RUNNING HEAD: LASTING INVESTMENT SUCCESS

Investment Research Paper: A Guide to Lasting Investment Success

Ryan T. Smith

Loras College
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Abstract

This paper is a guide to help the beginning investor make sense of the complex investment

world. It lays out a brief overview of the different methods, concepts, vocabulary, and tools

necessary to establish a strong background on investing practices. This guide also contains

recommendations from the author, as well as other respected financial scholars on how to

navigate the world of financial investing. It also provides a three-pronged approach to investing

using the top-down analysis method. The first step, economic analysis, covers how to read and

understand economic indicators and changes and what that means for their investments. The

next step deals with asset allocation and understanding the different asset types available to the

investors. Finally, the last step covers a few different investment theories, in addition to security

selection and the different dynamics of securing profitable investments. The goal of this paper is

to break down the investing world and to make it less intimidating to the average investor, as

well as provide recommendations on how to become a savvy investor.

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After spending the last four months desperately trying to figure out the magical formula

to make above average returns in the stock market, the endeavor has come up fruitless. I can tell

you first hand that the ultimate method to become a successful investor was not what I had in

mind when I first started this class. At the beginning of this class, I believed that all you had to

do was plug numbers into an equation and look at some graphs to understand what would be

profitable in the next quarter, the next year, and the next decade. This was the furthest from the

truth and I paid dearly for it. I want to give a quick summary of my performance so that we do

not make the same mistakes twice. First, we were given $100,000 dollars to invest in whatever

U.S. common stocks we desired. I chose, in my opinion a solid group of diverse stocks. About a

month and a half in, I was probably in the top 40% of the class in terms of rate of return. I

wanted to be in the top 10%, so instead of holding onto my overachieving stocks, I started trying

to beat the market by buying and selling, in my opinion, stocks that were most likely to explode

within the next week or so. I got lucky once or twice, but this is the number one mistake people

make when trying to play the stock market. They try and guess what will happen next, basically

attempting to beat the market, which is a theory we will talk about later, and hope for outstanding

returns. Needless to say, I ended the game with only a 1.67% return over a four month period,

severely underperforming the market average return of about 8% since February 1st. How did

this happened? This is because I did not follow the slow and steady method of investing, but

rather attempting the greedy, get-rich-quick method. This method has been proven to be the

incorrect method of investing for many years, yet people still think they are above average in

predicting what the market will do in the next period. In this paper, I want to outline the world

of investing, explain what I did, what I would recommend now, and then why my

recommendations would be an effective investing strategy.

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Now, where do we start? This is a major life-decision to decide how you will invest your

hard earned money into risky securities in hopes that they appreciate so you can achieve your

financial goals. First, there are two ways to begin, you can either use a bottom-up approach or a

top-down analysis. The first method simply put, is to look at a company that you want to invest

in and research its cash flows, risks, growth prospects, financial ratios, and other financial

information well talk about later. The opposite of that analysis would be the top-down approach

which analyzes the overall strength of the economy, then looks at the health of different asset

classes within the economy, and then finally analyzes and selects different securities based on the

goals of your investments. At the beginning of the investment game, I accidentally performed a

very lackadaisical bottom-up approach for my original investments. I basically looked at what

companies would have a high season in the coming months based on national events such as

holidays, tax season, and the changing of the seasons. This was an effective approach for a very

short-run outlook, but the top-down approach is definitely the best option for long-term

investing. I would recommend the top-down analysis because it takes many more variables into

consideration than the bottom-up approach.

To paraphrase Ellie Williams Investors Desk Preference (2001), The economy provides

a constantly changing environment for investing. Well-seasoned investors will make small

adjustments to their portfolio based on business cycles, economic indicators, and monetary and

fiscal policy changes. (p. 25) Based on this, we can derive that Williams emphasizes the

necessity to look at the overall status of the economy in order to create smart investment

decisions. She explains that understanding where the economy is in the business cycle,

expansion, recession, or depression, paired with knowledge on leading and lagging economic

indicators, and economic reports can give an investor a surface-level snapshot of the health of the
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economy. The primary reports and indicators she used to assess the strength of the economy and

used in the top-down analysis include the real interest rates, the Consumer Price Index (CPI),

Producer Price Index (PPI), and total output or GDP. These indicators or reports inform the

public on the cost of borrowing, price levels, and output from the overall economy. Based on

this information, the overall health of the economy can be inferred, and thus investors can make

more accurate investment decisions that can be used to exploit the economy in whatever stage it

is in. This is the first step in the top-down analysis that I would recommend to all investors who

want to begin investing.

