Foundation:

HCM's approach to investing is closely tied to the results of years of academic study of the nature, sources, and risks of market returns.  There is a much greater knowledge of market returns today than ever before, and research is continuing that surely will continue to enhance the understanding of those who wish to understand (which, unfortunately, does not seem to include all market participants).

Specifically, our insights of market returns has been shaped by two seminal works that form the foundation of Horizon Capital Management's approach to investing.

1) Modern Portfolio Theory:

The first is the work of Harry Markowitz on Modern Portfolio Theory ("MPT"), which was published by Dr. Markowitz  in 1952 and for which he won the Nobel Prize for Economics in 1990.  Dr. Markowitz showed that when considering adding an asset or a security to a portfolio, what was important was not the risk and return of that particular asset or security, but the marginal effect that adding the security would have on the risk and return of the overall portfolio to which it would be added. 

Simply put, MPT says that each time that we add a security to our portfolio, so long as that security doesn't move exactly the same way or at the same time as the rest of our portfolio, we will lessen our overall portfolio risk without lowering our expected return.  Conversely, when we build a portfolio out of non-correlated assets, we can expect more return without increasing our risk. 

That's all well and good, but with the number of publicly traded stocks in the U.S. alone approaching 10,000, how do we begin to figure out which of these move in tandem and which independent of others?  Are there any traits that we can look for that will tell us how to categorize all these stocks and how many categories there are?

2) Dissecting the Market: The Fama/French 3 Factor Model: 

The second groundbreaking piece of work was done by Eugene Fama and Ken French (currently of the University of Chicago and Dartmouth Business Schools respectively).  Fama and French pored over stock return data from 1964 to 1992 and found that once the universe of stocks was sorted by two factors, large companies versus small, and growth companies versus value, over 95% of the observed returns were explained by which of these two factors a person chose to build their portfolio around.

This work, then, defines the asset classes that we were trying to define after MPT. Essentially, we can think of the domestic stock market as consisting of four categories of stocks: 1) Large Growth, 2) Large Value, 3) Small Growth, and 4) Small Value (other classes, inluding REITs and utilities, lie outside of this analysis).

What does this mean? It means that you can try to slice the market any way you want to seek "extra" returns.  You can pick industries ("I think financials will do well in this rising interest rate environment"), management styles ("environmentally conscious companies tend to perform better than the market"), economic strategies ("I like cyclicals right now as a defensive play"), personal preferences ("I'm Irish and I like companies run by Irishmen") or just go with the old adages ("you can't beat the blue chips over the long run") and FOR ALL PRACTICAL PURPOSES, IT WON'T MATTER (or at least it never has)! 

Subsequent work by Fama and French (and Davis) confirmed the size and value dimensions of risk and return for time periods going back to 1927 and showed that whether a person picked large, small, growth or value companies in which to invest overwhelmed any other considerations that have affected the return outcomes of portfolios.  Additional research has confirmed similar effects of the size and value dimensions internationally.

3) Fine, but how do We Build Portfolios of "Asset Classes"?

Armed with this data, one Mutual Fund Company, Dimensional Fund Advisors ("DFA") has created funds premised upon these Asset Class definitions.  HCM has chosen DFA's products as the building blocks for engineering your portfolio.  We invite you to take some time to "tour" DFA's website at http://www.dfaus.com. 

Assumptions:

It is quite crucial to your satisfaction while investing through Horizon Capital Management, that you are willing to work along the basic assumptions that are the foundation of our porfolio design.  These are:

1) THE PUBLIC SECURITIES MARKETS ARE EFFICIENT.

The controversy surrounding this statement cannot be exxagerated.  What are we saying when we call the markets "efficient?"  Well, contrary to the efficiency naysayers, it doesn't mean that we think that the market is always "correct."  What we do mean is that all known information is instantly reflected in a security's price.  In order to beat the market consistently, a person would have to have better information than the aggregate of all market forces working to push a particular stock up or down.

Aren't we all looking for that one smart Broker, Money Manager, or Adviser who can repeatedly see through the market's flaws and choose under-priced securities for us to purchase and over-priced securities for us to avoid?  Unfortunately, reams of studies have shown that if this person exists, researchers have not been able to identify him or her. 

HCM's primary recommended products are passively-managed mutual funds from Dimensional Fund Advisors.  These funds are very low cost and are designed to put and keep the investor in as "pure" a sample of a particular asset class as is available.

2) DIVERSIFYING IS THE MOST EFFECTIVE METHOD KNOWN TO MAXIMIZE AN INVESTOR'S EXPECTED RETURN FOR THEIR INDIVIDUAL TOLERANCE OF RISK.

The standard deviation of the average returns of the entire U.S. stock market is about 15%.  The standard deviation of the average individual stock in the U.S. stock market (which by definition has the same expected return) approaches 30%!  By diversifying into all U.S. stocks, an investor cuts his risk in half without lowering his expected return.

Obviously, it's not practical to invest in each of the 10,000 stocks in the U.S. market.  However, by diversifying your exposure to the four asset classes in the U.S. market, and then doing the same internationally, an investor sharply increases his expected return, and sharply lowers his risk.

3)  "BUY AND HOLD" IS THE BEST WAY TO INVEST.

The stock market, over time, has returned handsomely.  Those returns, however, have been concentrated, unpredictable, and erratic.  An investor is rewarded for being a participant  when the returns are available.  Importantly, it's very difficult to know ahead of time when these rewards will be doled out and in what magnitude.  The best way to receive these rewards is basically to always be in the market waiting for them - in other words, to be a constant participant. 

HCM's strategy calls for a constant allocation of your assets in the market, so that you're always participating.