Best Practices #1: Staying in Your Risk Budget

Vanguard Research's study titled "Advisor Alpha" showed that their investors that stick to their original plan were more successful than those that made changes. Unfortunately, many investors tend to change their strategy at the wrong times. This leads to worse outcomes. Why does this happen?

Generally, people make their investment decisions based on recent performance data (1-3 years), rather than focusing on risk and longer-term goals. This usually leads to bad outcomes for the long run, as investors experience a roller-coaster of emotions, constantly guessing and moving around instead of benefitting from the long-term trends and performance of the investment markets.

Why this is important:

When stock markets rise (like they have in recent years), you will be thrilled to have more risk than your budget, or disappointed that you have not kept up if your portfolio had less risk than you wanted. Either way, you are more likely to increase your purchases of the funds/categories that have done the best over the past 1,3,5 years. One might even use the term, "I'm just getting more aggressive," or "Maybe I should add some more risk to my portfolio." Translation? "Those recent returns have been awesome. I want some of THAT! Surely last year will repeat itself." Unwittingly, you will often increase the risk of your portfolio near cyclical highs, "buying high".

On the other hand, when the inevitable bear market arrives, your now high-risk portfolio can drop far more than your stomach can handle. In this situation, one is most likely to "sell low" or "get more conservative" near a market bottom. This, Buy-High, Sell-Low system for investing creates frustration and can be life-altering in a bad way.

A similar situation if fate provides a bear market first. The "too conservative" portfolio can fell really good in down markets and can lead to confirmation bias, leading the moderate investor to remain more conservative than their risk budget would dictate. Such an investor may miss out on the tremendous buying opportunities afforded by bear markets. This can lead to lower long-term results and an awful cycle of guessing games and frustrations.

Morningstar research has shown this to be true in the real world, as mutual fund investors on average have sacrificed 0.70%-0.79% per year due to the ill-advised timing of their investments. You can read that article by CLICKING HERE.

When Your Portfolio Matches You

When your portfolio behaves in line with your expectations, you are more likely to stick to your original plan. A rebalancing discipline will keep your portfolio's risk in line with your budget and may improve the chances of buying lower and selling higher. How does this work?

When markets are near all-time highs, your plan will trim back those investments that have recently led, while adding to investments that may be more attractively prices. This will likely reduce your risk back to your budget. Conversely, when markets fall and your portfolio falls below your risk budget, you will likely buy up those risky assets that have recently fallen to get back up to your risk budget. Vanguard's research reports that simply sticking to an original plan can improve long-term outcomes by up to 1.50% per year.

Eliminating Decision Fatigue aka "Analysis Paralysis"

You need to take action toward your financial needs, wants, and wishes. The financial media and even many advisors spend a lot of energy trying to predict the future. What will the market do next? Which investment is best for the coming year? When investing for your lifetime, all of these things are unknowable and useless during a common investor's time frame. Focusing on uncontrollable and unknowable issues is a fool's errand and a waste of your energy.

The media makes money by keeping eyeballs glued to the screen. The brokerage firms make money by charging transaction charges and keeping investors trading. Don't fall into the trap. It's all about ratings, trading, and commissions.

The answer? Focus on high-impact, controllable factors that affect your financial future. Once your portfolio matches your risk budget, you can dispense with the distractions and focus on other high-impact financial decisions. We cover these in other posts. But first, let's find your exact risk budget.

Next steps:

Find your risk budget by CLICKING HERE without cost or obligation. If the spirit moves you, please contact us for a free evaluation of your portfolio. Here is a video to see how our system works: