Why investors miss the mark

Investors often get mired in the detail of managing a portfolio. Actively self-managed portfolios are often over traded as profits are chased and real opportunities missed. Passively managed portfolios are often under traded as asset allocations are forgotten.

If you want to avoid these common mistakes, then here are the three steps you need to take:

1 Define your need

This is about you deciding what you want your investment to do.

·       How much do you plan to invest? Is it a lump sum, or will you also be adding to your investment on a regular basis?

·       Is it required to produce an income now, or in the future?

·       Do you have a target amount that you want your investment to grow to?

·       How long are you prepared to commit your money to your investment – in other words, when do you want to see the benefits?

By answering these questions you will be able to put some numbers on your investment. For example, if you have $100,000 to invest and you want your investment to grow to $200,000 in ten years when you wish to start taking an income, then you can calculate what rate of return you need to make as an average each year. Investopedia has a great compound annual growth rate calculator which will help you do this – by the way, to double your money in 10 years you need your portfolio to grow by 7.18% after costs each year.

2 Set your strategy and investment philosophy

The first part of this step is to decide upon your investment philosophy. Will you actively self-manage your portfolio, spending time to conduct research and then buying and selling assets and securities in line with your investment strategy? Or perhaps you will use a passive buy and hold strategy (which I’ve discussed before as being a defunct strategy in the modern market)?

winning PortfolioThe likelihood is that you will invest via either mutual funds or ETF’s. These will give you access to a wide range of securities, with natural diversification and allow you to either invest passively or in funds that are actively managed. For this level of management, of course, you’ll be paying fund management fees which will negatively affect your investment performance. You need to take this into account when you’re calculating the return you need and the likely return you’ll achieve.

A word here about actively managed funds versus passively managed funds. Over the long term, there’s something very strange about actively managed funds that might surprise you. This strange occurrence can be summed up with these three facts:

·       Low cost passive index funds or ETFs that track a given market outperform almost all actively managed mutual funds that attempt to beat that given market. That’s right: the higher fund management charges paid by investors in actively managed funds buys worse performance.

·       Investors who have held a portfolio of passive index tracking funds or ETFs across the asset classes have outperformed almost all portfolios that hold a range of actively managed mutual funds. Paying a number of fund managers extra charges to actively manage a range of funds hardly ever works, either.

·       Keeping asset allocation reviewed on a passive basis outperforms most active asset allocation strategies.

So, perhaps an investment philosophy that will work best is to utilize a range of passive mutual funds, with low costs, that seek to replicate asset classes or market performance. Deciding upon this philosophy means that you can now look to build your investment strategy to meet your investment goals as discussed above.

Here you need to consider asset allocation and portfolio rebalancing.

Related: The Basic Tenets of Investing

Asset allocation

You know the return you need your portfolio to make, or the income it needs to achieve. You also know the amount you are investing. Now it’s time to decide upon the asset allocation you need to assign to your portfolio to achieve your aims.

Don’t forget here that high yield corporate bond funds and equity dividend funds can be used to produce both income and capital growth. Funds that reinvest dividends will help your portfolio to benefit from the compounding effect.

You can make decisions about asset allocation using the required rate of return and the expected rate of return each asset class will give.

At this point you also need to allow for your personal attitude to risk. How would you feel if some of your investments lost 20%, 30% or more? You need to balance this against your need for growth or income.

Once you have made the decision on asset allocation, and how much of your portfolio you will be allocating to each asset class, then it will be time to make your investments into the asset classes by selecting funds or ETF’s to meet your philosophy and strategy.

Related: 5 Reasons Investors Fail

Portfolio Review

Don’t just leave your portfolio to tick away in the background. If you do so, you’ll find that when one asset class outperforms another your asset allocation strategy will move out of sync, and your expected rate of return over the longer term will be skewed – and it is unlikely to move in your favor.

On the other hand, you don’t want to be changing and switching allocations or funds every week. You need to give your passive funds time to work some magic, and constant switching will not only lose this advantage, but also build up your dealing costs. If you plan to run your portfolio this way, you might as well invest in a few underperforming and expensive actively managed mutual funds.

However, you do need to review your portfolio perhaps once every six months, but more usual is once every year. And if you have invested in a range of asset based market or index tracking style funds, then your review will be at asset level rather than an individual fund level. The annual review should be focused on realigning out of sync asset classes to come back into line with your required portfolio allocation.

Keep some back

However much you invest, a good rule of thumb is to keep some of your investment in cash. It’s an asset in its own right, of course, but keeping, say, 10% in a high interest cash account will enable you the flexibility to turn a market downturn into an opportunity. Sell offs in markets tend to overshoot on the downside; having cash at hand will enable you to benefit from such an event.

Related: Individual Stocks, Mutual Funds or ETF’s?

3 Stay disciplined in your investment approach

You’ve set your goals, and built your investment philosophy and strategy to reach your targets. You’ve set out a timetable for portfolio review, and will rebase your portfolio to your required asset allocation when you undertake that review.

The final part of the puzzle is to stay disciplined and stick to your philosophy and strategy. If you become embroiled in ‘market noise’ the often sentimentally driven ups and downs of the market, you will lose focus and begin making poor investment decisions trying to chase that extra profit. And that’s when your portfolio will start to underperform.

Keeping your discipline through thick and thin markets will help you take out the emotional decisions that cause so many losses. Making portfolio changes in line with your longer term goals will mean you benefit from time in the market, as well as timing of the market.

In summary

Building a portfolio to beat the active managers takes a clear investment philosophy and a defined strategy. It also requires a disciplined approach, rebalancing at regular but intervals without overtrading. The first step to a winning portfolio, however, is to determine your aims for your investment, setting realistic goals. Keeping a little cash available will also allow you to take advantage of a sudden and overcooked downturn in an asset class to give your portfolio a little added bonus.

Michael Barton

Michael Barton

Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.