BY DAVID J. DELUCCIA

Author Deluccia had a lot more to say about investments than appeared in "The Money Issue." Here is the additional information regarding wise investing he submitted with the original article.

Understanding Risk
Risk is relative. Some individuals are very cautious (risk-averse or have a low tolerance for risk) while others are willing to be aggressive and will take a "chance" or gamble on an investment.

How risky are your investments? Risk can be defined and measured in many ways. The most commonly accepted method of measuring risk is that of Standard Deviation. Standard Deviation in more technical terms is a measurement of variance around the mean (average). A simple example may best explain Standard Deviation as it is used to measure risk.

Let's assume that Portfolio "A" has had investment returns over a three-year period of 9%, 10% and 11%. The average (mean) return therefore for Portfolio "A" is 10% (9%+10%+11% divided by 3 years = 10%). Let's suppose that a second portfolio, Portfolio "B", has had investment returns over the same three-year period of 0%, 10% and 20%. The average (mean) return for Portfolio "B" is also 10% (0%+10%+20% divided by 3 years = 10%). If we examine both portfolios side by side we see that they both have the same average return of 10% over a three-year period. So far so good. However, because Portfolio "A" has fluctuated much less in relation to its average of 10% it would be considered a less "risky" portfolio than Portfolio "B", which has fluctuated greatly from the same 10% average. The Standard Deviation of Portfolio "B" is therefore higher (riskier) due to its greater fluctuations around its average or mean. Given the choice between the two portfolios with the same 10% return, an investor should select the less "risky" portfolio, Portfolio "A".

Asset Classes
An "Asset Class" consists of investments such as individual stocks or bonds that have common investment characteristics. For example, the investment characteristics common to the most widely recognized asset class--the large company stocks represented in the S&P 500 (S&P 500) - are: (1) large market capitalization (large cap) which is a result of being widely held by investors, (2) a demonstrated history of stable dividend payments and (3) a well established record of continued business operations.

Some other asset classes and common indexes used to monitor their performance are: Small Capitalization Equities (S&P 600), Intermediate-term Bonds (Lehman Brothers Intermediate Government/Corporate Bond Index-LBIGC) and International Equities (MSCI EAFE-Europe, Australia and Far East). There are many others as well.

Asset Class performance is tracked by major rating services. As mentioned, to measure the performance of large cap equities it is common to view the investment performance of the S&P 500. The S&P 500 is looked at as a widely accepted representation of how large capitalization companies have fared collectively in performance.

The need to understand asset classes is significant. Electing to invest in any security (stocks or bonds) should be done with a knowledge of what asset class you have invested in. You then have a starting point for reasons of comparison to evaluate both risk and return. If your portfolio has a higher standard deviation and lower return than the corresponding index the message is quite clear.

Finally, if an investor decides to invest in large cap equities such as IBM or AT&T how would they be able to assess their performance in selecting those investments without a method of comparison? Using your knowledge of risk and asset classes as a basis for performance measurement should provide you with the ability to avoid undue speculation as you invest.

Performance Measurement and Evaluation
How have I done? We all want this question answered. Performance measurement is simply the art of determining how your investments have faired versus the appropriate benchmark (e.g. a large cap equity portfolio versus the S&P 500 index). Performance measurement quantifies how well your investments have performed, evaluation determines if this performance is acceptable. 

Why is this important? If your investments consist of large cap stocks as found in the S&P 500 then the performance of your investments should be compared to the performance of an index that accurately represents the characteristics of your portfolio. Certainly not another representing a different asset class (i.e. the S&P 600--small cap stocks). Why? Because if you were to use the S&P 600 to evaluate the performance of your large cap portfolio, you're comparing apples to oranges.

Different asset classes have different levels of risk as witnessed by the makeup of S&P 600 versus the S&P 500. The S&P 600 is made up of 600 completely different stocks (not the S&P 500 + 100 as one might suspect) that represent smaller capitalization companies that are more growth oriented and historically have a higher level of risk associated with them. Therefore a portfolio invested in the likes of IBM, GE and AT&T (large cap companies) would be measured against the S&P 500, not the S&P 600.

Once we have the correct tool to measure the portfolio performance things become a lot simpler. For instance, if the returns for the past year on the S&P 500 were 25% and your portfolio of large capitalization stocks returned 18%, the conclusion is easy. You've dramatically underperformed the index.

