It’s often said that managing investments can be simple – but not easy.
The investment world seems to be getting more complicated every day. Investors have access to more news, data, and software tools than ever before. The number of available investment options continues to expand (for example, the number of mutual funds exceeded the number of actual businesses listed on stock exchanges long ago). Investment jargon can quickly cause frustration and confusion and commonly used terms like alpha and standard deviation are often misused and misunderstood.
While there are always countless important details to consider, many unique to each individual’s situation, often the best approach to meeting complex financial needs is to simplify the process by concentrating on a few basic ideas above all others. Successful investment management must be based on a foundation of diversification, a disciplined approach, and a rational understanding of expected returns coupled with reasonable expectations.
Diversification is the bedrock
Diversification is a-time honored concept, and while it’s as important as ever, it is becoming more difficult to achieve as correlations among regions and between equity and fixed income securities have risen. In its simplest form, diversification is merely spreading risk among a variety of investments so that the failure or underperformance of one investment does not prevent the achievement of one’s overall investment goals.
Simply put, we diversify for protection and because we can’t ever be certain which investment option will provide the most benefit over our timeframe.
Adhere to a disciplined approach
An investment process doesn’t need to be complex to be successful. Discipline is tremendously beneficial to executing an overall investment plan – such as making regular 401(k) plan contributions – but one also needs discipline in making individual investment decisions.
A cornerstone of investment decision making is developing informed estimates about future outcomes; essentially estimating an expected return for a potential investment. If the assumptions underpinning the valuation of an asset don’t make sense, a successful investor must have the discipline to avoid the asset – or sell it
A disciplined approach provides protections against emotional errors. The best investment professionals know and understand the perils of emotional decision making and can help protect clients against it.
Trust the data, not the headlines
Getting access to data to make informed investment decisions isn’t difficult, especially with the explosion of resources on the internet. The challenging part is rationally applying the data and having confidence in your analysis. Investor psychology can have a big impact on the markets, which is why it’s crucial to not let emotions hold sway over the data.
Securities prices can be volatile, and occasionally (but regularly!) the market overreacts to temporary events. When this happens, prices of stocks or bonds may differ greatly from their actual value. It is important to understand the difference between temporary and permanent issues that may affect valuation.
When energy prices fell in early 2016, for example, (oil prices dropped to $20-$30 a barrel and natural gas prices similarly fell), there was fear that distress and bankruptcies in the energy industry would cascade through to other industries and trigger a crisis. Stock and bond prices reacted negatively and securities of energy businesses (and securities in many other industries) traded at steeply discounted prices. Predicting short term moves of commodities prices is notoriously difficult. However, a rational and objective review of the data – such as economic activity, long term energy consumption, global growth rates and demand forecasts – and a willingness to stray from the consensus opinion, rather than extrapolation of the recent headlines, rewarded investors who kept things simple.
Set realistic expectations
There’s nothing wrong with being optimistic about the future, but problems may arise if your financial goals are based on unrealistic expectations about financial returns. Rather than relying on historical returns, it’s important to estimate future investment returns based on reasonable expectations.
New investors often make the assumption that the value of their stock purchases will increase 8-10 percent every year. If their time horizon is sufficiently long enough, they may be right. There are certain points in time, however, like the market peak prior to the Great Depression, the internet bubble and the stock market highs prior to the global financial crisis just a few years ago, where it took many years before subsequent stock prices matched historical returns. A successful investor must understand the impact that starting valuations will have on subsequent investment returns.
When planning investments or working with an investment professional, don’t get too bogged down at first in the details. Think about the big picture, ensure proper diversification, adopt a disciplined investment approach and have reasonable expectations.
Contact an Argent office near you to learn more about our investment management services.