It's easy to make an investment. Just take your money and buy something with the hope it will be worth more tomorrow than it is today. It's just as easy to make an investment mistake, and most people do. According to an annually revised study by Boston-based investor research firm DALBAR Inc., both equity and fixed income investors have underperformed the broad market indices. Over the 20 years ending December 31, 2008, equity investors experienced average annual returns of only +1.9% while the S&P 500 Index of U.S. stocks averaged +8.4%. Fixed income investors experienced average annual returns of +0.8%, while the benchmark Barclays Aggregate Bond Index averaged +7.4% per year.
Why do so many investors fail to garner the returns that can be had by simply buying and holding indexbased investments?
The answer lies in the way investors behave when they handle their investments, a phenomenon known as "the behavior gap." Simply put, most investors experience poor investment results because they make investment decisions based on hope or fear, not logic.
To bridge the behavior gap, all you need is a well-reasoned plan and the will to follow it. Here are a few questions you can answer as you develop a plan for your investments.
1) How will this money be used?
When you take the long view, you'll realize that all the money you have today will either be spent or shared. You can't take it with you. So ask yourself, "What do I want this money to do for me?" Sample answers might include:
- Retirement: "I need my money to support me until the day I die."
- College: "I need my money to pay for 4 years of college starting [when the kids enter school]."
- Charity: "I want to see my favorite charity be able to [do good in the world]."
- Legacy: "I want to make sure my kids have enough money to [do something great]."
2) Do I really need to invest it?
If you have a whole bunch of money, it might not be necessary to invest at all. For example, if you're a 60-year-old ophthalmologist who lives on $120,000 per year and you have $12 million in your portfolio, you can stuff your money under the mattress, spend the principal, and never run out of money. Even safe savings vehicles might yield enough interest to support you. Don't take risks if you don't have to.
3) How much should I NOT invest?
The business cycle, or the boombust- boom phenomenon that you can see when you watch the economy, typically lasts at least 5 years. During that time, stock and bond prices may gyrate wildly. If you happen to make an investment during the wrong part of the cycle, then you may have a very long wait before you can recoup your capital.
For this reason, you should only invest money if you plan to use it in more than 5 years. Everything else might be better kept where it is undoubtedly safe.
- Planning to pay for your 20-something daughter's wedding? Take that money to the bank.
- Buying a retirement home for yourself with plans to move in soon? Stash that cash in some certificates of deposit.
- Planning to retire in the near future? Put a few years' reserves in a high yield checking account.
Once you've covered the bases for your near-term spending, you're set to invest the rest.
4) How much risk should I bear?
The answer to this question will make or break you as an investor. Get it right and you'll sail through the stormiest economic seas with your capital intact. Get it wrong and you'll jump overboard as your hardearned money crashes into the rocks.
You can approach the answer from two angles.
Measure your risk tolerance: To make an objective decision about this emotionally subjective issue, you might take a risk tolerance exam. The best-known exam is produced by FinaMetrica (www.finametrica.com), a company founded in 1972 by psychometric researcher Geoff Davey. An exam like this can help you begin to allocate your investments between high-, medium-, and low-risk options.
- Target a level of risk based on required returns: This approach looks not at who you are but at where you're trying to go. For example, let's say you've decided that you need a 6% rate of return in order to make your financial goals a reality. If you assume that high-risk investments can garner a 10% rate of return while low-risk investments garner a 4% return, then a 50/50 blend of high-risk and low-risk investments might deliver the return you are targeting.
You may find that the amount of risk you need to bear is more than the amount of risk you can actually stand, in which case it would be wise to target the tamer mix. It will be easier to stick to your plan, but it may also mean you need to save more, spend less, or reach your goals at a later date than originally planned.
5) How will I control risk?
In theory, the best way to manage risk is to select the best investments and buy them at the best time. If you do this successfully, you can avoid the losers, protect your profits, and reap the reward with less risk. In practice, stock picking and market timing lead to subpar and even disastrous results because you're more likely to pick the wrong stock and sell it at the wrong time.
A better way to control risk is to sort potential investments into two categories or "buckets":
- Your "high-risk" bucket includes anything that looks or acts like a stock. Stock mutual funds and certain bonds also belong in this bucket, like emerging market bonds, junk bonds, and small cap mutual funds.
- Your "low-risk" bucket includes pretty much anything that's not in your high-risk bucket, like shortterm corporate bonds, investment grade bonds, intermediate duration bond funds, and certain municipal bonds (which yield tax-exempt interest).
Each bucket has its role in your portfolio. High-risk investments give you a chance to earn returns that exceed inflation. Low-risk investments reduce the chance that you'll abandon your investment plan altogether.
Set a target for how much you'll invest in your high-risk and low-risk buckets, then write it down. This step is what the investment pros call "establishing your target asset allocation," and the document you're creating is known as your "investment policy statement" or "investment guidelines."
6) When should I make a change and why?
From time to time, you may feel the need to exchange an old holding with a new one. For example, if a stock in a taxable account has lost ground, you may decide to sell it and write off the loss against ordinary income. Or you might sell a mutual fund that has had a change of manager. In either case, you would probably turn around and reinvest the proceeds in something with a similar level of risk.
No matter what you do, resist the temptation to tamper with your target asset allocation. If the stock market is going through the roof, don't plow everything into the highrisk bucket. If the bond market looks like it's going to collapse, don't trade all your bonds for cash. While things may look rosy or horrific now, the most important thing you can do is stick to your plan.
Really the only good reason to change your target asset allocation is because something in your life has changed. For example, maybe you had a big family or a big divorce and you have been investing in an aggressive manner over the past several years as you try to catch up to your peers. Recently your Aunt Mabel died of a stroke (you told her to stop smoking, right?), and she's left you a large estate. So now you may have enough money to retire, and you might be able to reach your goal by taking less risk with your investments. It's time to reconsider your target asset allocation.
However, if your Aunt Mabel didn't actually die but she's been dying to share her stock market secret with you, beware. When she encourages you to sell all your dowdy low-risk investments and pile into the XYZ Opportunity Fund, what will you tell her?
7) Things look bad. Shouldn't I make a big change?
The answer is "no." Remember that your investment plan is supposed to guide you through thick and thin. If you've done your homework, thought things through carefully, and you've put a great plan in place, the odds are against you if you decide to make a big change. The key to success lies not in your ability to make better investments but in your decision to become a better investor by making and following a plan.
Mr. Utley is a Certified Financial Planner with Physician Family Financial Advisors in Eugene, Ore. Contact him at 541-463-0899 or visit www.physicianfamily.com.