Tips for Taking the Right Vehicles to the Stock Market

Dec. 12, 2013 -- One of the most common reasons investors fail is that they approach the capital markets without a plan that calls for the right investment vehicles for their needs. Or, if they have a plan, it may not adequately manage risk according to their individual tolerance for it.

Getting a good grip on risk and ways to reduce it is essential for women seeking to become financially empowered. Remember: The “e” in empower stands for “education,” and education about risk is critical.

Even if you have a well-thought-out asset allocation plan – one that sets what percentage of your money to invest in one asset class (eg., stocks) versus another (eg., bonds) – you may still face considerable risk from choosing the wrong vehicles to access different asset classes. This can mean too much risk, high costs or both.

When investing in stocks, there are substantial risks from buying ill-fated companies. Choosing companies that are likely to do well is an extremely complex undertaking that few professionals can master. The reason for this is what's known as company risk (or idiosyncratic) risk. Unbeknownst to its investors, a company can be awash in this type of risk. The CEO could become depressed, new board members could be ignorant cronies rather than savvy corporate stewards, an expected regulatory approval could be about to fall through or the company could be preparing to release a defective new product.

But what if you purchase a wide variety of stocks to spread company risk around? That's what professional portfolio managers do. They know that they'll unavoidably pick many losers, so their goal is to pick more winners. Yet this is extremely difficult to accomplish. It involves vexing choices about which industries to invest in and how much in each industry and each company. As I tell my clients, don't try this at home.

Good alternatives to stock picking include mutual funds or exchange-traded funds (ETFs) The objective is to reduce exposure to company risk by increasing the number of companies you invest in and decreasing the percentage of your portfolio invested in any one company. Instead putting too many eggs in one basket, you need many baskets.

There are two basic types of mutual funds—actively managed and passively managed. In actively managed mutual funds (typically known simply as mutual funds), investors pay fees that collectively comprise the high compensation of professional portfolio managers who buy and sell stocks for the fund. In index funds, there is almost no active management because the fund's performance is pegged to that of a set group, or index, of stocks – for example, the Standard & Poor's 500. This significantly reduces costs to shareholders, compared with those of actively managed funds.

ETFs function like an index funds, with some key advantages. One is that, because they're traded on an exchange, you don't have to wait until the end of the day to sell or buy, as you do with actively managed mutual funds.

If you invest in actively managed funds, you should get a significant return that compensates you for their higher costs. But the unfortunate truth is that most active managers don't earn their high compensation because the returns that most of them produce over those of index funds (known as their benchmark) fall short after expenses – and often, before expenses.