Investing Principle 6: Go with the Pros

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
August 28, 2008

The seventh article in an 11-part series on Schwab's investing principles.

It's time to shift gears a bit as we look at Schwab's Investing Principle No. 6: Choosing professionally managed investments can be a better way to invest.

Until now, our series on investing has emphasized:

The importance of understanding your financial goals.
The ways in which an investment plan will help you achieve your goals.
The importance of savings.
The importance of diversification.
The necessity of an asset allocation plan.

The topics above are incredibly important. Think of them as the building blocks for the foundation of a home: It isn't noticeable from the street and future buyers probably won't ask about it if you choose to sell the home, but a strong foundation is essential for your home to survive for the long-term, and having a solid foundation for your financial life is just as important.

3 important steps	10 proven principles
Create a plan	1. Having an investment plan that is realistic and actionable is crucial to meeting goals. 2. Understand your plan, follow it and adjust it when things change in your life.
Put it into action	3. Saving and spending rates have the greatest impact on success. 4. Diversification is the second-most important factor in reaching goals. 5. Select the asset allocation that’s right for you and stick with it. 6. Choosing professionally managed investments can be a better way to invest. 7. Acting now generally beats waiting.
Stay on track	8. Periodic checkups keep a portfolio healthy. 9. Progress toward goals is more important than short-term performance. 10. Use the right benchmarks to evaluate performance.

Let's assume that your foundation is in good shape. Principle No. 6 raises a simple question: Once your investment plan is in place, how do you go about implementing that plan?

For example, let's say you've considered your situation and decided that a moderate asset allocation—in between aggressive and conservative, with an allocation of 60% stocks and 40% bonds—is right for you. Now's the time to ask yourself the following questions:

How do I decide which stocks make up my 60% allocation?
How do I decide which bonds make up my 40% allocation?
Do I manage my portfolio myself?
Do I rely on professional managers?
If I use professionals, which ones make the most sense?

To help make sense of it all, let's address the most important question first: Should you manage your portfolio yourself?

I have no doubt that individual investors who make all of their portfolio decisions themselves can be successful. However, that path is not right for everyone. The way I see it, there are three prerequisites to successfully managing your own portfolio:

You need the expertise.
You need the time.
You need a certain portfolio size.

You need the expertise
Deciding which stocks and bonds to buy and sell on an ongoing basis is a skill that can be learned. If you've taken the time to educate yourself in this area, terrific! By doing so, you've cleared the first hurdle. If you haven't quite cleared the hurdle, I believe it makes sense to use investment vehicles like mutual funds and separately managed accounts. When you go down this path, you are, in effect, paying someone a management fee to make those buy and sell decisions on your behalf.

You need the time
To do the job right, you need expertise and the proper time commitment. Without both, you won't get very far. Thanks to advances in technology and the enormous wealth of information that individuals have at their fingertips, analyzing the market, sifting through thousands of possible securities, making the right calls and monitoring your positions is more possible than ever.

At Schwab, we see knowledgeable investors everyday who enjoy the analytical process and commit the necessary time. Are you one of them? If not, that doesn't mean you should stop investing, it just means you need to seek out the services of a professional manager and allocate your time to evaluating their performance.

You need a certain portfolio size
Think back to principle No. 4, where we discussed the importance of diversification. If you want to build a bond portfolio yourself, buying a few bonds here and there (or, if you're building an equity portfolio, buying a few stocks here and there) isn't going to cut it. To build a well-diversified portfolio of individual bonds requires about $50,000 minimum—if the bond portion of your portfolio is less than that, you're better off (in my opinion) with a mutual fund.

The same principle applies on the equity side. There's no hard-and-fast rule here, but you'll probably need about 30 to 40 holdings to get a well-diversified portfolio of large-cap stocks. Throw in similar numbers for small-cap and international stocks and you'll see why many equity investors prefer to use mutual funds or separately managed accounts.

