Want a hot stock tip? Come closer. Closer. (Whispers) Stop looking for stock tips...
When it comes to investments for the average person - average meaning less than multiple millions of dollars to invest - we need to forget finding a hot stock or trying to time the market. Let’s consider mirroring the market as a whole, make sure we are invested in a way that’s aligned with our risk tolerance, periodically rebalance our portfolio, and above all, behave!
So, what do I mean by all that? When I wrote that we should try to mirror the market, I mean we should try to have a piece of almost all the stocks out there and own that performance. So, when the market is up as a whole, so too will our portfolio likely be up. When it’s down, our portfolio will likely be down. Not just that, but we have to accept that because we own a diversified portfolio, when some segments are up - like the S&P 500 - our portfolio may be up, but not as much. But of course, when that same segment is down, our portfolio may be down...but again, not as much. We want to be diversified so that when some segments zig, others zag. So, we mirror the market, but we are aiming have a smoother ride than just one segment or stock.
That smoother ride leads me to risk tolerance. It’s just what it sounds like - how much risk can you tolerate? The more risk you take, the higher the opportunity for reward; but that can come with a higher chance of losing money. In general, stocks are riskier but offer more reward. Fixed income, like bonds, are generally safer but offer less reward. Most people combine both in a portfolio to get to the right allocation for them. So how much risk can we handle?
That comes down to a lot of things, but our time horizon probably has the biggest impact on our risk tolerance. If I need the money to buy a house in a year or if I’m about to retire - well then, I don’t have time to let the portfolio rebound if the market goes down. So, I probably don’t have a ton of tolerance for risk. But if I don’t plan on touching the money for decades, I may have plenty of time to wait for it to go back up if it goes down. So, I might have a higher tolerance for risk.
I also said the portfolio should consider a rebalance periodically. That also is related to risk tolerance. Let’s say I have a portfolio that has 80% of the money in equities (basically, stocks) and 20% in fixed income. If the market does well, by definition I’ll no longer have that 80/20 split. I’ll have a higher percentage of equities. So, we need to make sure our portfolios are consistently within our desired risk tolerances - so in the example above where I had 80% of my money in stocks and the market went up, well now I have more than 80% in stocks. Maybe it’s now an 85/15 split. So, I need to sell some equities and buy some fixed income to get back to the 80/20 split that reflects my risk tolerance. If we don’t rebalance, we might find ourselves with a portfolio that has way more risk than we can handle when the market goes down - or not the amount of equities we want when the market goes up.
Handling risk - staying on strategy - is the big key here.
According to a Dalbar study of 2017, the S&P 500 provided a return of 11.96% in 2016 and 7.68% over the last 20 years. Individual investors? 7.26% in 2016 and 4.79% over those same 20-years. Why is that the case? Because as cool as it is to think we do, we don’t know when a certain stock will go up or down. And absent someone to help us stay on strategy, it’s hard not to react emotionally and sell when the market is down.
And that’s what I mean by behave. More than anything else, this is how I believe I help my clients in the market. I help them behave properly. We have a plan and we need to stick to it. But it’s easy to stick to a plan when the market is up. When the market is down and we are watching our own money go down in value - money we are counting on for our future, money we worked insanely hard to earn - it’s not so easy to stay on strategy. Left to their own devices investors very often sell low and buy high. That’s what the Dalbar study suggests. And that’s one of the biggest ways I help protect my clients when it comes to investments - I help them behave properly.
Easier said than done. But that’s the biggest key to investing in my opinion - have a strategy and make sure you stick to it.