Developing an Investment Strategy

Many people approach investing in a haphazard manner, purchasing individual stocks and bonds, but never really deciding how to structure their overall investment portfolio. With no strategy to guide purchases, these portfolios can contain investments that are inappropriate for the individuals' circumstances. Thus, to help guide your investment decisions, take time to develop an investment strategy by following these steps:

1. Identify your financial goals.

This will help you determine how much money you need to accumulate and how long you have to do so. Your need for liquidity, desired return, current income needs, portfolio size, tax situation, age, and investment period can all have a significant impact on which investments are appropriate. For instance, funds that will be needed in a couple of years should be invested differently than funds that won't be needed for 20 or 30 years.

2. Review investment alternatives.

Don't confine yourself to currently owned investments. Investigate all options, including cash equivalents, bonds, stocks, real estate, and other choices. Make sure you understand the basic aspects of each, examining the types of risk they are subject to as well as their historical rates of return.

3. Assess your tolerance for risk.

Everyone has a different risk tolerance - some people can't stand the thought of losing any of their principal while others are comfortable with this concept if it means they can possibly increase their rate of return. Make sure you understand the potential downside as well as the upside to any investment. See the article "Understanding Your Risk Tolerance" for more details.

4. Decide on an appropriate asset allocation mix.

Decide what percentage of your portfolio should be allocated to stocks, bonds, cash equivalents, and other alternatives. Within these broad categories, make allocation decisions for each category. For instance, within the stock category, you can select large capitalization stocks, small capitalization stocks, and/or international stocks. (International investing has additional risks associated with it and may not be for everyone.) Each individual's asset allocation strategy will vary based on individual circumstances. In addition, your strategy is likely to change over time as your personal situation changes.

5. Compare your current investment portfolio to your desired asset allocation.

Calculate how much of your current investment portfolio is invested in each category. Take a fresh look at each investment you own, making sure the reasons you initially chose to invest still remain valid. At this point, determine what changes need to be made to your portfolio to bring it in line with your desired asset allocation. If major changes are required, you may want to make them over a period of time.

6. Monitor your portfolio periodically.

To ensure that your investment strategy stays on track, review your portfolio at least annually, making adjustments as needed. See the article "Monitoring Your Portfolio's Performance" for more information.

Developing an investment strategy requires evaluating many factors, but can give you a well-thought-out strategy to help achieve your long-term goals. Hopefully, it will also allow you to maintain your commitment to your strategy during periods of market volatility. If market volatility starts to make you nervous, review your written reasons for investing as you did. That reminder should help keep you focused on the long term.

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Monitoring Your Portfolio's Performance

At least annually, you should review your portfolio's performance to determine whether you're on track to accomplishing your goals. Consider following these steps during that review:

1. Measure the performance of each investment in your portfolio.

Although this may seem like a simple task, accumulating or calculating this information can be difficult. If you invest in individual stocks or bonds, you will often have to calculate performance figures yourself. Conceptually, total return is not a difficult calculation - it equals the change in market value plus any dividends, interest, or capital gains received, divided by the beginning market value. However, it can be difficult to calculate if you made withdrawals or additional purchases during the year. If that is the case, you may need the help of a computer to precisely make the calculations.

Other types of investments will typically provide you with periodic information about the investment's performance. You should understand, however, that there are different ways to report this information, which may be useful for different purposes. Keep the following points in mind:

A specific investment's return is typically reported on a time-weighted basis, which shows the investment's return for a certain period without regard to when you invested. Time-weighted returns are useful for comparing the performance of several different investments. Information about your portfolio's return is generally expressed on a dollar-weighted basis, meaning the return is calculated based on when you bought and sold shares. Dollar-weighted returns are useful for evaluating the performance of your portfolio.

Realizing that returns can fluctuate significantly on a year-to-year basis, investments often report cumulative annualized returns over a period of time. These returns show the average annual returns over that time period. For instance, an investment with a 60% cumulative return over five years would have an annualized five-year return of 9.9%. Annualized returns help you assess an investment's long-term performance.

2. Compare each component of your portfolio to a relevant benchmark.

A wide variety of market indices now exist to cover different segments of the market. You should be able to find indices that track investments similar to your portfolio's components. Making comparisons to these benchmarks will help you identify portions of your portfolio that may need to be changed or that you want to start monitoring more closely.

3. Calculate your portfolio's overall rate of return and compare it to your targeted return.

When designing your investment program, you assumed that your portfolio would probably earn a certain return so you could calculate how much you needed to invest to achieve your financial goals. Calculating your actual return will help you determine if you are on track. If your actual return is less than your targeted return, you may need to increase the amount you are investing, invest in more aggressive alternatives, or settle for less money in the future. Make sure to perform this analysis annually so you can make any needed changes gradually.

4. Review your overall investment allocation to see if changes are needed.

Changes may be required for a variety of reasons. For instance, if certain investments in your portfolio have performed well, you may find that they make up a larger percentage of your portfolio than you originally planned. Or you may want to change certain investments that are not performing well. You may also need to refine your asset allocation percentages, since your strategy may change over time.

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Understanding Your Risk Tolerance

Your tolerance for risk is an important factor in how you allocate your investment portfolio among different types of investments. While investments are subject to many different types of risk, risk tolerance typically refers to your ability to stay with an investment when the return is either less than you expect or the investment declines in value. You should only assume a level of risk that you are comfortable with, so that you aren't tempted to sell an investment when it is at a low point. Unfortunately, it is difficult to quantify your tolerance for risk. And even if you think you understand your tolerance for risk, you generally won't know for sure until you are actually faced with a significant downturn in an investment.

There are at least two factors that impact your risk tolerance. One is the level of investment risk that is appropriate for you based on your personal situation. Key factors to consider include your time horizon for investment, income level, asset levels, amount of debt, liquidity, and family responsibilities.

The other element is your emotional tolerance for risk. Even though your personal situation may indicate that you could assume a high level of risk, that may not be prudent if you are uncomfortable with that risk. To get a feel for your emotional tolerance for risk, it is important to ask yourself questions such as: How much would I be willing to lose in a one-year period without being tempted to sell the asset? For what length of time would I be willing to sustain a loss before selling the investment? What types of investments am I comfortable with and which make me uncomfortable?

Keep in mind that there are strategies to reduce the total risk in your investment portfolio. One of the most important is diversification, which means investing in more than one investment category, such as cash, bonds, and stocks, as well as within investment categories, such as owning several stocks rather than just one. A properly diversified portfolio should contain a mix of asset types whose values have historically moved in different directions or in the same direction with a different magnitude. The theory is that when one asset class is declining, other asset classes may be increasing in value.

Another form of diversification is time diversification - staying in the market through different market cycles. Remaining in the market over the long term helps to reduce the risk of receiving a lower return than you expected. This is important for investments that are more volatile, such as stocks, where prices can fluctuate significantly over the short term.

Other strategies that can help you become more comfortable with risk include:

	Become familiar with different investments and the types of risk they are subject to. Over time, your comfort level with risk will increase as your understanding increases.
	Maintain reasonable return expectations. If your return expectations are too high, you will become disappointed if the asset does not perform as you expected, another name for risk.
	Don't stockpile your cash and then invest a large sum. Many investors find that it feels less risky to invest smaller amounts of money rather than one large sum.
	If you want to invest in more aggressive vehicles but aren't sure you can handle the risk, start out by investing a small amount. You can increase your exposure as you become more comfortable.

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The Benefits of Asset Allocation

Asset allocation is an investment strategy that can provide several benefits to your investment portfolio:

	It provides a disciplined approach to diversification. An asset allocation strategy reflects your personal decisions about how much to invest in different investment categories, another name for diversification. By owning different types of assets, when one asset suffers a major decline, hopefully other assets in your portfolio will be increasing in value, helping to counter the impact of the asset that has declined.
	It encourages long-term investing. While you will need to make changes to your portfolio from time to time, an asset allocation strategy is designed to help control the long-term makeup of your portfolio. It should not change based on economic conditions or fluctuations in the markets.
	It eliminates the need to time investment decisions. Market timing is a difficult concept to implement. Not only do experts have a difficult time accurately predicting the market, but waiting for the perfect time to invest often keeps many investors on the sidelines. With an asset allocation policy, you don't have to worry about timing the market, you just have to ensure that your investments stay within the proper percentages.
	It helps reduce risk in your portfolio. The investments with the highest returns generally have the highest risk and the most volatility in year-to-year returns. Asset allocation allows you to combine risky investments with those that are less risky. This combination can help reduce your portfolio's overall risk.
	It provides a means to adjust the risk in your portfolio over time. You can adjust the risk in your portfolio by changing the allocations for the different categories of assets you hold. By anticipating your changing needs, you can make gradual changes.
	It keeps you focused on the big picture. Staying focused on the proper allocation for your assets will help prevent you from investing in assets that won't help accomplish your goals. Rather than investing in a haphazard manner, it gives you a framework for making investment decisions.

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To Sell or Not to Sell?

For many investors, the only decision more difficult than which investment to purchase is when to sell that investment. Although there are no hard and fast rules, consider these general guidelines:

	Compare your investments' performance to that of similar investments or to the overall market. Recognize that a specific investment's performance will vary over time depending on the market cycle. Consider selling an investment that has lagged in performance for an extended time.
	Don't sell at the first sign of trouble, since it is not unusual for an investment to go through a difficult period. Review the fundamentals again to determine if there is a permanent change.
	Psychologically it is difficult to sell an investment at a loss. Many investors prefer to wait until the investment rebounds to at least a breakeven point. Yet the investment may never rebound or may take a long time to do so. Continue to hold an investment only if its future prospects are good.
	When you purchase an investment, set target prices, both high and low, to reevaluate it. You don't have to sell at that point, but you should review the investment when it reaches the preselected price levels.
	It may be appropriate to sell an investment with mediocre prospects if you find another investment that appears more attractive.
	An investment may become so popular that its price climbs significantly. At that point, review its fundamentals again to decide whether it has the potential to increase even more or if the price is just too high.
	Resist the temptation to sell immediately following a market correction. Remind yourself that the market fluctuates and corrections are a normal part of that process.
	Carefully review all your investments at least annually. Read all information acquired during the year to assess future prospects. Look for major changes that may indicate problems or signal a change in focus. Make sure your investments still meet your financial goals.

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Investing Guidelines

	Adopt an automatic investment strategy. With a systematic means to invest on a periodic basis, you won't be tempted to sit on the sidelines waiting for the perfect time to invest. Dollar cost averaging is one form of automatic investing. Basically, you invest a set amount of money in the same investment on a periodic basis. Since you are investing a fixed amount, you will purchase more shares when prices are lower and fewer shares when prices are higher. Dollar cost averaging requires the discipline to invest consistently, regardless of market fluctuations. It does not ensure a profit or protect against losses in declining markets. Before starting a dollar cost averaging program, you should consider your financial ability to continue purchases through periods of low price levels.
	Invest only in investments you understand. Many complex investments are available, but you probably won't be able to monitor them successfully if you don't understand them. Stick with investments that you thoroughly understand.
	Look for investments with consistent returns over the long term. It can be tempting to change investments often, chasing the highest returns. Instead, concentrate on finding investments that will produce reasonable returns over the long term.
	Don't try to time the market. Market timing is a very difficult strategy to implement. The complexity of the financial market makes it very difficult to predict how the market will react to the vast number of variables that affect it. And in order to be successful, the market timer has to be right about two decisions - when to get out of the market and when to get back in. Instead, develop an investment strategy that you are comfortable with and stick with it - even during periods of volatility.
	Monitor your investments' performance. Calculate the return for each of your portfolio's components as well as your overall rate of return. This review should help you identify portfolio components that may need changing or that you may want to monitor more closely. Your portfolio's actual return should be compared with the targeted return used to design your investment program. If your actual return is significantly less than your targeted return, you may need to make changes to your investment strategy. See the article "Monitoring Your Portfolio's Performance" for more information.
	Rebalance your portfolio annually. Compare your current allocation to your desired allocation to see if changes are needed. Since different investments have varying rates of return, your allocation can stray from your desired allocation. You may also find that your allocation percentages should change as your personal situation changes.

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Copyright © 2000. These articles intend to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

FR2000-0105-0041