Answers in Portfolio Management

Warren Buffett is referring more to understanding how a company makes money. This rule of thumb does not mean you need to know the financial statements inside and out and be able to take over as the company CFO tomorrow. He is referring to it more in a broad sense. If you don't understand how a company makes money then how can you evaluate if it is a quality company or not. Starbucks sells coffee, Nike sells shoes and clothing and McDonalds sells hamburgers. The problem most investors get into is they look at a company or industry they don't understand and make an investment decision off of what the herd is doing or off of one metric, such as dividend yeild. This can sometimes lead to disasterous results. Enron is a great example of this. If you asked a common investor how Enron made money, they would have no clue. Mortgage REITS, some MLPs, and some other hard to define industries for the common investor are other great examples. Many investors look at a mortgage REIT and see the juicy yield, but they don't know how to evaluate the quality of the company management, the impacts of the housing market, interest rate risk, etc. I'm not saying any of these types of investments are bad, but you need to know how they make money so you can know how they are impacted by different enviroments. Buffett is merely making a broad statement on knowing how they make money.

This is a really difficult question, which is actually why I asked it :). I wanted to force myself to quantify what in my opinion is a the threshold of “understanding.”

In order to understand an investment you have to understand:

x) the business model x) the products x) the market opportunity x) the customers x) the competitors x) the company’s competitive advantage x) the history of the company x) the culture of the company x) the management of the company x) how much that’s all worth.

In order to truly understand an investment, you have to understand enough to have trust:

?) In the company’s future. ?) In management. ?) In yourself.

Following the crowd and investing in unfamiliar areas is not a sound investment strategy. You're much more likely to make money over the long term by focusing on investing in assets that you understand and are comfortable with. Invest in what you know, even if that means that you're slightly less diversified. Modulate your risk by holding excess cash. And always pay attention to valuation.

They're actually more different than most people realize. Both are contracts that entitle the owner to something, but that "something" is very different for each.

A bond, or fixed income security, entitles an owner to a fixed stream of payments denominated in a currency over a specified period of time. It is an agreement or a promise to deliver a specific amount of money.

A stock, or equity security, entitles the owner to a share of the assets of a corporation. These assets may produce income in dollars or they may not. They can be valued in dollars, but equities of companies with operating assets are not dollars or money themselves. For example, if I own equity in a shoe factory, I own a share of the factory, which has tradable monetary value, but is not money itself. I have ownership of the physical structure and its productive capacity to turn raw materials into finished products.

People who invest in stocks often mistake the market value of shares in their investment account as money just like in their bank account, but in actuality when you purchase shares of a company, you don't have money anymore you have ownership of an asset. If you bought an apartment building it would be clear to you that you have exchanged money for an asset. With shares of a company it is the exact same thing. The only difference is that Wall Street brokerages show you the tradable market value of the shares in your account on a daily basis if you choose to look at it that frequently. This can cause you to feel irrationally wealthy in a bull market, and like you are losing money in a bear market. These are psychological tricks to get you to trade in your account more frequently than you need to. The value you see in your brokerage account is only marginally related the real value of the assets you hold.

The other crucial similarity between stocks and bonds is that they are both savings mechanisms. They are ways for you to store the wealth that you have accumulated from working hard and transfer its purchasing power to a later date. They accomplish this in very different ways though. Depending on the price that you pay for each contract and the current investment environment, one can be riskier than the other. It's not always a fixed proposition as to which one is the riskier one though.

Here is my 2-cents:

It is very important to have a retirement plan first, which is properly diversified and allocated.

Second, you can look at how this money is invested, whether it is through individual stocks, mutual funds and/or ETFs.

Your Company Stock would fall under a specific Asset Class Bucket. I am guessing Domestic Small Cap (or Large/Mid). The bigger question is what percentage of your portfolio would you invest in that specific Asset Class and then of that what amount would you put in an individual stock, which could be the stock of the company you work for.

As long as you are not putting all your eggs in one basket, it is generally OK to invest in your company. Make sure it is a component of a bigger, longer term plan.

I have heard financial planners recommend not investing too big an amount in your company's stock as your wages come from it as well.

Invest in what you know. Make sure to diversify, but as an employee you probably know the company better than almost everyone on Wall Street. If you feel like the prospects for the company are strong and importantly if the price of the stock is fair (a factor that most people ignore at their own peril), then you should feel comfortable owning shares of the company.

On prospects a few pointers: Companies are at their core a collection of people. The more talented the team and stronger the culture the more likely it is that your company will succeed. If you trust your CEO your managers and your coworkers, feel like they are intelligent and operate with integrity and you feel similarly about other divisions then you are probably in good shape. One caveat is try to avoid an investment if you feel like the long term prospects for the business are difficult. Ask yourself the question: is my company in a dying industry? If the answer is yes, then it's going to be difficult for even the best team to succeed.

On valuation: Valuation is probably the hardest part for a non-professional to understand but you can use the price to earnings ratio as a rule of thumb. If the p/e of your company's stock is above 20x that means it's expensive and there is a good chance that if you wait you'll get a better buying opportunity. Conversely if it is below 10x it could be a great opportunity but could also be a red flag that the company's prospects are weak.

If you follow these 3 rules: 1) invest in companies you understand 2) which are high quality companies 3) selling for reasonable valuations, you're going to do very well as an investor. As an employee, you're in a great position to make these assessments.

