Investment Strategies

Risk & Return Considerations:

Your risk tolerance and the return you require or expect from your portfolio are two primary considerations when designing an investment strategy.

Portfolio returns can come in several forms: capital gains, dividends, and interest. If you are subject to taxation on your investments, then it is important to consider after-tax returns. Equally important is to account for inflation. You can earn a practically risk-free rate of return in a money market or savings account, but you may actually be losing money in terms of buying power if the interest you earn after taxes does not keep up with inflation.

Risk tolerance

At EAFA, we find that the best way to determine a client’s risk tolerance is to thoroughly understand their investment needs and goals. For example, a retired person may be a daredevil in real life but if they are dependent on their portfolio for income, then their investment risk tolerance may be quite small. Before giving advice on investment matters, we ensure that we have an in-depth understanding of your situation. An analysis of how your portfolio would have performed historically over various difficult investment periods is performed so that you are aware of the amount of financial risk to which you would have historically been subject (although historical returns may be quite different from future returns).

Diversification

For an investor with a small portfolio, diversification can be provided through mutual funds, exchanged traded funds, or various other pooled investments. For an investor with a larger portfolio, diversification can best be accomplished by carefully chosen individual holdings.

A properly diversified portfolio is diversified regionally and in terms of asset classes and industry groups. 

It should be noted that most portfolios do not contain meaningful diversification except to the extent that some of the money is in stocks and some in bonds. Many investment advisors will tell their clients that they have diversified the portfolio by putting some money into US stocks, non-US stocks, value and growth stocks, small and large-cap stocks, and emerging market stocks – the reality is that all of these markets are very well correlated and offer little diversification. 

As part of our research at EAFA, we measure the historical correlation between various investments and asset classes and help control risk by choosing holdings that we expect will have attractive returns but that are not well-correlated.  

Currency risk

If you are spending your money in a currency other than that of your savings, there is a risk that currency exchange movements will impact your assets’ value and income, and you are assuming what is known as currency risk. As an example, the US Dollar weakened vs. the Euro by about 50% from 2000 to 2008. At EAFA, we take into account your current circumstances and future plans so as to minimize your exposure to currency fluctuations while maining a well diversified international portfolio.

Interest rate risk

When interest rates are low, a major risk to many conservative investors is interest rate risk. When interest rates rise, bond prices fall and many conservative investment portfolios contain significant holdings of bonds, and even worse –bond funds. With discrete bonds that have a maturity date at least you know what your risk is since at some point the bond matures and you get your money back – but with most bond funds there is no maturity date and so no bottom to the risk assumed. Conversely, when interest rates are high and more likely to fall in the future, this may be a better time to invest in bond funds. 

Investment Policy

The EAFA Investment Policy Statement (IPS) is a written agreement between yourself and your Investment Advisor that describes how your account will be invested and how it will be evaluated. The document is updated yearly as necessary, in consultation with your EAFA investment Advisor, to reflect changing market conditions and any changes to your situation or financial goals. 

The IPS contains a summary of your investment goals, the strategy to be followed to achieve these goals, allowable risk exposure, any constraints on holdings or asset allocation, and a summary of investment products that may be used. There is also a section outlining the reporting requirements and the benchmark that will be used to evaluate performance. 

Your Investment Policy Statement should address the following: 

Strategy

The strategy section of the IPS should outline how your portfolio will be constructed and summarize your objectives for the account. Objectives might include income, growth, or capital preservation.  Regulatory constraints create an additional layer of restrictions for expats which must be navigated when formulating this strategy.  For example, certain types of EU investments may trigger US taxes or burdensome reporting, while certain US investments don’t meet EU rules for EU residents.   All of these elements are considered when formulating a bespoke investment strategy. 

Time horizon

A time horizon should be indicated that reflects your financial planning goals. This doesn’t mean that there cannot be withdrawals or additions to the account before the time is up, but certain investments are time-sensitive. For example, if a US government note that pays a coupon of 5% is purchased at par, it is reasonably certain (barring a default of the US government and assuming a 5% reinvestment rate) that a yield of 5% will be realized if the note is held to maturity. 

Expected risk and return

Risk and return go hand-in-hand. We would all like to have a low-risk portfolio that yields a high rate of return, but the reality is that there is always a trade-off. Once we have an understanding of your goals and risk tolerance, we will design a well-diversified portfolio that meets your unique needs.

Permitted holdings

It is important that portfolio holdings match the risk/return profile and time horizon. For example, a growth-oriented portfolio should contain a higher weighting to investments such as equities, whereas a conservative income-producing portfolio may be more oriented towards dividend-paying or fixed-income investments. 

Reporting

It is necessary to keep track of how well your investments are performingwith respect to your goals and also with respect to a benchmark. If performance is not measured and reported, then how will you know where improvement is necessary or whether your financial advisor is in fact adding value? 

At EAFA, we provide quarterly updates to our clients and the EAFA IPS always includes an appropriate benchmark that is decided in advance and against which portfolio performance will be compared.