This highlights two forms of analysis. Absolute and relative. On an absolute basis, yes, you have made 18%. Many would argue that is an excellent return. A very good year. However, on a relative basis, the more applicable test of your performance, you have given up 7% in return compared to the index. While percentages are helpful and necessary to study, this under-performance becomes even more glaring when actual investment dollars are plugged in. That same scenario applied to a $100,000 investment would translate to an under-performance difference of $7,000 for one year (25% return versus 18% return on $100,000).

Understanding this is essential is determining how you have done as an investor. In fact I believe that it is one of the most overlooked aspects by investors who blindly accept the opinions and conclusions of advisors. A moment ago you felt great that you had an 18% return on your portfolio. Now that you realize had you just conservatively kept up with the index you would have an additional $7,000 what are your feelings? Probably not all that happy. In addition, did the 18% portfolio take more risk than the index returning 25%? If so all the worse.

Trust but verify. When you are told you are doing great or had a great year, verify!

"Active" versus "Passive" Investing
Managing a portfolio while seeking to exceed the returns of the corresponding index it is measured against is considered "Active" management. An active manager will rely on research, market forecasts, and their own experience in making investment decisions or "bets" all with the intention of outperforming or "beating" the index return. An active manager investing in large cap stocks is trying to outperform the return of the S&P 500. More often than not active management will hold far fewer securities than the index it is trying to outperform, a disadvantage with respect to diversification and risk. 

Conversely an investment management approach that seeks to simply match the return of a pre-determined index is a management style known as "indexing" or "Passive" investing. There is no attempt to use traditional "active" money management techniques of timing the market or to make "bets" on individual stocks or narrow industry sectors in an attempt to surpass the performance of the index. The concept is fairly straightforward. Passive investing seeks to replicate the investment results of the target index by holding all-or in the case of very large indexes a representative sample of the securities in the index. Thus, indexing is a "passive" investment approach emphasizing broad diversification and incurs less risk than under-diversified active management.

How have the two styles faired? Historically there is significant evidence that passive investing has outperformed active investing. Why? The case for indexation is compelling due to indexing's inherent cost advantage. Indexing a portfolio employs no high-cost advisers, they have minimal operating expenses and very low brokerage transaction costs (since they buy and sell securities infrequently whenever the index may slightly change). Active managers, by and large, charge much higher management fees, have much higher portfolio trading activity and the costs associated with that trading. The higher fees and commissions will offset any higher performance that may have been realized.

The expense differential between active and passive management makes it extremely difficult for active managers to beat the index or indexed portfolios. With a natural tendency to try to outperform the market many first-time investors seem to favor traditional active management. Many experienced investors, understanding the difficult task of selecting in advance those active managers who will provide superior investment returns over the long run, tend to choose indexation for at least a portion of their total investment portfolio. In fact, given the statistics illustrating the ineffectiveness of active management versus the index many large corporate and government pension plans have trended toward indexation committing billions of dollars in assets to index strategies.

Creating and Implementing an Investment Plan
What asset classes do you want in your portfolio, and in what combination? The percentages that you assign to each asset class, becomes your asset allocation mix. For example, selecting to keep 10% in cash (money market), 30% in short-term bonds, 20% in intermediate-term bonds, 25% in large cap stocks, 10% in small cap stocks and 5% in international equities is quite simply your portfolio's current asset allocation. Answering what asset allocation is best depends on several things. Risk is foremost. How much risk are you willing to assume in arriving at an asset allocation? Remember the example of Portfolio "A" and Portfolio "B". They both had the same average return. Portfolio "B" took a wilder ride to get there. An individual in their mid-twenties may elect to have an asset allocation with a higher allocation to stocks than someone getting ready to retire. The individual facing retirement may have an asset allocation that has a much higher percentage in cash and short-term bonds.

The proportion of your portfolio to allocate to each asset class is also ideally determined based on historical data. You understand risk by way of standard deviation and can easily pick up the financial newspapers or search the Internet for historical asset class performance. Once you know the risk and historical performance of an asset class you are better able to decide what works best for your portfolio.

David J. Deluccia is senior vice president of Capstone Asset Management in Houston, Texas. 1-800-262-6631  x232

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