The primary reason? The people running them never seem to stick with them long enough. Computer help desks have an acronym for this issue — PEBKAC, or “problem exists between keyboard and chair.” Fear, higher volatility and significant drawdowns derail all but the most disciplined investors. As soon as trouble shows up, they are gone.
We must recognize our own behavioral errors. To be blunt, you are not likely to become a cognitive Zen master anytime soon. But a little enlightenment could keep you from making some common investing errors.
Knowing these limitations, we can design an investment plan to circumvent the behavioral pitfalls. And a good step is to simplify. Toward that end, keep these 10 ideas in mind when approaching your portfolio:
1 Go passive. Here is a dirty little secret: Stock-picking is wildly overrated. Sure, it makes for great cocktail party chatter, and what is more fun than delving into a company’s new products? But the truth is that individual stocks are riskier than broad indices. Managing those positions through the ups and downs is complicated and time-consuming, and most investors lack the skills and discipline to do it well.
Consider this: The world’s greatest stock-pickers got creamed in 2008. And the world’s worst stock-pickers made a killing in 2009.
Your solution is index ETFs, vastly preferable to picking individual stocks. Lower cost, reduced turnover, fewer taxes — and much less risk.
2 Diversify across asset classes. Owning a variety of asset classes means that some part of your portfolio will be doing well when the cyclical turmoil arises. A broadly diversified portfolio includes large capitalization stocks, small cap, emerging markets, fixed income, real estate and commodities.
A typical portfolio might look like this: 33 percent big cap, 25 percent small cap, 20 percent emerging markets, 15 percent bonds, 5 percent REITs and 2 percent commodities. Younger investors will want to include technology or biotech as a class as well. Older investors might want more income-producing holdings such as REITS and lower-risk holdings such as bonds.
3 Be mindful of valuation. When making purchases, valuation matters more than anything else. What you pay for an investment is the single biggest determinant for how successful that investment will be. When equity prices are high, your returns will be lower. When they are cheap, your returns will be higher.
The valuation challenge is that stocks become cheap during a panic and expensive during a boom. Your instincts will lead you to do what feels good — buy high, sell low — the exact opposite of what you should do. Our next step solves this.