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Stay On Course for Investing Success

January 25, 2012

The secret to investing success is within all of us. We all know that we should be investing for the long term. But it’s funny how plans change at the first sign of a vicious bear market. Suddenly we are selling when we should be buying. Admit it. We all make poor financial decisions in times of stress. The secret to success in the market is to structure our portfolios to reduce stress wherever possible.

Market Volatility

The stock market has never been so volatile as it has been the past 15 years. Fortunes have been lost, made, then lost again.

Volatility breeds on itself. Investor panic sets in when investors buy in fear of missing out after a huge run in the stock market. It sets in again when investors sell in fear after a long sell off, as investors fear they will lose their savings. Both waves of panic increase an already volatile situation in the market.

If more investors stuck to a long term plan and avoided trading in and out of the market, the stock market would become less volatile. In many ways, we are to blame for exacerbating the problem.

Begin With Self-Assessment

I firmly believe that the best exercise plan is the one you enjoy doing, and the best diet plan is the one you will stick to. The markets are no different. The best investing plan is the one you will continue to follow no matter what the markets do tomorrow.

Long term results suggest the stock market rises about 8 to 10 percent per year. This rate of compounding growth far exceeds bonds and other investing vehicles such as treasury inflation protected securities (TIPS).

For this reason many experts recommend investors put a large percentage of their money, if not all, into stocks. Most recommend diversification between stocks and bonds, with younger investors more heavily weighted in stocks and older investors increasing their bond exposure.

The problem with this blanket advice is that it fails to assess individual investor psychology. Greed and fear tends to drive investors to buy near market peaks, and sell near market bottoms. These investors clearly do not have an understanding of their own psychology, and did not assess their personal risk tolerance prior to investing.

Assessing Risk Tolerance

Assessing your personal risk tolerance requires you to factor in both your intermediate financial needs, and your psychological tendencies. Obviously any money which you absolutely need in the next few years should not be in the stock market.

But just because you don’t need to withdraw your money anytime soon does not mean that you should use blanket advice to determine how much money to put into stocks and bonds.

Ask yourself one simple question. If the stock market fell 50% next month, cutting your portfolio in half, would it cause you stress and sleepless nights? If you are not sure, the answer is probably yes. In this case you need to add more diversification to your portfolio than just stocks.

If your honest answer is that the 50% drop would not bother you, and might even encourage you to put more money into the stock market, then you have a greater than normal ability to handle market volatility and you probably don’t need to change your weightings.

Negative Correlations = Sound Sleep

The great thing about stocks and bonds as that they are historically negatively correlated. That is, when stocks are falling, bonds tend to rise. Diversifying between stocks and bonds usually means your portfolio will experience less volatility. During a bull market in stocks, your portfolio will rise but not excessively. During a bear market in stocks, your portfolio will fall but not as sharply as the stock market will.

Deciding whether to be 80% invested in stocks and 20% invested in bonds, or even 100% in bonds or stocks, is a personal choice. If you are absolutely honest about your psychology and risk tolerance, then you can set your diversification levels and basically put your portfolio on autopilot, never worrying about the stock market again.

Re-Balance Once Per Year

Once you determine which percentage of stocks and bonds meets your personal risk tolerance, stick to it. If you are a 50-50 or 70-30 person, be honest with your tolerance and invest with it in mind. Choose a date on the calendar. On this day every year, re-balance your portfolio to get it back to the diversification which keeps you cool and calm.

The reason you need to do this is because in any given year, stocks or bonds are going to outperform the other. This causes your portfolio weightings to change. If your stocks represent too small a portion of your portfolio after a year of autopilot investing, sell some bond shares or put new money into stocks so that the percentages are where you want them again.

Some studies suggest that simply letting your portfolio ride on autopilot generates a slightly higher return than re-balancing. What these studies fail to recognize however is that over time individual risk assessments get out of whack, and investors become so stressed that they make critical mistakes with their money.

Re-balance. It will keep you calm when others are panicking, and take the unnecessary stresses out of investing.

Conclusion

Successful investing requires a sound mind, as well as a sound plan. Diversification should take into account not only your age and financial requirements in the near and immediate term, but also your psychological reactions to market volatility. An honest self assessment is one of the most important steps to take toward successful investing.

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