Understanding Equities - How To Choose The Right Equity Investment
When creating an investment portfolio, equities are likely going to comprise the largest overall percentage. Typically, equities refer to stock certificates representing ownership in the underlying organization or company. Buying shares of a company’s stock means that you have some direct ownership in the underlying company. If you purchase shares through other methods such as index funds, mutual funds or options, this method is referred to as a proxy.
How to Choose Equities
You can invest into the equities market direct through the purchase of individual shares of stock, or you can purchase mutual funds. A mutual fund is a pooled investment offered only by a prospectus that invests in accordance with the fund’s stated objectives. Your funds will be pooled with other investor’s funds. The portfolio manager will utilize the funds to select and purchase investments on behalf of the group. Fund managers may purchase stocks in various industries, sectors or by following an asset class approach.
Asset Class Investing
Asset classes refer to groups of securities which share a similar underlying risk element. Each asset class will perform differently as market changes occur. For example, small company stocks and large company stocks will react differently to certain underlying market conditions. Asset class investors believe that by properly positioning their portfolios across asset classes, they will be able to leverage this diversification effect in order to achieve their desired portfolio return.
Here are some of the most common reasons this strategy is not leveraged by individual investors:
Most investors don’t fully understand the power of portfolio diversification. Diversification functions to improve returns, not to diminish them. Therefore, investors should be educated about the potential benefits of this strategy.
Many investors want to lean on the strategy of market timing with their portfolio.
An investor’s psychology prevents them from considering investment options outside of their comfort zone, often domestic securities.
The world’s leading academic economists conducted extensive research and found that asset class selection, not market timing, is the most important determinant of a portfolio’s performance. In their research process, these researchers discovered that:
- Markets process information so quickly that it is challenging to gain a competitive edge by taking advantage of market anomalies.
- Over time, riskier investments will provide greater returns, compensating investors for accepting greater risk.
- Adding higher risk, low correlating asset classes to a portfolio can work to effectively reduce portfolio volatility and increase returns. What does this mean? When some assets increase, others decline. Therefore, by diversifying your portfolio across multiple asset classes, you will be well positioned to take advantage of the positive market movements, not chasing them.
- Passive asset class portfolios can deliver the strongest investment for your given level of risk tolerance over time.
How you choose to leverage asset class investing in your overall investment plan will be dependent upon your investment goals, personal financial situation, investment time frame and your personal tax situation.