By RICK FERRI
Creating a portfolio is easy; staying the course is hard. Despite our best intentions we sometimes fall off the wagon. We’re inclined to chase performance, react emotionally to market swings, and generally do far more trading than good discipline would suggest.
We might have a written long-term plan, but if we don’t remind ourselves to read it when we get the urge to follow the herd, the plan is useless. I’ve seen good intentions go by the wayside because a well-written plan was never looked at again.
These observations aren’t limited to individual investors. Investment commitments and advisers who claim to be disciplined can give in to temptation too. They’ll say it’s to “adapt to changing market conditions,” but in truth, they just want to trade something, anything!
Poor discipline is particularly common in bear markets when people become anxious. An adviser may fear their clients are looking to take their business elsewhere unless something is done. Loopholes in Investment Policy Statements may allow an adviser to tweak a portfolio every now and again. That might persuade a couple of skittish clients to stay, but this breach of discipline is rarely in the best long-term interests of the client or the adviser.
I’ve put together six rules to staying the course. They will help you (and perhaps your adviser) make better long-term decisions.
1. Have a long-term investment philosophy based on sound evidence.
There are two investment philosophies in the world. You either believe you have a high probability of beating the markets or you don’t. I decided a long time ago that the markets are more efficient at pricing securities than I could ever hope to be. I do not have enough skill to consistently add value to a portfolio by picking mispriced stocks, bonds, industry sectors, countries, or entire markets. I don’t try. Market returns are all I need to achieve my long-term financial goal.
2. Form a prudent portfolio strategy starting with an asset allocation.
Asset allocation is how a portfolio is diversified among asset classes. A prudent asset allocation should be based on each person’s own long-term financial goals. This gives you a personalised beacon to follow through turbulent market conditions. The allocation should be in fixed percentages that you plan to stick with over time, rather than floating or tactical reactions to the ongoing turbulence.
3. Select a few simple, low-cost index funds or ETFs to represent each asset class.
Implement the asset allocation using an appropriate mix of index funds and exchange-traded funds (ETFs). These products provide broad diversification within an asset class for a very low cost. Building a select portfolio of index funds and ETFs that tracks the markets will help you receive your fair share of the markets’ returns.
4. Automate trading decisions as much as possible to maintain discipline.
Markets don’t remain at their current levels for long, yet a portfolio should be maintained at roughly the same asset allocation through all market conditions. Rebalancing helps control portfolio asset allocation. Systematic rebalancing can serve as the method to maintain a portfolio’s risk characteristics. Don’t think about it; just do it.
5. Only change an asset allocation when your needs change.
Investment plans are based on long-term needs and should be written for the long term. If you’re not willing to hold an asset class or fund for the next ten years, then you shouldn’t own it now. It doesn’t matter what’s going on in the markets today; build and hold your portfolio for the long haul, giving it the greatest chance to fulfil its intended purpose.
6. View market volatility as your friend because it means you can buy cheaper.
It’s not easy to invest new money in a market that seems to be heading into a bottomless pit, but that’s what must be done. Look at it this way; you get to buy at a bargain price! If you plan to invest every month, then invest every month, regardless of recent market activity. Disciplined investing is about forming good habits and practising them consistently.
Some critics of these methods say these rules are too rigid, that they don’t offer flexibility for what’s happening in the markets today. Well, that’s what discipline means! It’s discipline that makes you money — it earns you the return you’re seeking.
Disciplined investing is easy to talk about but much harder in practice. It’s like when doctors tell us to exercise regularly, eat right and get plenty of rest. That all sounds great, and it might go fine to start with… until it doesn’t.
Discipline is hard. That’s why we have to be reminded. My advice is to re-visit this post whenever you’re tempted to stray.
RICK FERRI is financial adviser and writer. Based near Austin, Texas, he runs Ferri Investment Solutions, a pay-by-the hour financial advice service. He also produces the Bogleheads on Investing Podcast. You can follow him on Twitter @Rick_Ferri.