Whether you are investing for the very first time or you want to analyze the vitality of an existing portfolio, you will need to understand a few basic principles. After all, investing can be scary, and going into it blind or making your decisions based off of a hunch could lead to disaster.
So, what should every investor know before they take the plunge?
Let’s take a look at 5 things you should know to give you a better understanding of how your decisions can affect your wealth in the long-term, and what you can do to help maximize gains while minimizing risk.
Risk is about more than tolerance
Our industry loves fancy words and jargon. We toss around investment terms like risk tolerance, asset allocation, beta, passive investing and other phrases because we think we sound smart.
Maybe we are smart, but if client’s don’t understand these things, then it makes us incomprehensible.
Risk tolerance is one of those terms. Tolerate implies that we just put up with something, in this case, risk. But what are those risks?
Risk is not just about the investments you should choose, it is also a vital part of your overall investment plan. Your income, age, timeframe for investing, goals, capacity for losing money, and even how you feel about your finances can all affect how risk factors into your portfolio.
The most common concepts around risk revolve around these ideas:
- How you feel about investing – this is often what we refer to as risk tolerance.
- Time until you have reached your goal – a longer timeline allows you to take on more investment risk than a shorter goal.
- How much can you lose and still reach your goal – having more money allows you to be able to lose more without jeopardizing your goal. This is financial capacity.
The amount of risk you are comfortable with has as much to do with your personality as it does with your financial circumstances.
For example, you might have two people, let’s call them Bob and Jim. They are both 30 years old, work at the same company, make the same salary, and plan to save for retirement over a 30 year period.
However, Bob has already established a retirement nest egg, while Jim is starting from scratch. Bob is prepared for financial emergencies and has a capacity for loss that Jim lacks. This means that Bob can invest with more freedom, while Jim should take a more conservative approach.
There isn’t one “correct” way of investing, because every approach must be highly personalized.
In any case, you will need to evaluate multiple factors – from available assets to your feelings about investing – in order to determine how risk will factor into your investment plan.
Diversification is critical
It cannot be said enough: putting all of your eggs in one basket is never a good idea. Even if your circumstances allow you to take on a lot of risk, you should still diversify your portfolio to protect against catastrophic losses.
The Periodic Table of Investment Returns proves this point. This chart ranks the annual returns for nine different asset classes from best to worst. Looking at 1999-2018, eight of the nine asset classes top the list for at least one year, while seven had the worst returns for at least one year.
And take a close look at the asset class that ranked on top for 2018: Cash.
The variations show that putting all of your investments in one or two classes will pay off sometimes, but not others; whereas spreading your funds among a variety of sources reduces the risk of taking a loss, and finding the right mix improves your chances of success.
More mutual funds don’t mean more diversification
Generally, when new investors hear the word “diversification,” they immediately look to mutual funds. While they are a great way to start bringing greater diversity into your portfolio, not all mutual funds are created equal.
Some funds reduce risk by investing in the broad market, while others focus on long-term growth in particular industries. However, many people don’t realize that many mutual funds share many of the same underlying securities. For example, the Vanguard 500 Index Fund and the Vanguard Total Stock Market Fund may sound different, but the top ten securities in each fund are the same.
In any case, it is a mistake for investors to blindly invest in more than one mutual fund without looking at the underlying stocks and industries. Sometimes the investments within different funds overlap, so you may be doubling up on stocks you like, and some you don’t.
Research the details behind each mutual fund you purchase. Dig into the underlying securities so you can make sure that different funds in your portfolio compliment one another.
Rebalancing keeps you on point
Knowing when to buy or sell stock is tricky, but important nonetheless. For example, let’s say your portfolio is initially valued at $50K, with 40% invested in US stocks, 30% bonds, 20% international stocks, and 10% cash. Suppose the stocks fall by 5%, causing the other areas to adjust. Now you are at 35%, 33%, 21% and 11%. Should you rebalance?
Rebalancing is more about managing risk than increasing returns. And there are multiple considerations to take before making the trades to put you back in balance.
- Time trigger – After a set period of time (a month, 6 months, a year, etc.), evaluate whether you need to rebalance.
- Threshold trigger – This is when you choose a threshold for asset changes. For example, if you see your assets drift in excess of 5% (or whichever threshold you choose), you can look into rebalancing.
- Tax implications – Often, rebalancing requires selling stocks, which can create a taxable event. You should evaluate the taxable impact when deciding when and how much to sell.
- Transaction costs to rebalance – Buying and selling stocks in order to rebalance your portfolio will also add transaction fees, which will chip away at your returns.
- Rebalance with cash flows – If you have a sudden influx of cash (i.e. a bonus check), you can use it to invest in an underweight asset class in your portfolio.
- Gifting – Charitable giving from your IRA can work as a tax write-off. This allows you to take funds away from an overweight asset class, while taking advantage of the tax rules.
Keeping an eye on how your investments are performing and sticking to your asset allocation is a good way to keep your asset allocation on track to meet your goals.
Monitoring vs. Managing
While you should never make rash decisions with your investments, it is also not wise to simply set it and forget it. This is why you should monitor your portfolio instead of managing your funds.
Monitoring your portfolio means keeping an eye on how your investments are doing. This is vital for any investment plan, even if you have no intention of making any investments in the immediate future. Monitoring allows you to check in on a regular basis to see what changes need to be made. It takes away the emotionality involved in the ups and downs of the market because you only make changes based on your defined parameters. Monitoring is strategic.
Managing your portfolio, on the other hand, implies that you are actively making changes and trades in the account. This method is more tactical requires more account activity. Managing a portfolio is also reactionary to market whims and creates additional fees for any purchases or sells, making it more costly as well.
Successful portfolio management is no easy task, and more often than not, investors require the expertise of a financial advisor. Are you looking for personalized financial advice to improve your portfolio? Jumpstart your investment strategy today with Pathfinder Planning!
Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.
Your Financial Mom blog posts are not meant to be legal, accounting or other professional service advice. Content represents the opinion of the author only. Pathfinder Planning LLC is not responsible for the accuracy or validity of content contained in third-party comments.