Individual stocks vs. mutual funds
The issue of achieving adequate risk reduction through diversification is an important one. On a couple of occasions, Schwab has studied this topic using the performance of our actual clients. In both studies, we took aggressive clients—defined as those with all of their money in stocks—and divided them into two groups. The first group invested in individual stocks; the second group invested in equity mutual funds. When we tracked the performance of the two groups, what we found was that, in both cases, the average portfolio in the mutual fund group exhibited half the volatility. What was also striking was that the returns of the mutual fund group were slightly better as well.

Do it yourself?
Once you've established a solid foundation for your investment plan (complete with a long-term asset allocation), you need to figure out how you're going to go about deciding what specific investments to make in order to implement that plan. The first decision is whether to do it yourself or seek the services of a professional money manager. The do-it-yourself route is sensible as long as you have the expertise, are willing to commit the time and have a large enough portfolio to make it worthwhile. If you lack any of these three, I think you're better off using mutual funds.

How do you pick good funds? That's a big question and beyond the scope of this brief discussion. Luckily, we have a number of articles that describe how we go about analyzing mutual funds in an effort to separate the good from the mediocre. We also have our OneSource Select List® where we showcase what we think are some excellent funds in a wide variety of categories.

Index funds vs. actively managed funds
There are some fundamental, philosophical differences when it comes to deciding how different types of funds are managed. One of those philosophical differences is best illustrated by considering the difference between index funds and actively-managed funds. Index funds are mutual funds that typically have low management fees and whose goal is to track an index (e.g., the S&P 500 index).

Conversely, actively managed funds aim to beat the index by exploiting "inefficiencies"—situations where the market price isn't a fair reflection of the true value of the security—in the prices of stocks and bonds. For example, if a lot of inefficiencies are present, there are bargains to be had for portfolio managers clever enough to find them. These clever portfolio managers can improve performance by buying up stocks that are underpriced and avoiding those that are overpriced.

Do enough bargains exist under real-world conditions to make active management worthwhile? We think index funds are wonderful investments, but there are enough situations where the market gets it wrong to justify the existence of active management. That's why we offer Schwab Equity Ratings—a tool that helps Schwab clients find stocks that are attractive (as well as those that should be avoided).

It's also possible to conduct research on active mutual funds and separate those that are likely to do well from those that are less likely to do well. Earlier I mentioned our Select List of mutual funds, which showcases what we believe to be some excellent funds in a wide variety of categories. Since 1997, we've tracked the performance of each version of the typical list, and about two-thirds of the funds appearing on the list have outperformed their category averages for the five years after appearing on the list. If you're looking for good actively managed funds, we think the Select List is a great place to start your search.

To outsource, or not to outsource?
Creating an investment plan is only the beginning. Once that plan is solidified comes the hard work of deciding exactly how to implement it. After all, a plan is just a piece of paper. If you're going to improve your financial life, start by implementing your plan with some specific investing decisions. Whether you make all the decisions yourself or use the services of outside experts, get started today.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Charles Schwab & Co., Inc. member SIPC, receives remuneration from fund companies participating in the Mutual Fund OneSource™ service for record keeping and shareholder services and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services.

The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Investments in managed accounts should be considered in view of a larger, more diversified investment portfolio. In addition, international and small-cap styles and investment concentrations in certain sectors are subject to greater volatility and therefore a greater degree of risk than portfolios that are more diversified across sectors or styles.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by marketing capitalization) U.S. headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Examples provided are for illustrative purposes only and not intended to represent results you should expect to achieve. Past performance is no guarantee of future results.

Diversification strategies do not assure a profit and do not protect against losses in declining markets. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations and other factors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

©2008 Charles Schwab & Co., Inc. Member SIPC. All rights reserved

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Resources

Mutual Fund OneSource Select List

Schwab Equity Ratings

Schwab's Investing Principles

Intro: Becoming a Successful Investor

1. A Blueprint for Success

2. Stick With Your Plan

3. The Top Success Factor

4. Diversification Is Key

5. Get the Mix Right

6. Go With the Pros

Coming soon
7. Act Now, Don't Wait
8. Get Regular Checkups
9. Keep Your Eyes on the Prize
10. How to Measure Success

See also

Our time-tested approach to investing

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