With a seemingly endless number of available investment options, investment planning has taken on an almost mystical quality, turning it into an activity that, for many investors, increasingly involves more faith than reason. As a result, many investors find themselves at the mercy of investment salespeople who charge exorbitant fees to recommend investment products of questionable value. While this dilemma can be avoided by working with a truly objective and independent investment advisor who adheres to fiduciary standards of care, all investors need to understand enough about investment planning so that they can control their own financial destiny.
The Two Tenets of Investment Planning Every Investor Should Know
Before you can narrow down your investment options in the context of a sound, long-term investment plan, it’s important to plan with a deep commitment to two fundamental tenets of investing: 1) Focus on your investment objectives, not investment performance, and 2) you can’t control investment returns, but you can control risk. So, before you undertake the daunting task of selecting from among a near infinite number of investment options, it is important to clearly understand your investment objectives and how to manage risk.
Tenet #1: Set clearly defined investment objectives
Many investors err by focusing on investment performance rather than their own investment objectives. That’s when they find themselves chasing the hottest stock or mutual fund without regard to their investment needs and taking risks that are beyond their tolerance. Or, they try to time the markets to cut their losses and maximize their gains, only to find they can’t accomplish either.
The most successful investors focus almost exclusively on their investment objectives as the primary benchmarks that matter. If, based on your needs, time horizon, and risk tolerance, it is determined that your portfolio needs to earn an average of 7% per year, what should it matter whether the market or a particular mutual fund is up 30% one year and down 15% the next, as long as your portfolio returns are meeting its benchmarks over time?
Your investment objectives should be aligned directly with your financial goals (e.g., a home purchase, college education, retirement), which should be prioritized based on their importance as well as their time horizon. Your risk profile should vary according to the time horizon with longer-term goals that stretch across multiple market cycles allowing for more risk than short-term goals. Each investment objective should take into account the following:
• Risk—how much risk are you willing to tolerate, financially and emotionally?
• Time—what time frames are necessary for your investment goals and objectives? What sorts of assets are suitable for short-term expenditures? What sorts of assets are more suitable for long-term goals, such as retirement?
• Return—how much return is required for you to achieve your investment goals and objectives within the desired time frame? Is this return reasonable, or will it force you to take more risk than you can tolerate?
• Tax—what sorts of investments will be most tax-efficient given your personal financial situation and your business arrangement of operating companies, holding companies, and family trusts?
• Liquidity—what sort of immediate access will you require to their investments? Are lock-in periods like those found in private equity funds suitable, or do you need more flexibility?
• Unique Circumstances—are there any unique circumstances, such as special needs children or trust arrangements, that should be taken into account and provided for separately?
It’s important to understand that no single investment option will be able to satisfy all your requirements, which is why an investment plan should include a mix of investments from different asset classes as part of an asset allocation strategy that can be tailored to your investment profile.
Tenet #2: Focus on controlling risks, not investment returns
Whenever you decide to invest your money, you have probably determined how much you expect to get back at some point in the future. Most people expect they will receive more than what they put in after a period of time. Some will expect to get back no less than what they put it in, while others are willing to accept less back for the higher expectation of a greater return on their money. The difference in these attitudes and expectations is rooted in each individual’s tolerance for risk.
Risk Tolerance and Investment Expectations
While it may be prudent for people to invest their money with the assurance they can receive 100% or their principal back, it comes with the expectation that the return on their investment will be lower than if they had no such assurance. This is the cause and effect of a zero or low risk tolerance when investing. For people seeking a higher return on their money, they must be willing to accept a commensurate amount of risk.
Investors also need to be aware that risk is present in several different forms, and that consideration should be given to striking the right balance and proper diversification through a mix of investments that can mitigate the overall risks of their money at work.
Controlling or Reducing Risk through an Investment Strategy
Diversify: Investors who put all their eggs into one basket subject their money to the highest level of exposure that is inherent in that basket, whether it is stocks, real estate, metals, or CDs. By spreading investment dollars among several different types of assets, risk associated with any one asset is reduced for the total portfolio.
Long term: Investments, especially those with exposure to market risk, interest rate risk, or inflation risk, should be considered as long-term commitments to allow them to ride through the inevitable economic and market cycles.
