Editor’s note: some exhibits may not display properly on the web.

4.1. What does Active Management Require?
The bulk of the remainder of our investment program will be concerned with active management of your funds. That is, hands-on investment of your money in such a way that you will decide which specific investments you will invest in. Please take a moment to review the previous section 2.3 “Do You Want to Be an Active or Passive Investor?” In that section, we discuss the following factors which must be considered when deciding whether to take the active management route: 1) time commitment, 2) total portfolio size and 3) transaction costs.

In this sense, active management on your part is different than you purchasing an actively managed fund. In an actively managed fund, the fund manager is active in that he is actively choosing investments whereas your role in purchasing an actively managed fund is passive.

Beyond these practical issues, active management also requires knowledge or a willingness to add to your knowledge. This falls under the broader category of a time commitment but also encompasses energy, focus and intellectual desire. We would categorize the additional knowledge required for active management into the following categories:

• Asset Allocation and Portfolio Construction – How to allocate your money among different asset types and how to construct a portfolio of investments within each asset type.

• Wide Base of “Macro-Knowledge” – A general understanding of the workings of the global economy, overall economic trends and the impact this has on specific types of investments.

• Understanding of Specific Companies and Industries – An understanding of the workings of specific industries and the competitive position of specific companies within an industry.

• Understanding of Valuation – An understanding of how to determine whether a specific investment is expensive or cheap relative to its future prospects.

We will be going into much more detail for each of these areas of knowledge in the rest of this program. However, we would first like to make a few general comments about these areas of knowledge. The amount of time that can be spent adding to each of these areas is limitless. While this can be intimidating for the investor that is just getting started on accumulating useful knowledge, we want to make two points: 1) the knowledge required for successful investing is reasonably attainable by most people with some time and effort and 2) the focus should be on useful knowledge and not knowledge for knowledge’s sake. Investors with more interest, curiosity and/or enjoyment in specific areas of knowledge may want to spend more time delving into those areas which interest her. Others may be satisfied with a basic body of knowledge and allocate only periodic times for refreshment and updating of that basic body of knowledge. However, we do want to re-emphasize that active management will take work on the part of the investor. Those unable to make a time commitment to understanding specific investments may be better served buying funds.

For those with more limited time and energy, our personal preference would be to focus more on the understanding of specific companies and industries and also an understanding of valuation. With these two bodies of knowledge and a long-term time horizon, an active investor can probably be successful in reaching his investing goals. Furthermore, an investor does not need to learn about every industry and every company within a specific industry. Instead that investor should focus his time and energy on companies and industries which would make the most effective use of his time. For instance, Warren Buffet says that investing in technology stocks is not within his circle of competence and so, does not spend time analyzing and investing in hi-tech companies. If due to one’s personal experience, either at work or outside of work, one may have a special competence in regards to a particular industry, this may be a good place to start.

Between asset allocation/portfolio construction and macro-economic knowledge, we would probably focus more time on asset allocation/portfolio construction. You should have at least a basic reasoning for how much money you are willing to put into specific investments even if one does not have a comprehensive asset allocation model or philosophy. Broad knowledge of the workings of the global economy is useful to the extent that it aides in understanding of specific industries and companies and their prospects. However, a true and accurate understanding of the workings of the economy is very difficult. This is why professional economists so often disagree and often get their predictions wrong. Professional economists do not disagree and get things wrong because they are stupid, lazy or not knowledgeable. They get things wrong because their subject matter is complex with a large number of variables and relationships. Given how difficult it is for professional economists, a non-professional economist should not necessarily have high hopes for being able to make accurate economic predictions. Instead, a general understanding of the economy should be the goal. In the long-run, economic cycles tend to even out and investments in good companies in good industries at reasonable prices should result in successful outcome even without a crystal ball on the economy.

In the following section we will start with a discussion of personal asset allocation. The macro-economy, analysis of companies and industries and company valuation will follow in further sections of the program.

4.2. Asset Allocation Revisited
We have touched on aspects of asset allocation earlier in section 2.2 ”Introduction to Asset Allocation”. We suggest you review this section first. In that section, we concluded with some suggested guidelines for asset allocation: stocks – 50-80%, bonds – 30-60%, real estate – 0-10%, commodities/precious metals – 0-10%. We added that more conservative investors should have a higher proportion of bonds and a lower proportion of real estate and commodities/precious metals and that aggressive investors may want to have a higher proportion of stocks, real estate and commodities/precious metals. These guidelines apply purely to the investment portfolio. In this section, we want to expand into two additional topics: 1) asset allocation in the context of your total personal balance sheet and 2) more details regarding investment portfolio construction.

As we mentioned above, the general guidelines for asset allocation into stocks, bonds, real estate and commodities/precious metals were applicable only for your investment portfolio. By investment portfolio, we meant the portion of your total assets which can be allocated to long-term investments. This portfolio should consist of investments which are not meant to be fully cashed out for long periods of time – perhaps 10 years or more. The goal of these investments would be to help finance long-term financial targets such as retirement, children’s college education, a larger house or one in a better neighborhood, a second house, etc. This does not mean that dividends from the investments cannot be spent or that a small portion of the investments can not be cashed out each year to finance periodic spending – such as would be the case in retirement.

