Long ago, I learned that success in any endeavor relies on two strategies – and making smart investment choices is no different. Quite simply:
- Do what works
- Don’t make avoidable mistakes
As applied to investing, I have made some interesting observations on both aspects in my now 17 years as an investment manager. Much like Edison and his lightbulb, I know many things that don’t work and a few things that do!
Know your risk and risk tolerance
As for what works, always know your risk. Otherwise, you may experience uncomfortable levels of fluctuation in the value of your investments. What is risk and how can investors determine their comfort level with risk? Simply stated, risk is the probability of a permanent loss of capital and believe it or not, many people don’t know how to measure this critical parameter, much less manage it.
Without getting too technical, let’s agree that stocks have more risk than bonds. Bonds have only two outcomes: they pay interest until maturity at which time they pay back face value, or the issuer defaults and goes to bankruptcy court.
Stocks, on the other hand, have a wide range of possible outcomes over time. In essence, more risk! This is where a careful asset allocation strategy is key to knowing your risk – and controlling it. On occasion and depending on the market, stocks can and do go down by 50% or more. A proper investment strategy must consider this possibility and choose an asset allocation to mitigate the risk of loss in your portfolio.
Watch the market movements
A second common investor mistake relates to the stock market. When it comes to stocks, know that the trend is your friend. As the major indices rise in an uptrend, they tend to lift the majority of individual stocks. When the major indices are in a downtrend, stepping aside can spare your portfolio from large losses. Over the long haul, avoiding big losses can have a tremendously positive effect on the long-term performance of your investments.
Know that timing does matter
If your portfolio contains individual stocks in addition to equity index exposure, be aware that quality and timing matter. Any individual stock selected should be based on sound fundamentals. So often people buy securities without knowing exactly where their money is going, this is a common investor mistake. Before buying any investments, research your options. There are a number of independent stock research companies, such as Morningstar and Value Line, that provide this information.
Additionally, the purchase should be timed when valuations are favorable implying that the stock has some room to move up in price. For both individual stocks and equity indices, valuation at the time of purchase will have a significant effect on your performance outcomes over time.
Consider fixed income investments
Fixed income interest from stable principal sources, such as individual bonds, matter to long-term portfolio performance. If you’re avoiding fixed income, then you’re making a common investor mistake.
Having a steady stream of cash coming into an account really helps smooth the returns and month-end account values.
Avoid emotion-based investing
Emotion driven decision-making versus data and reason driven decision-making is a costly – and common investor – mistake. I have seen a range of emotions that cause people to feel compelled to act in the markets and in turn lose money.
The approach that I use and advocate for others is to define the strategy using sound market principles, test the strategy to verify its validity, then implement the strategy. Being well informed drains the emotion from the process and allows data and reason to guide the subsequent investment decisions.
Don’t assume that risk equals reward
The single most common investor mistake I see people make is thinking if returns are inadequate, then more risk must be needed. This mindset is an amalgam of numerous faulty beliefs and can place an investor at risk for losses much larger than anticipated.
Over the years I have seen first-hand how the markets can punish those who focus on returns while being blind to risk. For this, and many other reasons, know and manage your portfolio’s risk. Let the returns be whatever the markets allow. I highly recommend controlling portfolio risk to around 10%. The asymmetry of risk and reward grows rapidly as drawdowns exceed this level.
If you keep these tips in mind and try to avoid making common investor mistakes you’ll be well on your way to creating a well-balanced investment portfolio with a risk level that matches your risk tolerance. That’s the key to a successful investment strategy.
Paul Kluskowski is a financial advisor in Farmington, MN. Questions or comments? Check out his GuideVine profile to watch Paul’s videos and learn more.