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The Meaning of Measures: How to Select Investments
By Lyn Dippel,
Look at any investment journal or Morningstar report and there is
enough technical jargon and numbers to make you cross-eyed. How do
you know what measures or indicators to consider when selecting
investments?
It has been our experience that the average investor chooses
investments in the following ways: They select those that are
highly rated (such as Morningstar’s 4 or 5 star rated
investments), investments that have generated the best returns
over the past year or several years, investments that are
recommendations of financial publications such as Money magazine
and/or investments that appear as one of the quarter’s top 25%
performers. There are two problems with that strategy.
First, different types of investments perform better in different
economic conditions. By choosing investments that are generating
the highest returns at any given time, you may not end up with a
broadly diversified portfolio. When the conditions change,
investment results will likely change as well. For example,
growth-oriented investments overall did particularly well from
1995 to 1998, whereas in 2000 and 2001 value style investing
generated the best returns. *In 1985-1987, international stocks
generated terrific returns, but subsequently did quite poorly as a
class from 1990-1992. Before focusing on individual investments,
it is important to determine an overall strategy that will include
investments of different types, styles, sectors and/or geographic
influences. This is referred to as a portfolio allocation.
Second, annualized returns or average returns over time do not
tell the whole story! By focusing the selection process on
performance, the average investor is ignoring risk. Some of the
top performing investments may also have higher risks associated
with them. One measure of risk is standard deviation. This is a
highly technical term that boils down to measuring how much
variation there is in the return of a particular investment over
time. The higher this number is, the larger the swings in results.
For example, consider this hypothetical scenario: Investment “A”
had terrific returns for a couple years and then had some negative
returns. Investment “B” had less exciting returns those first
couple of years, but maintained these returns for the next couple.
These two investments could have the same five-year annualized
return, but “A” has a considerably higher level of volatility.
Volatility is not inherently bad, but what level is acceptable
will depend on how long it will be before you might need to use
the money and how sensitive you are to seeing negative returns.
Other factors to consider beyond performance for managed
investments include; how long a particular manager has been
managing the investment and what their experience level is, how
closely they stick to their stated investment style, how many
holdings there are (higher numbers generally mean greater
diversification), what the investment turnover is (meaning how
long the average investments are held, which may affect your
taxes) and how high the management fees are compared with similar
investments.
*Ibbottson: Annual Asset Class Returns for Key Indices 1982-2002.
Past performance does not guarantee future results.
In addition to being the mother of two, Lyn Dippel is an attorney,
financial planner and co-founder of Symphony Financial. She offers
securities and investment advisory services through Cambridge
Investment Research Inc., a Broker/Dealer, Member NASD/SIPC and a
Federally registered Investment Advisor. For more information
about this topic or to receive a “Test your Financial Fitness”
checklist call 703-481-9876 or visit
www.symphonyfinancial.net
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