The Science of Successful Investing - as published in InsideNova.com
In my last article, I stated that to be a successful investor you need a combination of science and behavioral determination. Today let’s discuss the science side of investing. This involves building a portfolio that offers the best odds for achieving your financial goals with the lowest possible risk. How do we do this? It’s tempting to dive right into picking “winning” holdings. In reality, that’s the last, least vital step:
Step one: Ask yourself: What are my goals, and how soon will I need to fund them? The longer you have, the more your portfolio can withstand market volatility (ups and downs). If you have only two years before your child goes to college, a dramatic drop would be intolerable, so you should invest those assets conservatively. Conversely, if your retirement is decades away, you can invest more aggressively – if you stay the course during the inevitable bear markets.
Step two: Decide what percentage to put toward stocks, bonds, cash and hard assets (like real estate or commodities). This is called your asset allocation, and it’s among the biggest determinants of your expected returns. The more stocks, the higher but more uncertain the expected return. The more bonds, the lower, but more dependable the expected return.
Step three: Diversify your broad asset classes into subsets. For example, spread your stock holdings among big companies and small, U.S. and foreign, and growth and value. Since each of these have exhibited hot and cold patches at different times, this creates a smoother “quilt” of coverage to dampen some of the market risks required to earn market returns.
Step four: Now you can think about what to invest in. Don’t get distracted by fancy names or hot trends. Simply implement your portfolio as cheaply and simply as possible – usually passively managed, index or index-like mutual funds or exchange traded funds.
Once you’re all set, stick with the plan! Combining the science of investing with the profile of a patient investor is the best way I know to achieve financial success.