Investments that may need to be cashed out in a short period of time – perhaps less than 5 years – might be better off in more conservative assets such as short-term bonds, bond funds, money market funds or very conservative stock investments. Because in the short term, the overall investment environment is very difficult to predict, it will be difficult to ensure principal protection at the time the investment needs to be cashed out if the investment period is short.

This constitutes the first suggestion we would make regarding asset allocation: the investment portfolio will be funded by money which you would not need to pull out in a short period of time. Patience is important because it is only over time that the superior investment return that comes from successful investing can truly be captured. The magic of compounding returns over time will help sums to grow significantly as time passes but, just as important, the potential negative impact of years with a poor return will diminish significantly as time passes. Since markets go up and they go down, and the exact timing of these up and down cycles is difficult to pin down, the best insurance against having to cash out at the wrong time and having bought at the wrong time is time itself.

We now want to return to asset allocation within the investment portfolio itself. While we suggested guidelines for the allocation of funds by type of investment, including stocks, bonds, real estate and commodities/precious metals, we want to discuss other ways in which assets can be allocated. These include making a distinction between domestic and foreign investments and also the amount to allocate to different industries.

Regarding the domestic versus overseas distinction, we would prefer to transform this distinction into the currency of the investment, rather than the country of the investment. We will discuss investing in various countries along with our discussion of allocation among industries. In general, we would suggest that the vast majority of your investments be allocated to investments that are denominated into your base currency – that is the currency which you feel most comfortable holding large amounts of. For many people, this will be the currency in which they do most of their spending. For those residing in the United States, this currency is likely to be the US dollar. However, for those investors from countries whose currency is not a major world currency, such as the Yen, the Euro or the British Pound, we would suggest picking one of the major world currencies as your base currency. We think a good guideline would be to invest between 40-100% of your assets in your base currency with 0-60% in investments denominated in a foreign currency. Those with larger portfolios or more risk tolerance can move the foreign-denominated currency investments to the upper end of the scale.

It should be noted that investing in your base currency does not rule out investing in other countries. For instance, in the U.S. in particular, there are many American Depositary Receipts (ADRs) which are denominated in U.S. dollars but which represent shares in overseas companies. The same can be said of Global Depositary Receipts (GDRs) in Europe. In addition, you may even find U.S. companies whose majority of revenues are derived outside of the United States, such as the Coca-Cola company. If this is the case, however, you should be aware of the exposure to foreign countries which you are taking on and take this into account when allocating your assets.

We suggest having the majority of investments in your base currency to minimize currency risk. As we mentioned above, we suggest the base currency track closely the currency in which you do most of your spending. Having a large proportion of investments in foreign currencies exposes you to risks that that foreign currency falls in value. Of course, if the foreign currency rises in value, this may be a benefit if the underlying investments do not fall as a result of the rise in the foreign currencies value as may happen for some companies heavily dependent on exports. Our main point is that investors should stick to their base currency for the majority of their investments to minimize unwittingly speculating in currencies. If investors have sufficient knowledge to expose themselves to the currency risk, then our guidelines may not apply.

Within the stock portion of your portfolio, we would suggest some attention be paid to the allocation of investments among industries. At the same time, some attention should also be paid to the allocation of investments among countries or regions of the world. Putting all of your stock portfolio into one industry exposes your portfolio to the risk that an unexpected negative development, or even catastrophe, takes a big bite out of your portfolio. To minimize this risk, we would suggest spreading out your investments among several industries. Similar thoughts apply to exposure to particular countries and regions. It is less necessary to invest in foreign companies simply for the sake of diversification but it may help to minimize single country risk and may even enhance return over time if those countries are growing faster than the other countries in which your investments earn revenues.

To set rigid guidelines for investment by industry or country may not be so appropriate in our view as there are no simple rules to follow. However, we would draw your attention to Exhibit 1 which classifies investments in various industries and countries as being defensive or aggressive. These classifications are general in nature and should be taken with a heavy grain of salt. However, the takeaway from this chart should be that asset allocation among industries and among countries does have implications for the volatility and riskiness of your portfolio. Aggressive investors that can tolerate wider variations in the potential outcome of their investment returns may be willing to put more money into the industries and countries labeled as aggressive while more conservative investors may want to stick to the more defensive industries and countries. No matter what the distribution of investments is, the main goal should really be to find undervalued investments which have a greater chance of making you money than losing you money.

Exhibit 1: Aggressive and defensive industries

A final topic which we want to touch on and which we will revisit later is that of portfolio rebalancing. Over time, the proportion of your assets allocated among various investment types, currencies, countries and/or industries may differ from your original intention. This will happen due to underperformance or outperformance in returns in various parts of your portfolio. It may be useful to review the balance of your portfolio among different investment types, industries, countries etc., to make sure that, if there have been changes, you are comfortable with the changes. If you are not comfortable with the changes, you may want to re-balance your portfolio while taking into account whether this re-balancing is worth the extra transaction costs, and perhaps an inconvenient timing with regards to market prices of your investments, before putting the re-balancing into action.

Re-balancing also has the added benefit of adding discipline to your selling and buying of investments. Re-balancing will tend to have you selling investments which have gone up and buying investments which have gone down. This may tend to have you buying and selling investments at more appropriate times than would otherwise be the case.