Now the next step in the top-down analysis would be to analyze the strength of different

asset classes within the market. For example, stocks, bonds, cash, international investments, real

estate, and commodities are just a few of the different assets that potential investors could put

their money into. Now based on the research we have already performed on the economy, how

can we use that to analyze these different asset classes? To start, we can analyze general trends

in the market based on economic conditions. During economic expansionary periods, investors

are more likely to invest in riskier companies, start-ups, luxury items, and consumer goods

companies. In economically depressed times, investors tend to put their money into more

physical assets such as land and precious metals, in addition to utility and well-established

companies. Based on the condition of the price levels, interest rates, and overall output, you can

make an accurate assumption on the current state of the economy and where it will be in the

short-run. This will be a sufficient amount of information to make smart investment decisions

for the time-being. After you have created an economic skeleton of the economy, then you can

begin to allocate your assets into different investment options.

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This portion of the overall analysis is greatly underrated and quite possibly could be the

most important part of the method. According to the Essentials of Investments (2013) textbook

in Chapter 18, over 97% of portfolio success has been based on asset allocation. (p. 607) Gary

Brinson, founder of Brinson Partners and author of two books on global investing and asset

allocation, was quoted in Investment Titans (2001) saying, Asset Allocation was more crucial to

investment returns than either the specific stocks you picked or market timing. (p. 180) I will

touch on asset allocation shortly, but first I want to analyze my previous methods of security

selection. During the game, I did not know what asset allocation was, all I knew from previous

knowledge and education was to diversify. So I put some money into stocks, mutual funds, and

index funds. While I thought this would be a sufficient spread in the game, in the real world, it

would not even be close. Even though we could only invest in stock based securities, I would

not recommend what I did. In the real world, I would recommend getting to know your

economic-self first before doing any sort of investing. My following recommendations are based

on Burton Malkiels, author of A Random Walk Down Wall Street, ideas, but have been tweaked

to fit my own opinions. First, I would say to journal about your financial goals and what they

will be in the next year, five years, ten years, twenty years, and then finally at retirement. Next,

you should talk about how risky you are willing to be with your investments. Are you willing to

be very risky, or risk-adverse? Then you should look at your own intrinsic financial information.

How much money do you make, what are you willing and able to save/invest, do you have a lot

of debt, what is your end-all financial goal, and so on. After you have established this, you can

then begin your asset allocation process of selecting the desired types of assets you want to

invest in. Now returning to asset allocation, or the allocation of your investment portfolio based

on asset classes such as stocks, bonds, commodities, cash, international stocks, real estate etc.,
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Burton Malkiel and Gary Brinson both agree that asset allocation is one of, if not the most

important part of your investment strategy.

Before any selection takes place, Malkiel (2013) lists five main principles that he

recommends investors keep in mind while they are selecting their assets. They are: risk and

return are related, holding period return is dependent on your strategy, consistent contribution

amounts are a good tool to use for lifetime investing, periodic reallocation is valuable, and

similar to the reallocation principle, you must reanalyze your financial position on a regular

basis. (p. 360) I want to briefly review these principles and how they can be used within my

investment recommendations. The first principle is self-explanatory, the more return you desire,

the more risk you must be willing to tolerate. If you want to earn above market returns, you will

need to invest in riskier assets such as stocks rather than, for example, safer government issued

securities. This principle aligns with my risk-adverse question everyone should be asking

themselves. Depending on your financial goals, you need to determine what amount of risk and

return you will need to meet them. Following that, the holding period that an investor desires is

important to their financial success. Malkiel (2013) explains, A substantial amount of the risk

of common-stock investment can be eliminated by adopting a program of long-term ownership.

(p. 362) This could mean allocating more of an investors money into larger time frame securities

or planning to hold onto securities for longer than they wouldve anticipated. This is the part of

the questionnaire that I recommended everyone ask themselves about their financial goals during

different timeframes of their life. Next, the recommendation Malkiel makes is to make regular

contributions to your investment portfolio periodically throughout its lifetime in order to assure

continual growth. Now I agree with his idea that regular payments should be made, but I believe

they should be altered based on the health of the market and the financial position of the investor.
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I disagree that the contributions should be the same at each interval. Contrary, they should be a

little higher when the market is down, and a little smaller when the market is expanding

substantially or if the investor is in a tighter financial situation. In addition, the investors should

take into account inflation and alter their investment contributions on a yearly basis. Other than

that, I agree that regular interval contributions should be made to the portfolio. Finally, the last

two principals that Malkiel elaborates on in his book talk about how the readjustment of a

portfolio based on your financial situation and needs should be done at regular intervals

throughout the investors life. These align very well with the final list of questions I would

recommend all investors ask themselves before deciding on what assets they would want to

invest in. In the book, Malkiel preaches regular re-allocation of securities within asset classes, as

well as the classes themselves based on the investors age, income level, risk capacity, and any

changes in future financial goals.

