We all have probably heard of people saying “Investing is easy, we just buy low and sell high.” But how often we let fear gets in the way when the market is plunging and end up selling low? When market is doing well while others are making a lot of money, so we follow and end up buying high? Sometimes the worse enemy is ourselves.

With the recent increasing market volatility, we want to refresh you with the basic investment fundamentals in hope to help you navigate the market.

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First, let us talk about the Nobel winning “Modern Portfolio Theory.”

We all understand that we have to take on more risk in order to get higher return. Very often, when my clients ask me to take a look at their existing investment portfolios, I found out that with the same similar performances and returns, some portfolios are taking way more risk than the others. I worried when the market correction comes, those portfolios will face much worse drops.

Modern Portfolio Theory provides a framework for building an optimum portfolio, which brings highest return with the lowest risk by using the investment algorithms.

The focus of applying this theory is to make sure the asset allocation and diversification that will maximized your return with consistent with your own risk tolerance, so you can sleep well at night. Periodically, the portfolio is also needed to rebalance to restore to its originally weighted percentage of the asset mix.

Second, let us take a look at Efficient Market Hypothesis.

Index funds and ETFs are becoming more and more popular. Vanguard launched the first index fund for individual investors in 1976.

Efficient Market Hypothesis (EMH) proposes that investors are unable to outperform the market on a consistent basis. The hypothesis contends that security pricing reflects all knows information, which is obtained quickly and enables a company’s stock prices to adjust rapidly. In addition, it is believed that the daily fluctuation in prices is a result of a random walk pattern. There are three different forms of EMH.

Strong Form of EMH states that all public and private information is already reflected in the prices of securities, neither technical nor fundamental analysis can improve upon the efficiency of the market to determine prices. If you are a believer of Strong-Form of EMH, index funds will be the most appropriate strategy for you.

Semi-Strong Form of EMH states that security prices are reflected not only from historical data, but also from data analysis of the economy, industry, and company financial statement.  If you are Semi-Strong Form of EMH, a combination of index funds and actively managed portfolios, in which the managers will study the fundamental of the companies, might be the suitable strategy for you.  

Weak Form of EMH states that security prices reflect all pricing of volume data and fundamental analysis may have some value in identifying companies whose share values may increase. If you are Weak Form of EMH, you will look for a more active managed portfolio which attempts to outperform the market.

Third, Dollar Cost Averaging (DCA)

It is the simplest effective strategy for long term investors. DCA is an investment technique of buying a fixed dollar amount of a particular investment on a regular basis, regardless of the share price.  You buy more shares when prices are low and fewer shares when prices are high, that eventually lower your average cost. Why this strategy works? Because we all know that historically, the market is on an upward trend in the long run, and the reality is that no one knows when exactly the market is going up or down.

In summary,

  • Constructing asset allocation and diversified portfolios that match your risk tolerance, and rebalancing portfolio periodically.
  • Combining of passive management and active management based on your own believe.
  • Using the simplest dollar cost averaging strategy.

Investing for the long term and ignore the short term fluctuations. Understanding the investment principles will help you make wise decisions and to make sure you do well.