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Investing: Think Carefully

June 27, 2014 | About:
anandjha89

anandjha89

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Ah, I just love the playful irony of that rock surgery phrase that makes the headline of this article. Becoming a successful investor can be child's play. It's simple. Buy the broader markets. Stay invested. Reinvest regularly. Keep your fees low.

I could stop there. But I won't. It's not that difficult to make reasonable returns from the traditional mix of stocks or stocks and bonds over a longer time period.

1. It takes funds to invest.

2. It takes patience and time.

3. You must match your investments to your risk profile.

4. Hold a diversified portfolio.

5. Keep your fees as low as possible.

6. Have a plan.

The most important part of investing is staying the course. Most money is lost or left on the table because the investor holds a portfolio that delivers a level of volatility that is beyond the risk tolerance level of the investor. In my opinion investors should err on the side of caution when creating their portfolios. If you're new(ish) to investing it's hard to predict what your risk tolerance level may be. As Dan Bortolotti writes at canadiancouchpotato.com trying to predict one's risk tolerance level is like asking someone how long they think they can hold their hand in ice water. 90 seconds might sound like a good and reasonable guess until you actually stick your hand in that muscle crippling cold and discover that your guess wasn't that accurate.

Lower the volatility level of your portfolio to match your risk tolerance level. Of course, bonds are still the tried and true asset class that, when combined with stocks, lowers the volatility of the portfolio. As I stated in this article Asset Allocation is Alive and Well. Many investors and writers fear rising rates and the effect on bonds and bond funds. But as I wrote in Bonds: Don't Fear the Reaper rates could stay low and range-bound for a decade or more. They might increase steadily meaning bonds will deliver modest returns. And rates could rise violently. No one knows. But if your reason for holding bonds is to reduce portfolio volatility, that reason for holding is not going to change just because rates are at historic lows.

In this article I demonstrated the traditional stock to bond asset allocations from balanced income, balanced to balanced growth and to equity growth - the models and asset allocations that we use with our index-based portfolios at ING Direct Canada.

And here's a real-world test of how asset allocation affects volatility. Certainly past performance does not always predict future results.

The markets fell by some 60% from 2008 into 2009. Our balanced income portfolio - 70% bonds to 30% stocks fell by less than 10% from its pre-crash peak. Our balanced portfolio - 60% stocks to 40% bonds fell by some 20%. Our balanced growth portfolio - 75% stocks to 25% bonds fell by some 35%. Our equity portfolio was not available at that time, but certainly the stock market correction was the great equalizer bringing the U.S. (SPY), international (EFA) and Canadian (EWC) markets down by some 60%. You can use those numbers as a general barometer of how asset mix affects volatility, and to match your own risk tolerance level to the asset mix. Are you 'comfortable' with a 60% drop, a 35% drop, a 20% drop or a 10% drop? Mix and match!

Find the funds.

Create a budget. How much are you spending? How much income and cash flow do you have in your household? Are you in a true positive cash flow situation, with money to invest on a regular basis? You have fixed costs (mortgage, debt payments, car payments bills and insurance(s), food etc. You have discretionary costs that you can adjust - such as entertainment, travel, gifts and little Johnny's $300 a month skating lessons. If you're not in a positive cash flow situation that allows you to invest on a regular schedule, get out that red pen and start chopping. If your situation doesn't look promising you might have to have a look at your fixed costs. There's nothing to say that you really need the BMW, boat and a cottage if that's going to get in the way of you retiring one day.

Reinvest.

Once you find the funds, put your investment portfolio on auto pilot. Invest on a regular and defined schedule. It's great behaviour and the dollar cost averaging will actually help boost returns coming out of choppy and down markets. If you have some extra funds lying around during those severe market corrections, get greedy to the downside. Who doesn't like 50% off sales?

Keep your fees low.

Know what you're paying. Check the MER on your funds. Keep a tab on your trading fees if you manage your own portfolio. If you have an advisor, ask what you're paying in fees, and what benefits you're getting for those fees. If your advisor is not delivering the market returns or better; Houston we have a problem.

Diversify.

Hold enough stocks and bonds in your portfolio to minimize poor performance of any one or three companies. Also avoid over-concentration in any sectors. Many who are heavily into REITs and utilities recently discovered that one sector can quickly bring your portfolio to its knees. Of course buying the broader market delivers instant diversification with one holding. One should also diversify internationally as well - say goodbye to your home bias.

If you really don't have the time or knowledge to pick your own companies and bonds, don't. Buy the markets and ETFs for any sector plays.

Stay the course. Don't sell.

Once you have a plan, stick to it. There's no reason to sell on short term news. Don't worry about the noise, the wars, the inflation, the deflation, the government debts, the low yields, the high yields, the debt ceilings, the demographics, the housing meltdowns and the politicians who seem to get everything wrong. The markets have seen it all before. They're going to go down, and then they're going to go up. But they're going to go up by more than they go down over time. At least that's what history tells us.

Have a plan. Run a retirement calculator.

For retirement or any investment goal, run a calculator to see how much you need to invest, the required rate of return, starting with your end date. There's no sense investing blindly. Know where you're going and how long it's going to take to arrive. You might discover you need to alter your route, or vehicle.

On staying the course ... stop thinking.

This is very important. The markets will do what they will do. No one knows when the markets (bond or stock) will go up or when they will go down. Do not react to noise. Do not guess. Do not think - because the stock market does not have a brain, nor does it need to act rationally. Trying to guess what an irrational entity will do can be quite costly.

The stock markets will "typically" deliver about 9% annualized returns (before inflation). Here's some historical perspective on the S&P 500.

That's very decent to say the least. And if you add some bonds to temper volatility you're going to potentially lower those returns over certain periods, but you can still likely generate 6-7% returns with a balanced portfolio in most extended periods. That said, nothing is guaranteed. Rolling rates of 15-year returns for the S&P 500 show that it's possible to only have returns of 6-8% at the time of market corrections and conversely annualized returns of 16-18% over some robust 15-year periods. That demonstrates the benefit of reinvesting along the way to boost those returns during the secular bear markets.

The returns are there for the taking. All you have to do is grab them, and not let go.

About the author:

anandjha89
Anand focuses on Technology, with an eye for dividend income and long-term capital appreciation. He allocates a portion of his own portfolio, to small and medium sized companies offering compelling risk/reward propositions.

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