Three Simple Steps Help Blaze Through the Investment Maze
One of the major problems with investing in today’s information-drenched environment is that there is so much noise out there that investors are totally confused about what is going on and what they should do.
Many people feel like a lost child at the mall because they can’t even figure out where to start with their investments. If you want to get on the right path, follow a few simple yet important principles: organization, allocation and rebalancing.
The first step to solving this problem is organizing the investment universe into an easily understandable framework. Everything you can invest in falls into four basic asset classes: stocks, bonds, cash and hard assets. There is no other place that you can put your wealth.
These are the primary colors of investing, and once you understand this, it is easy to go to your portfolio and identify your investments as one of the four basic classes of assets. When you have done so, you can arrange them on a pie chart and visually inspect your portfolio for imbalances. Whether or not there are imbalances depends on your investment objective and risk tolerance.
The relative allocation of asset classes in a portfolio becomes the primary determinant of risk and return. Stocks and hard assets —like commodities and real estate —provide growth potential but are very volatile. Bonds can provide income, and cash can provide greater price stability, but both offer little if any growth.
Emphasizing one or the other in your portfolio controls most of your risk level and your potential return. Another potential benefit of asset allocation is that asset classes are distinct from one another because they will usually react differently to the same stimulus. That is, when one class zigs and another zags, it is unlikely that the entire portfolio will move in tandem.
This characteristic is the basis for proper diversification. The simultaneous presence of all four asset classes in a portfolio can help reduce, but will not eliminate, volatility —which is a primary measure of risk. A properly trained financial adviser can help you determine an allocation that makes sense for your particular circumstances.
This is an important but often overlooked part of the simplification process. Simply stated, rebalancing prunes your portfolio back to your target allocation at regular intervals. This should happen at least annually.
Rebalancing forces you to sell high and buy low, the basic axiom of successful investors. For example, generally when your stock allocation is above its target, it has outperformed the other asset classes. A rebalance would take money from stocks and add it to a class that is underperforming. Without rebalancing, portfolio allocations become distorted and may no longer reflect the investor’s risk tolerance and return objectives.
Rebalancing works best when it is automated. The investor is taken out of the process and not allowed to second guess the decision. It is important to understand that rebalancing investments may cause investors to incur transaction costs or taxable events that might increase their tax liability.
Following these simple principles can help you cut through the confusion, get your portfolio in shape and keep it that way while more fully assuring that what you have is manageable and reflects who you are as an investor.
As seen in the 9/30/2010 issue of Washington Business Journal