26 Oct Don’t Get Scared; Get a Process!
How to Make Better Investment Decisions with an Investment Process
October has been a crazy month for stocks. Volatility is back; we’ve seen moves of one, two and even 3 percent in the major indices. Today (Oct 26, 2018) the S&P briefly dipped into “correction” territory, having fallen more than 10% below its September high of 2,940 before regaining some ground. Stocks have suffered in recent weeks due to fears of rising inflation and interest rates— not to mention uncertainty surrounding the mid-term elections. Nearly half of the S&P 500 is in bear market territory. Scary stuff!
So, now is a good time to temper one’s emotions. Clear heads prevail. A well-thought out investment process helps in making good investment decisions, regardless of how the markets are reacting.
What do I mean by an investment process? All investors allocate capital with the expectation of profit. However, many investors pick and choose stocks and bonds with not much thought into building a diversified portfolio based on their unique circumstances. Then, when markets get spooked, investors panic and let emotions take over. Here, I’ll give a few tips on how to design and implement your own investment process so you can make better investment decisions.
Identify Your Investment Objectives
Are you investing for retirement, college for the kids, diversification from business or real estate assets, or just having fun? When will you need to withdraw from your account or liquidate your investments (time horizon)? Having clear goals and objectives is imperative. If you don’t understand what it is you’re trying to accomplish, you can’t evaluate how you’re doing, or if your process needs tweaking.
Evaluate Your Risk Tolerance
Risk in financial planning is the possibility that you might not reach your goals. Altering the level of risk in your investment portfolio changes the range of potential investment outcomes. That is, when you increase the risk in your portfolio, you increase the possibility for larger gains, but also the possibility for larger losses. Risk tolerance refers to how comfortable you are within the range of potential outcomes. How much uncertainty will you tolerate? Will large investment losses cause you to reach for the Tums®? Understanding your risk tolerance is key when making investment decisions.
Develop Realistic Expectations
Investing in risky assets and expecting gains each year (or month) is not realistic. The market is volatile. Investors cannot expect gains of 20% year after year. Even a balanced portfolio will still suffer losses from time to time. The future is uncertain, but the longer you stay invested in quality investments, the better chance you have of achieving “normal” returns.
Create an Investment Policy Statement
Write down your objectives, risk tolerance, time horizon, and the investment strategies you will use. What type of assets will you invest in? Will you regularly contribute additional money to the account(s). How much (if any) flexibility will you give yourself to make changes? Perhaps you want a hands-off approach by simply investing with a “robo” adviser. Or maybe a more personalized strategy with an investment adviser might be more your style. A written plan will help you stay disciplined and accountable. When markets start acting up and you become panicky, you can pull out the written document and realize volatile markets are part of the game. Make your investment process rules-based rather than emotion-based.
Build a Portfolio Through Asset Allocation and Diversification
Asset allocation refers to how you divide your portfolio among various asset classes: U.S. equities, international equities, fixed-income, emerging market debt, etc. The right mix will depend on your investment objectives, risk tolerance, and time horizon. Diversification refers to spreading your money among many investments— ie not putting all of your eggs in one basket. It is the only “free lunch” in investing because it may reduce your overall investment risk without lowering your expected return.
Pay Attention to Fees
When selecting investments, it’s a good idea to keep an eye on fees, as they can quickly add up (especially over time). Low cost, commission-free ETFs are good for both buy-and-hold/passive investors and more active investors who realign their portfolio more often. If you want to hire a professional or use actively managed funds, then expect to pay more, but the cost should reflect the value you receive. It doesn’t make any sense to pay 1% in fees to a fund that simply tries to match an index. You can find an investment that does that for close to zero cost.
Monitor and Rebalance the Portfolio
Periodically review your portfolio and make adjustments. Rebalancing your portfolio maintains your desired asset allocation; it forces you to sell your winners and buy your losers. That may sound counter-intuitive, but it is a good risk management technique- it helps to keep your desired risk level in check.
Overtime, you may want or need to change your investment objectives. Risk tolerance can sometimes be a moving target. Updating your process and investment policy statement from time to time is always a good idea— but try to avoid making big changes to your investments during volatile markets. The point of having an investment process is to keep a level head and make good decisions in any market environment.
Also, keep in mind that even a well-thought out investment process or strategy won’t work all the time. Don’t get discouraged when things go badly; it might just be bad luck. Investing is, by nature, uncertain. By consistently making good decisions with your investments, you’ll reduce the frequency of outcomes attributed to bad luck while increasing the likelihood of achieving your goals.
If you would like help developing your own investment process, contact a CPA financial planner today.
Originally posted 10/26/2018