COLUMN OF KNOWLEDGE

Do-It-Yourself Investors: Beware

By Phil Henry
“What’s the big deal,” you might say to yourself. “There are thousands of individual stocks or other investments to choose from. If I pick a bad one, I’ll sell it and buy something else. Why should I incur extra expenses to involve a financial advisor like you, so you can allocate my money across various asset classes as you call them?”

Financial planners commonly refer to this type of individual as a “do it yourselfer,” or DIY. Believe me when I say that my peers and I do not want DIYs as clients. Of course, the feeling is mutual. To us, DIYs allow the fee tail to wag the dog, and may cause unnecessary harm to themselves owing to a lack of diversification and understanding.

To be sure, there are many DIY success stories, such as those who placed huge bets on Microsoft near its inception. Locally, those who have over weighted their portfolios onto Matthews International have been rewarded handsomely. But for every success story, there are an equal number of DIYs who have faced financial ruin. Think of employees with 100% of their 401Ks allocated into the stock of companies like Enron, Tyco, or U.S. Airways. I don’t mean to wax psychological here. After all, I am Phil Henry, not Dr. Phil. I’m just trying to understand what makes a DIY tick.

Someone innocently says, “But I own five, different investments. Isn’t that enough diversification?” If the combined holdings comprise the spectrum of available asset classes, then yes. But if the majority of the holdings in those funds are invested in similar companies, that would be akin to having a five-course meal with potatoes as the appetizer, followed by potato soup, potato salad and mashed potatoes, and you guessed it, potato pie.

So what is asset allocation and why does the majority in my field kneel at its altar? By definition, asset allocation is a disciplined, long-term financial strategy for investing money into various asset classes based on your investment goals, time horizon, and risk tolerance.

Asset allocation can help to reduce your investment risk and optimize your potential return by using a strategic mix of asset classes rather than trying to pick the best- performing investment. Asset allocation, however, does not assure a profitable portfolio nor does it prevent losses.

With asset allocation, your investments are spread among various asset classes, such as stocks, bonds, and cash. Within these broad categories, there are different types of stocks and bonds, as well as different investment strategies, such as growth and value investment styles.

In any given year, one asset class will win, another one will lose, and the rest will fall in between.

An investor who minimizes the number of asset classes may risk taking on more volatility. This added volatility can help or hurt portfolio performance in a given time period.

An elementary, yet extreme, example may drive the point home. Let’s say astute investor, Johnny DIY, is over weighted in one particular asset class and as a result, gains 100% in year one, but then loses 50% in year two. Alternatively, the results could have been the exact opposite, a loss of 50% followed by a positive rebound of 100%. So where’s the evil in this? Johnny is still ahead by 50%, right? Do the math and start with a sample $10,000 portfolio. In both cases after year two, Johnny retains only his originally invested amount, for an average return of 0%.

“Yes, but I would have timed the market to avoid the losses,” says Jane DIY! To this, I’d reply, “Jane, Jane, Jane. Please don’t tell me what you would have done. Show me exactly what you did, or more important, what you will do going forward into the uncharted waters that lie ahead. ‘Would’ is not reality, but wishful thinking.”

There will always be successful DIY stories. Whether by sound strategy or by sheer luck, my hat is off to those who succeed. For the majority of those who cannot afford to take on additional risk, an investment portfolio built around the sound principals of asset allocation is just what this Dr. Phil orders.