Primary Pillars of Investing
Written by Gregory Palacorolla, CFP®
Investopedia says, “Investing is the act of allocating funds to an asset or committing capital to an endeavor (a business, project, real estate, etc.), with the expectation of generating an income or profit. This begs the question, “How do I increase my chances of generating an income or profit?” Then, of course, our minds quickly move to “How do I achieve the highest possible return or profit?” These are great questions that many scholars and brilliant minds have worked tirelessly to answer. Unfortunately, investing is not an exact science. There is no specific formula that will guarantee high returns or a handsome profit. There are too many external variables that are dynamic in nature, and events that happen along the periphery, which have a significant impact on investing results. However, even though there is no guaranteed magic formula to apply, you can position yourself for investing success through an understanding and application of these key pillars of investing.
Risk vs. Reward
Understanding the relationship between risk and reward is crucial in developing an investment philosophy and plan. All investments carry some degree of risk. Typically, the higher the risk, the higher the potential return. Therefore, it is very important you can gauge an investment’s level of risk. Then, you must determine what level of risk you feel comfortable with as an investor. Oftentimes this is measured with the use of a risk tolerance questionnaire and/or detailed line of questioning during a meeting.
There are consequences of taking on risk when you invest in vehicles other than savings accounts or money market accounts. Loss of principal, lagging inflation, a shortfall in retirement income, and being bombarded with expensive fees or other costs often associated with actively managed mutual funds are some of these consequences. Investors who want to play it on the safe side by putting their money in treasury bonds, certificates of deposit, and T-bills should know that the risk may be low, but so is the return. They can certainly play a part in an investment plan, but it probably isn’t prudent to expect them to carry the entire portfolio.
There are three primary investment options available to most investors: stocks, bonds, and mutual funds. Risk varies with each of these vehicles and within each asset class. Stocks in established, blue-chip companies that pay annual dividends are less risky than a penny stock firm or start-up company where the returns will be much more volatile. Bonds tend to offer more safety than stocks, so many choose to allocate a certain percentage to them to offset the risk inherent in stocks. When looking at bonds, investors should always consider their rating. You can find these ratings via Standard and Poor or Moody’s. Most mutual funds are managed by professional portfolio managers and have a variety of stocks and bonds within themselves. There is a wide range of funds available to investors, all with the potential to counteract some of the risk in an investor’s portfolio.
Knowledge of How the Markets Behave
There are many theories and models out there that try to predict how markets will react under certain circumstances. The Capital Asset Pricing Model and Efficient Market Hypothesis have a good track record of predicting the markets. However, there are some who don’t support these models. For example, some investors, like day traders do not believe in EMH. They still try to beat the market averages by looking at short-term trends/patterns and finding buying and selling opportunities based on these patterns. Whether you are a proponent for the models or not, most will agree that the markets are influenced by many things.
Rising interest rates have a negative impact on bond prices and a debilitating effect on stock prices. The relentless global media news loop oftentimes triggers substantial market volatility and superficial knee-jerk reactions. Investors are filled with uncertainty already, and the media serves to fuel that uncertainty and worry even more. A change in presidency, a threat from overseas, news of turmoil within the banking system or a Fed meeting can all spawn market reactions. Major global stock markets overlap in market hours, so investor reactions to global events happen in real time. When that reaction is negative, it can create a string of sell-offs across regional stock markets that generates endless borage of news and market changes. During a correction, this dip in stocks can be difficult to break. The bottom line is that markets will always behave like a creature of the wild. Your best chance at survival will be to learn as much as you can about them, recognize patterns, and make decisions based on objective data and experience, rather than speculation.
Recognition of Investor Psychological Tendencies (Behavioral Finance)
Behavioral finance is a relatively new field of study. It looks at psychology and emotion and tries to explain why markets don’t always go up or down the way we might expect. On a macro level, we can with a certain degree of confidence, say that investors tend to struggle with two primary fears: the fear of missing out and the fear of losing everything.
The fear of missing out can lead to speculative decision making without proper research into the underlying investment strategy. They will invest in emerging areas or new trends without doing their homework because they see their peers are doing it, and they are afraid of missing out. The cryptocurrency craze is a recent example of this.
The fear of losing everything can be seen when investors move everything to cash during extreme volatility or a significant downturn to avoid a sell-off or market crash. Rather than staying the course, investors panic and make irrational decisions. They lose the ability to see through a long-term lens and resort to a short-term viewpoint with a very dismal hue.
Understanding and believing in the investments you are in and how they all play a part in your overall plan will help you keep your emotions in check. Employing patience and reminding yourself that markets have always and will continue to go through ups and downs over time, will help you stay the course.
Investing Trifecta: Asset Allocation, Diversification, Rebalancing
Asset allocation divides an investment portfolio among various asset categories such as stocks, bonds, and cash. Asset allocation is in large part determined by your personal tolerance for risk and time you will be investing in order to achieve a specific goal (aka time horizon). Stocks, bonds, and cash/cash equivalents are the most common asset categories. However, there are others such as real estate, commodities, and private equity. Market conditions can cause one asset category to do well and another to do poorly. By investing in multiple asset categories, you reduce the risk of losing money and your portfolio will have a smoother ride. Asset allocation is strongly correlated with whether or not you will meet your financial goals. Too much risk and you won’t have enough money to fund your goals. Too little risk and the investment returns won’t be enough to sustain you.
Diversification is a strategy that involves spreading your money throughout different investments, so if one investment suffers losses, the other investments will make up for those losses. Diversification can lower portfolio volatility, increase risk-adjusted returns, and reduce the dependence on any single country, sector, or company. A portfolio should be diversified between asset categories and within asset categories. The goal is to identify investments in segments of each asset category that may perform differently in varying market conditions. There are several ways to diversify your portfolio. The most popular is through using mutual funds and exchange-traded funds. You can invest small amounts and still have access to hundreds of different investments. You can also build your own portfolio by combining stocks from various countries, industries, sectors, and corporate backgrounds, and then add in bonds and other investments. No matter which diversification strategy you choose, the important takeaway is that in general diversification strives to provide a safety net so the pain the investor feels is limited when one of their investments doesn’t perform well.
Rebalancing is defaulting back to your original asset allocation mix. Over time some of your investments may become misaligned with your investment goals. You’ll want to ensure that any one asset category does not get become over weighted. This is achieved through rebalancing. There are three different ways to balance a portfolio: selling off investments from over-weighted asset categories and using the proceeds to purchase under-weighted asset categories, purchasing new under-weighted categories outright, or altering your recurring contributions so more money is going toward under-weighted categories. No matter the method chosen, you should weigh the transaction fees or tax consequences involved. Your financial advisor or tax professional can help you minimize these costs. You can rebalance your portfolio based on a regular time interval such as every six months or when the relative weight of an asset class increases or decreases more than a certain percentage.
No investing strategy around has guaranteed results, and every portfolio will carry at least some degree of risk. The key is understanding the foundational tenets of investing and how they can be used to your benefit when building your own portfolio. Having a solid grasp of your financial goals and overall strategy being used to achieve them is also crucial to investing success. Knowledge is power. Speak with a financial advisor today to learn more by calling (410) 824-1853.
Sources: The Balance/ Kiplinger/ Forbes/ Motley Fool/ SEC.gov
© Geier Asset Management, Inc. May 2019. Gregory Palacorolla, CFP ® is Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of May 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses