To compliment an article I previously wrote called “The Essentials to Construct your Ultimate Investment Portfolio,” I decided to write this article to point out what factors lead to a successful portfolio.
Step #1: Determine Risk Tolerance
This is the foundation of all investment portfolios. If you don’t determine your risk tolerance you won’t get anywhere. Knowing how much risk you can take and sleep at night is important because you don’t want to be getting in and out of investments when there is a market event.
Step #2: Expect to take Risks
This ties in directly to what I just said about determining your risk tolerance. It’s very difficult to have a successful investment portfolio without taking risks. If you’re extremely risk averse and don’t want to invest in anything other than term deposits, I want you to really consider the other risks involved such as inflationary or purchasing power risk. If you invest in a term deposit that gives you dismal returns, inflation will likely beat out your investment return and eat into your purchasing power. So if your investment portfolio could buy 100 bananas today, it might only be able to buy 90 bananas in 10 years. Why, you might want to buy 100 bananas is beyond me, but you get the point.
I also believe that the more knowledge you have, the more you will be willing to take more risks. So please please please do yourself a favor and spend time learning about the risk involved in investing. Write down what bothers you about investing, is it like gambling? Can you not stand the drops in the stock market? The investing world isn’t as scary as it might seem if you know what you’re doing and have control.
Step #3: Your Personalized Asset Allocation
Based on your risk tolerance, you’ll be able to determine the approximate asset allocation of your investment portfolio. If we focus on financial securities and you came out as an aggressive investor you would have an asset allocation consisting of 0-10% in cash or cash equivalents, 20-25% fixed income, and 65-70% in equities. Depending on your source, you’ll see a minor difference in the percentage that you put into each asset class but this should give you a good idea.
This asset class is important because it acts as a guideline as you invest your funds. If you have $1,000 to invest every month you could leave $0-100 in cash, invest $200-250 and $650-700 in stocks. But as you might guess this isn’t exactly very efficient. So in reality, you would likely keep money in cash until you can invest the funds in a bigger amount. For example you would wait until you have enough for a $1,000 fixed income investment or $2,000 to buy a certain stock. Some investments have minimal investment amounts while others have a transaction-based fee, that’s why it might not make sense to buy stocks in small chunks. Of course, you can adjust to what works for you.
As a smaller investor, your biggest option is mutual funds, which will allow you to invest small portions to achieve the asset allocation. If you have a small investment portfolio of say less than $5,000 this is a great place to start but as your investment portfolio grows bigger I would not recommend this because in general mutual fund management fees could eat into your long term gains.
Step #4: Don’t Time the Market for short-term gains
As tempting as it might be, don’t try to time the market. You might think a stock is cheap and think it will rebound a dollar or two for a quick gain only to watch it drop another $5 after you buy it. Or you might think that a stock has topped out as it hit a new 52-week high, but after your sell it, that stock that has strong momentum might continue its strong trend a rise another 10%.
While you might not lose money trying to time the market (although most people do), you might do something a lot worse. Limit your long-term gains. Most investors, myself included, get excited when we see a winning trade. You invest $5,000 and you’re up $500, that’s 10%! You’re scared to lose that paper gain and you sell the stock only to watch it continue to climb to the point that you could have had a 25% gain or $1,250 gain. This is what greed does to us.
I honestly think not letting your winners run is a lot worse than not cutting your losses. This is because I have an investment portfolio and not a lineup of speculative trades. This means that even if my losses are falling because of some horrible financial news, I’m not too worried because I have solid stocks in my investment portfolio that I know will be the last to go under. I don’t mind having paper losses for my trades. In fact, I’m happy that my solid stocks are losing because that means that I’ll be able to buy more stocks with next dividend reinvestment plan or DRIP (read about why dividend investment stocks are so awesome here, if you don’t know what a DRIP is) or be able to buy the stocks at a cheaper price when I have cash available to add to my investment.
Step #5: Aim for singles, not home runs
While I’m not a huge fan (anymore) of having speculative trades I think it’s ok to have a small set percentage of your portfolio that is designated only for these trades. If you’re smart about it, it can add a juicy return to your overall investment portfolio. Instead of looking for homeruns or a 200% gain on stocks, look for smaller 5-10% gains on stocks, which is much more realistic.
Step #6: Invest Regularly
This is a given but it’s worth mentioning anyway. If you want to reach financial freedom or have a successful investment portfolio, you have to contribute funds to your investment portfolio regularly. You should be doing this automatically, putting a set amount aside every paycheck. But to take this a step further, every time you have extra funds instead of buying something put that money into your investment fund to accelerate the growth of your portfolio. You want money to work for you and not the other way around, by investing the funds you have the power of compounding on your side.
Step #7: Focus on lowering fees of your portfolio
Fees are killer and while it might not seem like a big deal, over time it will really dig into your returns. Let me illustrate what a 1% difference can make on your overall portfolio.
Let’s compare an investment portfolio that has a 4% return vs. a 5% return, investing $500 a month, for the next 30 years.
If you want to do the calculation on a financial calculator yourself here are the numbers to punch in (read this article to understand how this calculation works):
5% (PMT=-$500, N=12 months*30 years=360, i=5%/12months=0.4167%, FV=?)
4% (PMT=-$500, N=12 months*30 years=360, i=4%/12months=0.3333%, FV=?)
The 5% portfolio will have: $416,129.32
The 4% portfolio will have: $347,024.70
So as you can see over the 30-year timespan, that measly 1% compounded turns into $69,104.62 that you could have had but instead disappeared in fees.
That’s just one illustration but I hope it gives you an idea as to how important it is to minimize fees as much as possible. Not everyone can construct their own portfolio, but I’m someone that will do my asset allocation all on my own because if you make your own portfolio, there are no maintenance fees. You only pay transaction fees based on the stocks you buy and sell or the fixed income securities that you buy. Fixed income securities usually just expire so there’s no selling fee unless you decide to sell early for some reason.
Step #8: Reinvest Everything
Getting dividends and interest payments in your bank account are nice, but if you really want to have a successful investment portfolio, then you need to have the mindset of reinvesting everything that your portfolio provides you. This is where the power of compounding will help you and one of those rare times that time is actually on your side.
Unless you’re in dire needs of the funds from your investment portfolio there’s no reason to take even a penny out. Make it so that your investment portfolio is off limits until you really need the funds or when you hit financial freedom.
Step #9: KISS: Keep it Simple Silly!
As I’ve said numerous times on this site, both financial planning and investing can be very complicated. But that doesn’t mean you need to make your investment portfolio complicated. Keep it simple. Find things that you are good at and stick to them. Sure you need to diversify a little and you should definitely make sure that you invest in a variety of stocks to cover all the bases but that doesn’t mean you need to invest in derivatives and implement insane strategies that even a hedge fund manager has difficulty dealing with.
I’ll eventually be talking about how to construct your own portfolio and try to make it as simple as possible. While I can’t replace what services a real financial or investment advisor might provide I can hopefully help you understand the basics of creating a simple investment portfolio, which I personally think is all you need. There’s no need to have 1,500 different holdings in a portfolio.
Step #10: Ignore Fads
If you watch financial news, you’ll hear about stocks that have hit new 52 weeks highs, IPO (Initial Public Offerings), and other news about stocks that are the hot new fad. Ignore those stocks like the plague, by the time it hits the news the stock is likely past it’s peak and those that have been in the stock during the big uptick are cashing out. Let the news do the talking about focus on your portfolio. If you stick to you plan, given that it’s a sound one, there’s no need room for “hot picks” in your investment portfolio.
That pretty much sums up the 10 steps to a successful investment portfolio. Yes this isn’t a comprehensive list as a comprehensive list would be the length of a book, but I think I hit some of the essential areas. Do you have tips that you might want to share? Did you like this article? Please share it with your family and friends!