Focus on Finance

The Internet Investor

Version 1: The Defensive Investor

By George Morgan

Changes in technology have led to an explosion in the number of investment options available to the investing public. This gives individual investors the ability to design and execute an investment program that meets their unique financial condition and temperament. The strategies and the investors who implement them run a wide spectrum, from those who are extremely cautious and want to have the whole process managed by a third party to those who will accept significant risk and are willing to take the time and effort to manage the process without professional assistance.

My space here is limited, so I can’t cover all three investor profiles in a single column. This month, I will discuss version 1: the defensive investor. Over the course of the next two months, I will explore the profiles of version 2: the involved investor and version 3: the enterprising investor.

The top priority of defensive investors is to avoid losses and serious mistakes. They desire to exert as little effort as is necessary and to make as few decisions as possible. The demographics of defensive investors run the entire gamut, from young to old, from small accounts to major accounts. Some are professionals and some work blue collar jobs. They can be male or female, retired or just entering the work force. Any person with any amount of money to invest may have a defensive investor personality and adopt the defensive investor strategy.

It is not unusual for a defensive investor to turn all decision-making responsibility over to a third party. This third party may be a friend, relative, or significant other. The third party may also be a financial professional such as a broker or financial planner. In some cases, the driving factor motivating the transfer of responsibility is not the quality of the investment decisions that the third party is likely to make, but rather the fact that the investor doesn’t want to deal with it. If the third party is a not a financial professional, they must treat the assets as if they were their own.

Because of their desire to avoid loss, with the understanding that this most likely will result in reduced long-term earnings, defensive investors tend to keep a significant portion of their portfolio in either a bond mutual fund or a money market fund. In both cases, the return is small relative to the return available in the stock market, but the principal is exposed to a much smaller amount of risk.

Many of those categorized as defensive investors are drawn to target-date mutual funds. These funds are attractive because they are readily available, inexpensive to hold, and simple to monitor. Target-date funds are mutual funds that are organized and managed with the owner’s potential retirement date in mind. The objective of a target-date fund is to maximize the owner’s asset value at the time of retirement while keeping in mind the owner’s risk-averse personality. Named for the year in which the investor could potentially begin utilizing the assets, target-date funds are considered to be extremely long-term investments; thus, low rates of return versus other types of investment must be anticipated.

The farther that the target date is in the future, the higher the percentage of stocks in the portfolio and, thus, the lower the percentage of bonds. As time passes, the percentage of stocks in the portfolio is decreased and the percent of bonds is increased. Under normal circumstances, the portfolio’s allocation of stocks and bonds is adjusted on an annual basis.

There are several things that a defensive investor (or the defensive investor’s representative) needs to be aware of when purchasing target-date funds. First: the fees. When target-date funds were introduced 30 years ago, they charged higher fees than other mutual funds. However, in today’s competitive environment, those fees are on the decline. Second: the relative proportion of stocks and bonds. Defensive investors may feel safe because of the bond-heavy mix of stock and bonds. However, target-date funds vary dramatically in the type of stocks used in the stock portion of the portfolio. Funds that incorporate more aggressive stocks carry a higher risk profile.

Just like any group of people, investors are not all cut from the same cloth; therefore, a one-size-fits-all approach does not apply to investment strategies. An effective way to find an investment strategy that is right for you is to begin by deciding which type of investor profile (defensive, involved, or enterprising) best describes you. Once that is decided, the investment strategy that is right for you will fall easily into place. Check this space next month for a profile of version 2: the involved investor.

Editor’s Note: Professor Morgan has over 40 years’ experience in the investment field, both as a university professor and as a financial advisor. He currently serves on the faculty at the University of Nebraska at Omaha, where he directs a program designed to educate 401(k) plan participants on how to improve their investment strategy.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.