Q: I am taking your advice and looking over my investment portfolio of mutual funds to determine whether or not it is designed in a way that should help me meet my goals. What kinds of things should I be looking at?
A: Good question. If you are going to manage your own portfolio, then you have a lot to learn. I'll introduce you to some of the terms you should be familiar with.
1. Asset class: Each mutual fund in your portfolio falls into one or more asset classes. The term asset class is just a category of investments. Large U.S. growth stocks, small U.S. growth stocks, and short-term government bonds are examples of three different asset classes.
2. Asset allocation: Many investment managers, backed by academic research, feel that how you allocate your assets within your portfolio is the most important determinant of the overall long-term performance. The percentage of your portfolio holdings in each asset class (the "asset mix") represents your asset allocation.
3. Total return: Your portfolio will generate income in the form of interest and/or dividends. Stocks in your portfolio should, over time, go up in value. Total return is the combination of this income and capital appreciation.
4. Yield: Each asset class may provide income in the form of interest or dividends. Bonds will generate interest. Stocks may pay dividends.
5. Efficient frontier: This term, from Modern Portfolio Theory, represents the place where you want your portfolio to be.
If you make a x-y graph on a piece of paper with the x-axis representing return and the y-axis representing risk, you can plot the asset mixes that provide the best trade-off between risk and return. If your portfolio is on this "efficient frontier" then you are taking the least amount of risk necessary for your assumed return. In other words, you are getting the maximum available rate of return for a given level of risk.
6. Risk: You cannot know ahead of time what the investment performance of your portfolio will be. For example, you may expect it to be plus 8 percent per year, but it may actually be plus 4 percent or minus 10 percent. That deviation from the expected return is the risk you take when you invest. Investment professionals normally use the statistic known as standard deviation to measure risk. Assets mixes that have relatively low risk are considered conservative. More aggressive portfolios have more risk.
7. Sharpe ratio: This statistic measures the added return you may achieve by taking additional risk. The higher the better.
8. Capture ratio: I introduced capture ratio in last week's column. It will tell you how much a mutual fund will go up or down relative to the movement of its benchmark. If you have the right software, you can calculate the capture ratio of your overall portfolio against your portfolio benchmark. Ideally, you will capture 100 percent or more of your benchmark's upside movement and less than 100 percent of its downside movement.
If you really want to take a shot at managing your own portfolio, learn how to do it right. Do some research. There are plenty of books available that focus on building a good investment portfolio.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth Inc. in Monterey. Send questions concerning investing, taxes, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or firstname.lastname@example.org.