Growing Your Nest Egg – Investment Fundamentals 101
It’s everyone’s favorite question to ask a financial planner – “So what’s the market going to do?” And my favorite answer is I don’t have a clue!
Now some folks will read that and wonder how you can consider yourself a financial planner when you don’t have an opinion on the stock market. And that’s fair. However, my answer is to the question that I perceive is being asked – will the market go up or down IN THE SHORT TERM. And to that question, there is absolutely no “known” answer. My investment philosophy is based on the concept of efficient markets. The philosophy pretty much states that the market is priced fairly at all times and is based on all available information. This suggests that you CANNOT figure out the next “hot stock”.
Think about it this way, what’s the probability that you have the magical piece of information that no one else has that enables you to identify if a stock will go up or down? Put another way, what’s the probability that you’re smarter than all of the other investors in the world at this point in time? Hopefully the answer to both of the above questions is obvious – the sum total of all of the information available far outweighs your/my knowledge when it comes to the pricing of stocks in the market place.
Rule #8 – Investing isn’t about getting lucky. It’s about having a stable, well defined strategy that you follow without fail.
With the above in mind, my suggestion to develop an investment strategy is as follows:
- Identify your goal/objective. Until you know why you are investing, it’s foolish to even think of entering the investment game.
- Determine the amount of risk you SHOULD take. Associated with your goal/objective, there’s a required amount of return that is necessary to achieve your objective. Associated with this return is a requisite amount of risk. Return requirements drive risk requirements.
- Determine the amount of risk you CAN take. While the amount of risk you SHOULD take is based on your objective, the amount of risk you CAN take is based on your psychological make-up. Some folks can’t sleep at night if they have too much at risk. That’s critical in determining your investment strategy. Individual psychology drives risk tolerance.
- Based on the amount of risk you CAN and SHOULD take determine the asset allocation for your portfolio. Some folks may be 100% in equities (stocks) and 0% in fixed income (bonds). Others may be 0% in equities and 100% in fixed income. Most folks are going to be somewhere in the middle of these two extremes.
- Determine the composition of your equity and fixed income portfolio. Within the world of equities (stocks) there’s a whole collection of asset classes: large cap, small cap, international, emerging markets, REITs, etc. Within the world of fixed income (bonds) there’s a whole collection of asset classes: short term, mid-term, long-term, government, corporate, etc. You’ll need to decide on what percentage of each asset class you want to hold.
- Determine the specific holdings within your equity and fixed income portfolio. Once you decide on the percentage of your portfolio to hold in each asset class, you’ll need to decide on the specific investment vehicle you want to use. You have a choice to invest in individual securities or “pooled” securities. You’ve got the choice to either invest in individual stocks and bonds or “pooled” stocks and bond via mutual funds or ETFs. Personally, I stay 100% AWAY from individual stocks/bonds in favor of mutual funds. There’s just too much business risk, in my opinion. Associated with buying one company’s stock or one organization’s bonds.
- Under the assumption that you’ve chosen to go with mutual funds or ETFs, the final decision you’ll need to make is whether you choose to pursue “actively managed” or “passively managed” funds. To me, this choice is easy. Google “active managed versus passive managed mutual fund returns” and you’ll see that all of the studies suggest that passive management is the way to go
- Rebalance your portfolio to ensure compliance with your targeted allocations. Finally, you’ll need to review your portfolio on a regular basis to make sure that you buy/sell your holdings so as to remain consistent with your targeted portfolio allocation.
So there you have it, the fundamentals of investment management.
Finally, don’t fall in to the “pursuit of perfection” trap. There are a ton of investment management strategies that can likely get you to your objective. Too often folks suffer from “paralysis by analysis” and fail to take any action. That’s a recipe for disaster. Similarly, folks fall in to the “latest and greatest” trap where they’re continually chasing the new fad or trend. Also a recipe for disaster.
The two biggest keys to successful investing are (i) the existence of a well-defined strategy and (ii) the consistent application of that strategy. If you follow the above steps, you’ll be well on your way to reaching your goals.
ACTION ITEM: Follow the eight steps above to develop and implement your personal investment management process.
[author] [author_image timthumb=’on’]https://www.f5fp.com/wp-content/uploads/2012/02/100_3458-Cloned-background-1-214×300.jpg[/author_image] [author_info]F5 Financial Planning, L.L.C. (F5FP) is a comprehensive, fee-only, financial planning firm serving Naperville and surrounding communities.
Led by Curt Stowers, F5FP focuses on providing corporate executives, entrepreneurs, and families with comprehensive financial planning that leads to financial security, simplicity, and success. As an executive with Caterpillar for 18 years, Curt brings real, practical experience to financial planning. Curt has successfully passed the examination to be awarded the CERTIFIED FINANCIAL PLANNER™ credential.[/author_info] [/author]