By Carrie L. Coghill, CFP
After a year like last year, investors are left scratching their heads wondering what to do with their portfolios, especially since there appears to be no place to run and hide. So how do you avoid making mistakes with your portfolio? The following five steps should serve as a guide.
Don’t react emotionally. The toughest part of investing is keeping your emotions out of it. Sound fundamental investment philosophy generally works against your emotions. The basic principle of “buying low, and selling high,”as easy as it sounds, is actually very difficult to implement. Take a look at the past two years: the height of buying took place in the first two months of the year 2000, when the markets were trading at their peak. Over the past couple of months, liquidations out of the market and cash on the sidelines have risen, as the markets are trading at new lows. Having a solid understanding of what your time frame is and how markets perform over various time frames can help prevent you from making an emotional decision.
If you review the performance of stocks over various holding periods, you gain an understanding of the potential volatility associated with those time frames. Historically, from 1802-1997, a holding period of one year provided returns as high as +67% and as low as -39%. However, looking over a five-year holding period, the range of returns were as high as +26% and as low as -11%. Therefore, as long as you have a reasonable time frame and understand how the length of time you hold an investment reduces your risk, this should prevent you from making emotional decisions.
Investors are inclined to put their money on the sidelines until conditions improve. Finding the ideal re-entry point is nearly impossible and can be damaging as the market recovers. For example, let’s take a look at the five-year period ending June 30, 1998 to see how performance would be affected if you were trying to time the market and missed certain trading days.
If your remained fully invested, your average annualized return would have been 23.03%. If you missed the 10 best days, your return would have been 16.62%. If you missed the 20 best days, your return would have been 12.28%. If you missed the 30 best days, your return would have been 8.48%. As you can see, the danger of timing the market is far greater than remaining fully invested.
Understand the true meaning of asset allocation. Most investors will tell you they employ asset allocation principles, but react and manage their money on a very short-term basis. Asset allocation works over the longer-term. The nature of asset allocation models is that not all of your individual investments will perform at the same time for the same reasons, but, over time, you should achieve more consistent performance with your overall portfolio.
Unfortunately, investors want to micro-manage each position. This tends to cause more volatility and less performance. Asset allocation is based on the principle that, as economic conditions change, various sectors and styles of management outperform others. The problem is that we don’t know when these changes take place.
As you can see from the example above, as an investor, you cannot afford to miss performance by moving your assets in and out of various segments of the market. Focusing on the performance of your overall portfolio will enable you to set performance targets and have a better understanding of the risk levels associated with your portfolio. The key is to stay diversified through the ups and downs in various market segments. Your specific level of diversification as it relates to stocks vs. bonds, and growth styles vs. value styles, will dictate the return potential of your portfolio and the corresponding risk associated with it.
Don’t use last year’s performance numbers to make your investment decisions. How often have you heard “last year’s winners are this year’s losers” and vice versa? And yet, investors still want to chase performance and sell investments that have lost money and move it into investments that have done well. Based on the fact that different industries and management styles tend to have cycles of being in favor and then pausing and possibly giving back some of their return, chasing performance is a formula for disaster. Investments need to be analyzed based on how they look, going forward. Usually, it is the investments that have sold off the most or have not performed that represent the best value.
Let’s take a look at some examples of specific sectors: International Bonds: best in 1987 (+23.00%); worst in 1988 (+3.00%). International Stocks: worst in 1992 (-11.80%); best in 1993 (+33.00%). Large Cap Value: worst in 1994 (-2.00%); best in 1995 (+34.40%). Large Cap Growth: best in 1999 (+33.20%); worst in 2000 (-22.40).
Correct your mistakes. In a market environment such as the one we’ve experienced over the last two years where stocks hit all time highs and then came tumbling down, investors sometimes become complacent or seek the easy way out. Statements such as, “I’m selling everything and going to cash,” or, “I’ll wait and make changes when my stocks get back to where they were” can prevent you from achieving positive results with your money and illustrate the need for professional management of assets.
Once again, you need to forget about what has happened in the past and ask yourself the question, “Would I buy these investments today?” If the answer is yes, hold tight and maybe even buy more. If the answer is no, sell and move on!
Many of the Internet-related and dot.com companies may end up in bankruptcy. Therefore, if you didn’t buy a stock based on sound fundamentals, you should consider selling it and allocating those dollars to an investment that may have better potential. Many solid companies have declined in price during the 2000/2001 sell-off and are trading at tremendous discounts. Moving money currently invested in “financially weak” companies into these types of discounted companies may improve your performance going forward.
Always use “your goal” as your benchmark. I received a call from a client the other day that was panicked that the NASDAQ was down almost 40% in 2000. I replied by telling the client, who owned bond funds and very conservative stock mutual funds, that his performance was actually positive for the year. As investors, we sometimes get wrapped up in all of the hype of the market and forget that it is our own personal goals that really matter. If you can achieve your retirement goal by earning 10% per year, then you shouldn’t over-react to the issues that aren’t affecting you and your ability to achieve your personal goals. Any investment decision you make should be driven by the result or outcome you would like to achieve with that particular sum of money.
As a financial planner, I’ve never had anyone walk into my office and tell me that his or her goal was to “beat the market.” They typically want to know how much money they need to save to send their kids to college, and retire. The rate of return required on investments is typically driven by the availability of resources, time frames and risk tolerance. In addition, any investment strategy should incorporate preservation of assets by avoiding excessive taxes and fees. If you stay focused on your goals, not only will you have a better chance of achieving them, but you’ll also maintain peace of mind.
Carrie L. Coghill, CFP, is president and co-founder of D.B. Root & Company, a financial planning firm based in Pittsburgh.