These principles closely align with what I would recommend to different investors. As a

recommendation I would follow this plan. When an investor is young and does not have any

dependents or financial responsibility, they should be more risky with their investments. They

should invest more in stocks and other equities and less in fixed-income securities. I would

recommend an 85% allocation to stocks, mutual funds, and other equities, 10% in fixed-income

securities or value stocks, and 5% cash or cash equivalents as a starting point for an investor. As

the investor grows older, marries their spouse, has kids, or changes their financial goals, they

need to begin to reallocate. As they grow older and their goals change from aggressive

investments to more conservative fixed-income options, then they need to reallocate. My

recommendation would be to reallocate a small portion, based on risk-tolerance and investment

goals, every year from their riskier portion of their portfolio to a more conservative position. All
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of this reallocation is based on the investors opinions and goals, but every ten years, I would

move about 5-10% of their investments from their initial riskiest investment assets to more

conservative investments such as value-stocks, fixed-income securities, or cash equivalents.

Now that an investor knows the health of the economy, what his/her investment goals are, and

what asset allocation is and a general rule to follow, they are ready to decide how to allocate their

money and to begin their third and final step in the top-down analysis: security selection.

This part is the most time consuming out of the three phases of the top-down approach

because of all the decisions you have to make. I want to go through each step of this process to

give a clear background on why my recommendation is what it is. To begin this step we have to

look at all of the information that we have been given. We know the strength of the economy

and what assets we want to put our investments in. Even with all of this information, we still

have to look at all of the information that the market itself is able to give us about each

individual security. To understand how the market does this we have to look at a concept called

the Efficient Market Theory. This theory analyzes how the market operates. There are three

forms of this theory. The first form is the weak-form of the markets. This position states that

only past information is taken into consideration for the price of the security. The semi-strong

form says that all public information at that moment in time is taken into consideration for the

price of the security. The final form is the strong-form. This position says that all public, past,

and insider information is taken into the price of the security and not any amount of information,

old or new, is not already taken into consideration. My advice to the investor is to believe in the

semi-strong form of efficiency. This means that all public information available is taken into

consideration for the price of a security. Burton Malkiel (2013) supports that by saying,

Although it is abundantly clear that the pros do not consistently beat the averages, I must admit
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that exceptions to the rule of the efficient market exist. (p. 189) This means that if all investors

were rational, which they are not, then the strong form would be true and no mispriced securities

would ever be existent, but since investors are not always rational, there are market anomalies

that cause some non-public information and irrational actions to be useful in the selection of

mispriced securities. This irrational behavior can be explained by behavioral finance.

Behavioral finance is the models of financial markets that emphasize potential

implications of psychological factors affecting investor behavior. Basically, investors do not

always interpret data correctly and consistently make suboptimal decisions. I believe that due to

investors irrationality, the semi-strong efficient form of the market is the most consistent form of

the market. Malkiel (2013) agrees that, (Behavioralists) believe that irrational trading creates

predictable stock-market patterns that can be exploited by wise investors. (p. 266) While

Malkiel does not believe as strongly in behavioral finance as I do, he does admit, referring back

to the quote on page 189, that exceptions to the rule of the efficient market do exist. Because of

my strong belief in behavioral finance, the semi-strong form of efficiency, and in the irrationality

of investors, my following recommendations on how continue with security analysis will make

much more sense.

Since we now know how efficient markets are and what can cause inefficiencies within

them, we can now dive into the details of security selection. First, the investor must select an

active or passive management approach when it comes to his/her portfolio. The difference

between the two is that passive management is a buy and ride approach with little outside

interference, while active management is the continuous search for mispriced securities. Within

the active management methodology, there are two main types of analyses used to value

securities: technical analysis and fundamental analysis. Technical analysis is the method of
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predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the

air theory. Simply put, this method tries to value stocks based on past information and trends

and then attempts to perform an action on that security based on what they believe the masses

will do. Fundamental analysis on the other hand is the technique of applying the tenants of the

firm-foundation theory to the selection of individual stocks. This basically means that careful

analysis of a stocks intrinsic value and future prospects, analysts can derive its true intrinsic

value. Given this value, investors can either purchase the stock if it is undervalued or sell a stock

if it is overvalued. Based on what I have learned and researched, I would recommend neither of

these methods, but rather a passive investment strategy. Malkiel (2013) that the academic

community believes that fundamental analysis is no better than technical analysis in enabling

investors to capture above-average returns. (p. 186) Even Paul Samuelson (2013), a Nobel

laureate, agrees that To that passive investor, chance alone would be as good a method of

selection as anything else. (p. 187) To sum up the recommendations of myself and evidence

from multiple, respected financial academics, Warren Buffet and Peter Lynch (2013), the head

fund manager of the Magellan Fund at Fidelity Investments from 1977-1990, said it best, most

investors would be better off in an index fund rather than investing in an actively managed equity

mutual fund. (p. 188)

