Investing Glossary

Modern Portfolio Theory (“MPT”) refers to an investment technique which suggests that each investment should be considered for its effect on the overall portfolio.  A wisely chosen portfolio will tend to maximize expected long-term return for some value of risk/volatility or, equivalently, minimize risk/volatility for some expected long-term return. 

Mutual Funds are investment vehicles whereby many investors buy shares in the fund, the proceeds of which are then used to purchase an array of individual investments.  Mutual funds are the most efficient way for all but the largest institutional investors to achieve a diverse portfolio.

Risk Tolerance refers to a person’s individual comfort level with various types of and levels of risk/volatility.  In general, the investments which return the most in the long run tend to be the riskiest. But a particularly volatile investment that one person may be completely comfortable with may prevent another person from sleeping at night.  Therefore, assessing each client’s personal level of risk tolerance is central to determining an appropriate asset allocation.

Small Company Stocks have been shown to perform better over the long term than large company stocks, although they are riskier.  But as MPT has shown, it is not the risk of the individual asset that matters but the contribution of risk by this individual asset to the portfolio that matters. If appropriate, we normally allocate a small portion of your portfolio to small cap funds.

Asset Allocation refers to the allocation of a portfolio across asset classes.  For example, one could allocate various percentages of their assets to each of the following asset classes: Large US Stocks, Small US Stocks, US Bonds, and International Stocks.  Several academic studies have shown that, on average, over 90 percent of the variability of a portfolio’s performance over time is solely attributable to the portfolio’s asset allocation. Therefore, the asset allocation decision is by far the most important in the financial planning process and should be made early in the process.  We consider this decision to be central to selecting an appropriate investment portfolio.

Diversification refers to spreading your investments over many asset classes and, within each asset class, over many individual assets.  The old adage, “Don’t put all your eggs in one basket” applies.  In fact, prudently selecting how to spread your portfolio can actually increase your expected long-term returns while decreasing your portfolio’s expected long-term risk/volatility. 

Efficient Market Hypothesis ("EMH") refers to an explanation of market pricing.  EMH suggests that, in a market where information is free flowing and where there are large numbers of rational, profit maximizing participants, prices always reflect all available information about that asset.  An interesting corollary is that the market’s best guess at each stock’s future prospects is already “built into” the stock’s current price.  Therefore, unless you are either smarter than the rest of the market or more lucky, there is no way of consistently outperforming it through fundamental analysis (or technical analysis — a.k.a., "charting").  That doesn't mean that there are no prudent investing strategies — it just means that fundamental analysis and technical analysis aren't among them.

Growth Investing refers to a strategy of buying stock in companies which are expected to grow quickly.  Growth stocks tend to be overvalued compared to the “book” value of the company.  This is the opposite of value investing.  Recent academic research has shown that value investing tends to give superior long term results with less long-term risk/volatility than growth investing.  Therefore, we tend to recommend that growth funds be somewhat underweighted in some portfolios.

Value Investing refers to a strategy of buying stock of companies which are undervalued compared to the “book” value of the company. We normally recommend that value stocks be somewhat over weighted in most portfolios

Indexing refers to investing in index mutual funds.  Index mutual funds are a type of mutual fund which attempts to match its investments to those in an index.  As an example, many index funds mirror the S&P 500 index.  In other words, those funds invest in substantially all the individual stocks making up the S&P 500 index in substantially the same proportions in which the stocks are represented in the index.  Studies have consistently shown that, in the long run, the average mutual fund tends to perform worse than the index which best represents its investment philosophy.  This, combined with the fact that index mutual funds tend to be more highly diversified, have lower fees, and may be more tax-efficient than their non-index counterparts, makes them preferred vehicles for investment. 

Investment Time Horizon refers to the amount of time between now and when you expect to use the money from an investment.  As an example, if one intends to buy a house in five years, their time horizon for that purpose is five years.  Conversely, a 25-yr old person saving for their retirement has a time horizon of at least 35 years for those assets.  It is usually appropriate for the amount of risk/volatility in one’s portfolio to be proportional to their investment time horizon.  This is because, in the long run, one tends to be rewarded with higher returns if one accepts higher risk/volatility.  But if one needs the money soon, one can less withstand the dramatic short-term downturns that are expected from more risky/volatile investments. 

Market Timing refers to a strategy of buying stocks and other securities at the “right” time (i.e., when the price is low, ideally at its lowest point) and selling them at the “right” time (i.e., when the price is highest, ideally at its highest point).  Unfortunately, one only knows the “right” time after the fact.  There is no way of knowing in advance what is going to happen in the future.  In fact, studies have shown that investors tend to have a knack for buying and selling at precisely the “wrong” times.  It is not possible in the long run to successfully (and consistently) time investments or divestments in order to gain an advantage over other investors.  In fact, attempts to do so usually have a detrimental effect on returns.

There is very little credible evidence that it is possible in the long run for anybody to successfully predict which individual investments will produce superior risk-adjusted results in the future.  If it were possible, mutual fund managers would certainly successfully and consistently be doing it. But the evidence is clearly to the contrary: in the long run, the average non-index mutual fund performs worse than the average equity in its investment universe after fees and expenses. Buying individual stocks also makes it expensive and difficult, to say the least, to assemble an adequately diversified portfolio.