Establish a liquidity fund: By creating a secure cash fund with sufficient monies to provide for short-term or emergency needs, you are better positioned to ride out market downturns.
Rebalancing: Many investors are willing to “let their profits ride”; however, disciplined investors will lock in their gains by selling securities that have exceeded their objective and buying securities that have greater upside potential. Through annual rebalancing of your portfolio, you can be assured of capturing gains wherever they occur while maintaining the opportunity for growth. More importantly, it ensures that your portfolio allocation always remains properly aligned with your investment objectives.
Developing a Long-Term Investment Plan
Studies clearly show that investors who adhere to a plan with clearly defined objectives and a tailored investment strategy outperform those who don’t. A well-conceived investment strategy is what keeps investors from falling into investment traps, such as chasing returns or trying to time the markets.
• Having a plan enables investors to stay focused on their individual benchmarks rather than market benchmarks or indexes, which are meaningless to an individual’s long-term strategy.
• A plan keeps investors firmly grounded in risk management principles that closely track their personal risk profile while optimizing their asset allocation.
• More importantly, the plan shields investors from the irrational behavior of the herd, which is often driven by euphoria or panic. From 2007 to 2010, investors who maintained their long-term strategy performed significantly better than those who bought as the market neared its peak and those who sold in panic as the market plunged.
Steps to Developing Your Investment Plan
Step 1: Assess your current financial situation
Step 2: Establish clearly defined financial goals
Step 3: Create an investment profile
Step 4: Develop your asset allocation strategy
Step 5: Select your investment strategy
Step 6: Build your portfolio
Step 1: Assess your current financial situation
Investment planning begins with a thorough assessment of where you are today and then creating an accurate profile of your assets, liabilities, income, taxes, career prospects, family considerations and plans, and lifestyle.
Step 2: Establish clearly defined financial goals
Your goals and objectives become your investment benchmarks—an absolute measure of your investment strategy’s performance. Setting goals enables you to discern between “needs” and “wants,” establish priorities and timelines, quantify the cost of your most important goals, and establish measurable benchmarks.
Step 3: Create an investment profile
In the context of where you are today and where you want to be (financial goals), an investment profile needs to be created that explicitly defines all aspects of your investment plan, including your tolerance for risk, investment-type preferences, tax appetite, liquidity needs, and your investment aptitude. An accurate profile will enable you to quickly narrow down your investment options.
Step 4: Develop your asset allocation strategy
Asset allocation is a method of allocating your investments among different asset classes in a way that matches your investment objectives and profile. Different types of assets perform at different levels during different cycles that are difficult to predict. Proper asset allocation ensures that when one type of asset is in a down market cycle other assets in your portfolio may perform well because their cycles are different. The overall goal of asset allocation is to generate more stable returns in your portfolio over time.
Step 5: Choose your investment options
With your asset allocation strategy established, you can then begin choosing from among the investment options that best fit your investment profile to fill your allocations. The most important principle that guides investment selection within your asset allocation is diversification—ensuring you don’t have too much exposure in any one security, sector, or market segment that could increase your risk.
Step 6: Monitor and measure
Once your investment plan is in place, all the moving parts need to be monitored to ensure they are performing as expected. Generally, investment performance is measured against annual benchmarks, at which points adjustments are made according to changing objectives, or the portfolio is rebalanced to ensure your asset allocation strategy continues to match your investment objectives and profile. The tendency by some investors to “overmonitor” can lead to investment decision-making driven more by emotion than by a disciplined adherence to a long-term strategy.
You Don’t Have to go it Alone
With the proliferation of investment and personal finance websites, investors have access to a great number of resources and tools that were once only available to financial professionals. And, while an increasing number of investors consider themselves to be at least somewhat self-directed in their investment decisions, the ever-expanding world of investments and the increasing complexity of financial markets require much more than a part-time approach to planning. With so much at stake, investors should seek the guidance of a qualified, trusted investment advisor, if for no other reason than to validate their own plans and decisions. Choosing the right investment advisor can be one of the more critical decisions an investor makes. Please contact R. W. Rogé & Company and ask to speak to one of our Senior Wealth Advisors for a free consultation.