From this information, I can derive and confidently recommend to all investors that a

passive management approach for a portfolio would be the most successful. After establishing

our type of investment strategy, we need to select our securities. In order to select the right

securities, we need to look at an important concept known as the Modern Portfolio Theory

(MPT). This theory is widely accepted in the finance world as one of the least controversial

ways to construct a portfolio. The MPT aligns with the Efficient Market Theory and the passive
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management approach. It (Malkiel 2013) supports that the stock market is so good at adjusting

to new information that no one can predict its future course in a superior manner. (p.196) Since

no one can accurately predict what the market will do, the next best option is to decrease the

amount of risk you take when investing in the market. Risk is the chance that an expected

securitys returns will not perform to the optimal level believed to occur. The greater the risk, the

more likely a security will drop in price. In order to reduce this risk, individuals must, according

to the MPT, diversify their investments. All of the mathematics that come along with the MPT

tells us that the best way to decrease the overall risk or variance of your portfolio is to make it

optimal. This is the primary point within the MPT and on the Capital Allocation Line (See

Figure 1.1).

The optimal portfolio is the combination of two or more securities to create a weighted

system that finds the optimal combination of those selected securities with the lowest risk. In

order to find that optimal position, the investor must calculate or find the alpha, firm specific

excess returns, of that optimal position and see if is worth the risk (standard deviation) they are

assuming. As you can see from the graph the optimal position is the point where the efficient

frontier is tangent with the capital allocation line. The efficient frontier are all possible

combinations of two or more assets, while the capital allocation line is the Sharpe ratio which

measures the average return earned in excess of the risk-free rate. All of this may seem

confusing, but all it is saying is that there is a specific combination of two or more different

securities that when invested in at different weights, they can earn the highest return with the

lowest amount of risk. After the investor is able to derive this, then he or she is able to construct

an optimal portfolio.
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As a final thought, I want to summarize what we have learned and what

recommendations I have made for the investors. First, the investor must analyze the economy

and its relative health. After that, then the investor must journal about their financial goals and

the requirements they have for their portfolios. Based on this information they need to allocate

their assets that can meet these goals. This means following my recommendation of investing in

riskier assets earlier and more conservative assets later in life when you edge closer to

retirement. Finally, they must analyze different securities to come up with the most optimal

combination of securities that give them the most return for the least amount of risk. The types

of assets they choose do not matter as long as they are not highly correlated, move in tandem

with one another, and are diversified across different sectors and industries within the economy.

In essence, index funds, as recommend by Warren Buffet and Peter Lynch that cover different

industries of the economy earn the best returns with the lowest amount of risk, due to

diversification. Even Malkiel (2013) says, that a simple buy-and-hold strategy of a group of

stocks typically makes as much or more money, than individual groups of stocks. (p. 145) This

is the climax of this paper. A well-researched, passive, diversified, long-term investment strategy

of index or market funds is the optimal investment strategy for those who want to earn the

highest possible return over the long run.

In conclusion, if I was to invest my $100,000 dollars today, I would analyze the economy,

which at this point is at a relatively stable state with lower than normal interest rates and bullish

first quarter, and then select different assets. Since the economy is relatively strong and I am a

young investor, I would invest 85% of my total amount of money into stocks, 10% of funds into

long-term equities or value securities, and then 5% I would keep as cash equivalents for both an

emergency cushion and for purely recreational speculation. Then I would select a wide array of
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index funds that covered several industries and sectors within the economy and possibly abroad

that have the most optimal combination. Finally, I would invest in target retirement mutual funds

and value stocks for my long-term equities portion and buy several short and long term CDs for

my cash equivalent portion of my portfolio. Hopefully this paper has cleared up a few things for

the beginning investor and given them a possible strategy to follow when starting their own

portfolio. This is definitely not the most perfect strategy by any means, but it is one to base your

own personal one after and hopefully share with other investors who might be struggling to fine

the most effective way to invest their money.

References

Bodie Z., Kane A., & Marcus A. J. (2013). Essentials of Investments (9th Ed.). New York, NY:

McGraw-Hill

Burton, J. (2001). Investment Titans. New York, NY: McGraw-Hill

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Malkiel, B. G. (2012). A Random Walk Down Wall Street (11th Ed.). New York, NY: W. W.

Norton Company.

Williams, E. (2001). The McGraw-Hill Investors Desk Reference. New York, NY: McGraw-

Hill
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Figure 1.1