By: Dan Hunt, Senior Investment Strategist
One of the biggest mistakes I see investors make is confusing investing with stock picking. Ask many people how their money is invested and they might quickly jump to tell you the latest hot stock they’ve purchased and the investment thesis that explains why they think it’s going to take off.
What is their goal? Probably just to make some quick, easy money, which neuroscience has shown makes us feel good.
Unfortunately, behavioral economics tells us that acting on such impulses tends not to end well. To be true to the term, investing must start with a specific goal corresponding to a specific time horizon. The goal itself could be anything: buying a new car in two years; purchasing your first home in five years; or retiring in 40 years. What’s most important is to have the goal be the focus of your approach.
Once you’ve identified a goal, an investment plan can take shape. How much savings can you devote to it? How much time do you have? How realistic is the goal given the first two questions and the amount of risk you feel comfortable taking? By answering these questions, you will have gone a long way to devising an investment strategy that can help you achieve that goal.
Saving for Retirement
Let’s consider someone saving for retirement. After all, that is typically the focal point around which other financial goals orbit. A plan for that goal could include a desired amount of spending needed to fund your lifestyle in retirement, an intended amount of savings each year that would be needed to achieve that goal, and a suggested asset allocation. There are a lot of moving parts, with adjustments that need to be made along the way. However, many tools now exist, including the kind of digital software that Morgan Stanley has developed, that can help you connect the dots and track moving targets in changing markets.
Since equities are more volatile, but usually return more than bonds over a market cycle (around seven years, on average), investors may need a higher percentage of their portfolio in stocks to reach their long-term goal. For example, 35-year-olds could have 80% of their portfolio in stocks, and possibly more depending on their circumstances and the market environment. That age group could likely withstand the higher volatility in stocks.
If the goal is less than a full market cycle away, the investor should probably take less market risk to avoid the possibility that the stocks could suffer a substantial decline close to when he or she would need to convert that equity into cash. An equity allocation of 30%, for example, may be appropriate for someone later in retirement who relies on her portfolio for a substantial portion of living expenses.
Once the asset allocation is set, careful security or fund selection techniques can improve performance, reduce risk and lower costs.
What if a retirement plan is off track? At that point, investors can use other levers to help fulfill their goals–things like increasing savings, pushing back retirement a year or two or coming up with a plan to work part-time in retirement (for more ideas, see “What to do if You’re Off Track on Your Goals”). While these kinds of trade-offs may not be desirable, they may be the best way to manage the risk of more serious shortfalls in your finances.
Goal-Setting and Tracking Matters
What I hope you’ll see in these examples is the importance of setting a goal and tracking your progress against it when investing. If you don’t have a plan, you may lack perspective on how chasing a hot stock in the short-term can damage your long-term finances. More to the point, you may not realize how positive the impact of compounded returns from sound strategies can be over time. You also may not realize that you need to make adjustments along the way to stay on track.
There is no magic stock-picking formula that will make your most ambitious desires a cake walk. In fact, while security selection is important, research shows that what matters most in investing success is asset allocation–the decisions you make to invest your money across different sectors of the stock market and different types of securities, including bonds and cash.
When you have a goal in mind, your time horizon and risk tolerance will inform your decisions. Setting up your asset allocation in the context of a realistic plan that can be adjusted for life and market uncertainties should put you well on your way to achieving your financial objectives.