Investment Strategy
Financial Innovations provides a clearly defined approach grounded in academic science, with a focus on investing, not forecasting. Differentiated from traditional investment management where the primary objective is to beat the market by stock picking or market timing, we work diligently to invest consistently apply the following financial principles:
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Markets Work
Markets throughout the world have historically rewarded investors for the capital they supply. Companies compete with each other for investment capital, while investors compete with each other to find the most attractive returns for their capital. This fierce competition helps to drive prices to fair value or towards price equilibrium.
Security prices change every day as they incorporate new information about changes in expectations and opinions of all market participants. Because the current price of an individual security reflects all current information that is currently known , we believe the current price is typically the best approximation of actual value.
Traditional investment management tries to taking advantage of pricing "mistakes" by speculating on future prices. While often a costly exercise for the traditional market investor, this is great news for the long term investor. It means that prices for public securities are fair and that persistent differences in average returns are explained by differences in average risk. Financial Innovations rejects speculation, forecasting and guessing. Instead, we focus our efforts on understanding where risks comes from and continually monitoring how much to take.
Risk & Return Are Related
In order to have real returns, investors must take real risks. In theory, risk-free investments do exist. For US investors, T-bills (1-month or 3-month) are commonly used to benchmark the return available for risk-free investors. Although T-bills are very conservative investments, in practice, they do actually carry some investment risk. Investing in anything that has an expected return greater than t-bills assumes real risk.
There are many risks when investing, but there are three primary risk and return relationships to consider when building a portfolio:
- Market Factor - First, equity markets (stocks) are riskier than credit markets (bonds); therefore, stocks have greater expected returns than bonds.
- Size Factor – Second, smaller company stocks are riskier than larger companies; therefore, small company stocks have higher expected returns than large company stocks.
- Price Factor – Finally, growth stocks have a higher price per share compared to value stocks relative to book value or earnings. Investors are generally willing to pay more per share for companies that are more “healthy” or established. Investing in lower priced stocks generally provides greater upside compensation as these companies prices reflect higher underlying risk.
As with equities, the risk and expected return of fixed income securities are also related. Understanding this relationship enables investors to plan the total risk/return profile of their Portfolio. The two primary risk factors that we consider when looking at fixed income are:
- Maturity – Longer-term bonds are riskier than shorter-term bonds.
- Default – Bonds with lower credit quality are riskier than bonds with higher credit quality.
Financial Innovations believes that increasing bond portfolio durations generally provides smaller incremental returns with higher incremental risk. Our fixed income portfolios are global in nature with focus on short-term (less than five years), high-quality (investment grade) instruments.
Diversification Is Essential
While some risks are worth taking, some are not. Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on "information" from rating services. Proper diversification eliminates many avoidable risks including the random movements of individual securities while ensuring your Portfolio captures broad market returns.
Financial Innovations portfolios are invested in over 12,000 securities through a full range of global asset classes . Utilizing structured asset classes allows the investor to benefit from the different roles that each asset class provides. Investors have the ability to achieve greater expected returns with more consistency than they would in a less comprehensive and diversified approach.
Investing Requires Long Term Discipline
Investing, by definition requires a long-term discipline and perspective. The alternative to taking a long-term view; placing money at risk for a short-term, is generally called gambling or speculating. We never endorse this. When making decisions in life regarding money, family, career or relationships, the longer the term considered, the better the results. The chart below compares 1 Yr., 5 Yr., and 10 Yr., holding periods returns of the US stock market from 1927 to 2008.
Asset Allocation Determines Risk
Nobel Prize winner William Sharp says, “It is generally agreed by theoreticians and practitioners alike, that the asset allocation decision is by far the most important one made by an investor.” The Financial Analyst Journal published a study by Brinson Hood & Beebower to determine the effectiveness of security selection, market timing and asset allocation of the largest U.S. pension plans. The results indicated that asset allocation explained 94% of investment performance.
Financial Innovations combines many classes of securities, including stocks and bonds, both domestic and international into customized structured portfolios. In general, the greater the proportion of stocks a portfolio holds, especially small cap and value stocks, the more "aggressive" its profile. The higher the risk, the greater is its expected return. The following chart illustrates different portfolio models and their risk return relationships.
