- Define your financial goals so you know how your portfolio needs to perform.
- The higher the potential investment return, the higher the risk.
- Asset allocation is the single most important factor in determining investment returns.
- Rebalance your portfolio and adjust asset allocations as your goals and risk tolerance evolve.
Most of us wouldn’t think twice about calling in an expert to fix our car, or build a cabinet or teach us how to play the bagpipes. The specialized knowledge required to go it alone seems out of reach. But when it comes to managing investment accounts, there are so many online resources available that many people with a little confidence and a willingness to learn can build a decent investment foundation on their own.
If you want to try the DIY approach to investing, you’ll need to understand some basic principles. But since investing is full of technical jargon, let’s first define a few terms:
- Portfolio—All of your investments collectively across multiple accounts, such as 403(b)s, IRAs, brokerage accounts, and savings accounts, plus real estate and other assets.
- Risk—The chance that an investment will be worth less than what you paid when you need to sell.
- Return—The change in value of an investment over time (either positive or negative).
- Volatility—The degree to which a particular investment may go up and down in value over time.
- Time horizon—The length of time your money will remain invested before you need to start taking withdrawals.
- Asset allocation—The percentage of your money invested in different types of investments, called asset classes, such as stocks, bonds, real estate, cash investments and others. It’s closely aligned with the broad concept of diversification, or not putting all your eggs in one basket.
Focus on your goalsInvesting is a little like planning a trip. You need to know where you’re going or you might end up wandering around aimlessly, or worse, getting lost. Your financial goals are your investment destinations. Pin those down so you know what kind of performance you need from your investment accounts.
Short-term goals could include buying a new car or replacing the refrigerator. In the medium-term, you may be saving for a larger house or for your kids’ college education. Your long-term goal should be focused on how much income you’ll need to provide a comfortable lifestyle throughout a long retirement. Our Retirement Income Calculator can help with the last one.You’ll likely have several accounts earmarked for these various goals, from bank products like savings accounts and CDs, to taxable brokerage accounts for buying stocks and mutual funds, 529 college savings plans and IRAs and 403(b) plans to supplement your retirement pension. To remain focused on the big picture, manage the investments in each individual account as specialized parts of your overall investment portfolio.
Understand the relationship between risk and return
One tenet of investing is the relationship between risk and return. Generally, the higher the potential return, the higher the potential risk. Historically, stocks offer higher returns and risk potential, while money market or cash investments offer lower returns and risks. Bonds typically fall somewhere in between.
The amount of risk you take on in your portfolio is determined primarily by two factors:
- Your time horizon; and
- Your tolerance for volatility, which is your ability to sleep at night as the investments in your portfolio go up and down in value over time. This is sometimes called your “risk personality.”
The longer your time horizon, the more risk you can theoretically take on because you’ve got time for your investments to recover from any temporary drops in value. But you’ll have to balance this against your risk personality.
Allocate your assets to your time horizon and risk personality
Studies have shown that your asset allocation is the single most important factor in determining investment returns. To help manage risk, create an asset allocation that aligns with your time horizon and risk personality.
For most people, that means a larger percentage of stocks for a long-term goal like retirement, with a lower percentage of stocks for shorter-term goals. Again, the percentage of stocks in your asset allocation will correlate with your level of risk, so the percentages may change depending on whether your investment risk personality tends to be aggressive, moderate or conservative.
Rebalance to stay on course
Asset classes tend to perform differently from one another. At any given time, stocks could be doing well while bonds are lagging behind. Before you know it, the reverse could be true. This is why diversifying across different asset classes and different investments within each asset class helps to spread risk. And it’s also why your asset allocation can get skewed over time. For example, if stocks outperform bonds for two years running, the stock percentage of your allocation may grow and the bond percentage may shrink. This will change your risk/return ratio.
When this happens you need to rebalance your portfolio to get back to your preferred allocation percentages. You can do this by directing new money into the asset classes lagging behind, or, you can sell some of the better performing investments and reinvest those profits into the lower performers. Either way, you want to maintain the allocation percentages you previously determined provide the best combination of risk and return for your time horizon. Depending on the volatility of the markets and the overall economy, plus your own portfolio performance, you may consider rebalancing every quarter or just once a year.
Adjust your strategy as life happens
When you experience life events such as marriage or having children, your financial goals can change. Also, many people tend to get more conservative as they get older and may want reduce their risk exposure.
Periodically review your goals and risk tolerance and check it against your investment strategy and asset allocation. At some point, you will start to adjust your allocation percentages. You also need to review your investment performance to make sure you are on track to reach your goals. If your investments are not providing a high enough return, you’ll either need to get a bit more aggressive in your allocations or put more money into your accounts.
Review your account statements quarterly, or at least annually, to see if changes are warranted.
Being patient, disciplined and unemotional
A study by DALBAR, a leading financial services market research firm, revealed that from 1990 to 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. Over that same period, the average individual stock investor earned just 3.49% annually. Why the big difference? Because individuals got too emotional about their investments when they weren’t performing well. They tended to sell their stocks after they had dropped in value. But they couldn’t bring themselves to buy them back until after they had already gone back up in value. That’s a surefire way to sabotage your investment return potential.
The lesson here is to be patient and disciplined. And take the emotion out of the equation. It takes time to make money with your investments. There will be rough patches where your portfolio may lose value. But if you’re disciplined and generally stay the course, you’ll have a better chance of getting decent returns over longer time periods.