What if you could idiot-proof your portfolio in four simple steps?
What if the idiot you were proofing it against was…you?
Let us explain.
You’ve heard that markets are irrational. But what does that even mean? The market isn’t some inanimate object; it’s made up of people. People are irrational. And sometimes they behave that way.
It’s this version of you that you need to protect yourself from. The part of you that sees the market drop 4% in one day and instantly claws to get out of the investing positions you’ve navigated yourself into. Or the part of you that sees the market go up 7% in a day, freaks and sells. Only to find out later you missed 50% of the eventual rise in the market.
No, you want to insulate yourself from all of that emotional behaviour. The way to do that is to establish clear rules and expectations for your portfolio, and trust us – it will be stronger for it. It’s fun to get carried away by the promise of some hot new stock but the exercise of developing a management strategy is what will keep you in the game for the long run.
Here are the 4 steps you can take to make your portfolio stronger – starting right now.
1. Goal Setting
You can’t really know where you’re going without a map. Writing down your investment goals will act as a roadmap. It’ll inform you when you veer off the path.
Make sure you can answer the following questions:
What is the purpose of my investments? What am I trying to accomplish? Is this a retirement portfolio or am I just trying to make a quick buck to finance my illegal sweatshop operation in Bangladesh?
What exactly are you looking for? Financial independence? A portfolio that offers some income in the form of dividend payments?
Write it all down.
How much money do you want to have, 5-10-20 years from now? Work backwards to figure out how much you will need to invest and what sort of return you will need to reach your goals.
For example: A 25 year old wants to retire with a million dollars. Assuming he retires at 65…that’s 40 years of investment time. He could then work backwards to figure out that he would have to invest $400 per month, earning an annual return of 7%, to become a millionaire by age 65.
Isn’t that great? Suddenly our fuzzy dreams of investment nirvana have crystallized. We’ve got a realistic plan of action.
2. Asset Allocation
Goal-setting should flow into asset allocation. This is where you start to think about what mix of assets you should own in your portfolio. The ratio here should reflect your investing goals at any point in time.
So if you were that 25 year old with the dream of retiring with a million dollars, you’d need to figure out what you’re going to buy with your $400/month.
There are a lot of options at this point. You will need to consider how much risk you’re comfortable with. Let’s say that the only way you could achieve your 7% return was by investing risky junk bonds. If the thought of investing in SHADYCORP LLC makes your stomach turn…well then perhaps you need to adjust your expectations.
But suppose that, after much research, you find out that historically, the stock market returns 10% a year and bonds return 5%. If you split your portfolio equally between the two assets, you could expect to earn the average of those: 7.5%.
So $400 invested every month in a 50/50 portfolio would get you to your goal of a million dollars by age 65.
The important point here is: do the research! Find out which approach makes sense for you. This may be the point where you realize that the level of return you want might be out of reach. That’s ok, going through this process will help you to develop realistic expectations.
3. Automation and Stop/Loss rules
How hands-on do you want to be with your portfolio? Do you want to set it and forget it, or do you see yourself as a more active investor?
If you are into a buy-and-hold approach, then next you should think about automation. How are you going to set up your portfolio so most of the work is done behind the scenes? Arranging for an automated transfer every month into your investment portfolio makes sure that the job is getting done and you never have to think about it.
If you want to get down and dirty then your job has just begun. At this stage you’ll still want to write down your strategy for different situations. What will you do when there is a bear market? How will you adjust your portfolio allocation during a bull market? Will you change the amount you invest per month based on whether Jupiter is in retrograde or not?
Maybe you decide that during a bear market, you’ll adjust your asset allocation from 50% equity to 5% equity and 45% cash. Who knows…your portfolio will be unique to you.
Finally, write down stop/loss rules. What will you do if you lose $X? Will you keep your money in or will you take it out? Write it down – along with your reasoning. That way you can come back to it during what will likely be a stressful time and use it to evaluate your intended course of action.
The last step to a bulletproof portfolio. Take the time every quarter, or every 6 months to review your portfolio. How are you doing? Is your portfolio consistent with your goals and expectations?
Hopefully all the work you’ve done in the earlier steps will make this step a breeze. The review should not take a long time, and if adjustments need to be made then you’ll know exactly what to do since you’ve already done all the work up front.
Follow those four steps to minimize the anxiety and worry that tends to come hand in hand with investing.
Remember that your portfolio is yours alone. It should reflect your personal tastes and goals – while allowing you to keep peace of mind during stressful situations.
Best of luck!