Stop asking the wrong question. Wall Street gets you to focus on the investments and not your plan. Right question: Do you recommend we start with a financial plan and match the portfolio to the plan? Right answer: Yes! How would you know what to invest in if you never took a deep dive into your financial life? From there things like portfolio construction, fees, expected return, goofy sales pitches on hot managers that will blow up next year can follow. Warning: understand what you need to do first will limit your desire for stupid expensive investments.

To echo the sentiment of others on this post, it really does depend on the investor, but the right choice is generally a function of expertise and time. The more time and expertise that you have as an investor, the more useful it will be to look at individual securities, because these investments carry the highest possibility of reward, but also generally introduce greater risk to the portfolio.

ETFs and mutual funds are just vehicles to help an individual diversify across a broader set of individual securities so that the return of the portfolio is not as dependent on an individual company. Diversification does come at the expense of potential returns. However for most non professional investors the benefits of reduction in risk far outweigh the reduction of return.

Technically speaking the difference between ETFs and Mutual Funds are not material to most investors. The distinction that is more important is the distinction between active and passive management. To return to the issue of time and expertise, individuals with the time and expertise to vet the managers who are investing their funds should feel more comfortable using active managers which manage money congruently with individual investment philosophies. If you don't have time to vet the managers, then you could consider using a passive index fund (either ETF or mutual fund).

Note: it's very important to remember that it's not possible to ever truly offload an active investment decision. If the active decision is not being made at the security level, it's being made at the asset allocation level and asset allocation determines the vast majority of a portfolio's returns. This is why if you don't have investment expertise it's a good idea to hire an advisor who does. But remember that the advisor is an active manager with his or her own personal investment philosophy. So, like any other active manager, it's extremely important that the individual vets that manager.

Another note in hiring an active manager: It's important to look at fees but only to the extent of making sure they are not egregious. Fees are not the primary determinant of forward returns. It's most important to choose the right manager or index for the individual. Even two low cost index funds can have divergent returns. The Dow underperformed the S&P 500 by ~5% last year. High fees are more a question of the manager's character than ability. It's ok to pay a good investor a reasonable fee, but not an exorbitant one.

Stop! Leverage? Really? Then you mention dividend yield. Start over - you made a good move by not engaging in most active funds and using ETFs. It's a great start of someone who has no professional help. Don't waste your time reading how leveraged ETFs are a bad investment. You already know that. They are designed for degenerate gamblers that the financial media refers to as day traders. You don't need dividend yield - you need total return. Liquid ETFs are one of the better way to get the returns of markets including their dividend yield. Keep working on your career, family, and overall life. Don't let Wall Street get you off your dime.

There's a common misconception among the advisor community that asset classes exist on a static risk and return spectrum. The conventional wisdom is that fixed income assets (bonds) are least risky and equities are most risky and that portfolios can be built around these principles to match the risk tolerance and objectives of an individual client.

While some elements of this logic are true, the conventional wisdom misses the important fact that price is the most important determinant of risk and return. In other words even the least risky stream of cash flows can become extremely risky at the wrong price, while the most volatile stream can become a safe bet at the right one.

Because market prices change constantly, the right mix of assets for an individual is NOT static. Proper investing requires being flexible and engineering a portfolio that truly matches the risk and return objectives of the client, while being prepared to act on changes in the investment environment

Unless you are a full time investor, the best thing you can do for yourself is to keep your investments simple. Aside from the numerous structural deficiencies inherent to leveraged ETFs, they introduce unnecessary risk to an individual's portfolio. The vast majority of the average American's wealth will be built by saving and investing on a very long term basis. If you're only 32 that goes double for you.

I would like to add to other responses. In my opinion, leveraged and inverse ETFs should only be used by Traders and not Investors. These are great investment vehicles for expressing a short term trade vs. a longer term investment. Be extremely careful and diligent when using these as it is easy to get burned, as sometimes What You See is NOT What You Get!

In my experience, the worst mistakes in investors portfolios generally come from using leveraged ETFs. The losses quickly compound and the gains are often eroded by the effects of tracking error and compounding over time. A leveraged ETF is only designed to track the DAILY price movement of its underlying index. Therefore, if an index returns 10% over a six month time frame you generally won't be able to correlate that to a 20% return in a 2x leveraged ETF. This can be frustrating to investors that don't understand how this effects their returns.

If you do decide to use these funds I would highly recommend that you employ tight stop losses and adhere to a strict trading discipline to ensure that you define you risk. You don't want to buy and hold a leveraged position and let it get away from you.

An index fund is any vehicle that provides exposure to an index. The structure could be an Exchange Traded Fund, Exchange Traded Note, Mutual Fund, Closed End Fund, etc. Although, most commonly used vehicle is an Exchange Traded Fund. These are generally rules based and do not involve any manager subjectivity. The most common index fund is SPY, which provides exposure to the S&P500 Index.

These are generally considered passive investments, as they merely replicate an index at a low total cost and do not need to be actively managed. However, given that the markets have been sliced and diced in myriad ways with these indices, wall street is now getting creative at launching active ETFs that mirror active indices.

To expand upon Martin's answer, the ETF industry has continued to grow significantly due to many fund providers creating unique indexes to support their ETF products. There is now an ETF for nearly every broad based index from Wilshire, Dow Jones, S&P, and Russell. In addition, the fund providers are creating fundamental indexes that select stocks centered around rules based criteria such as sales, earnings, book value, cash flow and dividends.

As the ETF industry continues to evolve they will create and release new indexes for more niche company sectors, industries, and strategies. Ultimately some will be successful and others will fail, but it's up to the investor to decide if the index meets their goals for diversification and exposure to a specific asset class.