as “international” typically includes only companies from “developed” countries with relatively stable economies, such as Japan, Germany and the United Kingdom.  Companies based in more volatile economies are considered “emerging markets,” which include countries like China, India, and Brazil. There are also “global” funds, which invest in securities from all parts of the world, including U.S., developed and emerging markets.

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 equally 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 general stock market) in a given period of time, or they try to predict future market movement, shifting funds into cash in expectation of a downturn and back into stocks when they anticipate a market rise.  Passive managers try to simply match the returns of a market index.  Both methods carry risk because they involve investing in the market, an inherently risky business, but actively managed funds involve an additional layer of risk since the manager might guess incorrectly in his or her attempt to pick hot stocks or time the market.  Actively managed funds are generally more expensive (i.e. have a higher expense ratio) than passively managed funds. 

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 the returns of these investments typically underperform the index 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 mutual funds and exchange-traded funds that provide wide diversification across asset classes at a low cost.  We use funds that avoid the timing risk and cost of actively managed funds while providing more trading flexibility than an index fund.  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.