Like many things in life, managing your own investments becomes more complex as you get older. For young professionals just starting out, it often makes sense to do the required research and self-manage. As individuals become more experienced in their careers, there is typically more wealth to protect, greater income opportunities leading to planning complexities, and even a family to provide for. Properly managing your investment portfolio and entire financial life can be quite time consuming at any age. Before you can assess whether you have the bandwidth to manage your investments, you will need to know what exactly that entails.
Components of a Successful Investment Management Strategy
1. Understand investment concepts and terminology
Before you set an asset allocation in your investment account, you will need to do some research on securities and the types of investment accounts available to you. How do mutual funds differ from ETFs? What is a target-date fund and an expense ratio? Understanding more basic investment concepts is critical at this stage.
You will also need to determine what type of account you wish to invest in. Broadly, there are two main types of investment accounts: retirement and non-retirement. Retirement accounts include 401(k) plans, IRAs, and other tax-deferred or advantaged accounts. Non-retirement accounts, such as a brokerage account, do not have tax advantages but are the most flexible. Once you are comfortable with the broad strokes of asset management you will be better equipped to make informed decisions regarding how your money is managed.
2. Outline your goals and risk tolerance
Everyone has lifestyle goals, but not everyone can articulate (or agree on) them. Write down your goals including funding details in today's dollars in 3 buckets: short-term (less than 5 years), mid-term (5-10 years), and long-term (10+ years). To have the best chance of achieving your goals, you need to ensure your investments are aligned with your risk tolerance.
Consider keeping funds for any short-term goals in cash to avoid the fluctuations in the stock market. Mid and long term goals can be bucketed and invested according to your overall risk tolerance.
Special note on risk tolerance: many new investors are tempted to purchase single stocks. Holding only the stock of a handful of companies is quite risky, particularly when the decision to do so is based on the buyer's preference for a company, product, or service and not necessarily on current market conditions or in-depth research on the firm's financials. Individual stocks inherently carry a much higher risk than a diversified broad-based fund or ETF. Unless the account is simply a "play" account where the funds are not ultimately needed, investment risk management should be a critical component to your asset allocation strategy.
3. Asset allocation strategy
To set your asset allocation for your portfolio, you will need to consider your risk tolerance to arrive at an appropriate mix of asset classes to build a diversified portfolio. There are plenty of common "rules of thumb" out there which may suggest a 70/30 split between equity and fixed income for pre-retirees. Unfortunately, the problem with rules of thumb is that they're so high-level and universal that they won't be appropriate for all investors as all pre-retirees certainly do not have the same risk tolerance.
As you consider what split between stocks and bonds is appropriate for you, you must also consider what type of each is best for you. For example, equity is divided by location (US, international emerging markets, international developed markets, etc.) as well as type (growth, value, blend), and also on market capitalization (small, mid, large). You may also wish to include other asset classes like real estate (REITs), which will also be categorized by location and risk. Creating a diversified portfolio of multiple asset classes and sectors is a time-intensive process but essential as it is the building blocks for your financial strategy.
4. Fund selection
After you identify your asset allocation, you will need to select the particular funds or securities you wish to hold in your portfolio. Given the expansive universe of products, this can be quite time-consuming, so remember to be patient. Morningstar offers resources for investors to research the various components of a security: overall rating, tenure, performance, expenses, composition, objective, and so on. There are many factors to consider so you will need to determine what criteria you would like to prioritize.
The fund selection process is both art and science. It requires trade-offs and careful attention to various facets of a security or fund. As you are evaluating the different funds available to fit the asset classes and sectors identified in step 3, also consider whether you wish to use active or passively managed funds. There is a fundamental difference between the two investment philosophies in addition to the well-documented discussion on investment expenses and historical portfolio returns.
As you are choosing which funds to consider, there are two key points to keep in mind. First, when you open an account with a broker-dealer like Vanguard, Fidelity, Schwab, etc., the representatives you speak with and the pricing structure will be geared towards selling you their own proprietary products. Why? That's a major source of revenue for them. Incentives like free trades or a reduced fee may be offered on their securities. This doesn't mean you should automatically stay away from their fund family, just another factor to consider when you aren't working with a fee-only financial advisor.
The second key point for do-it-yourself investors to remember is that you won't have access to all investments. Some securities or fund families may require an institutional relationship from an approved advisor. For example, at Darrow, we have the ability to use Dimensional Fund Advisors (DFA) assets in our clients' portfolios as part of our investment management program; which individual investors cannot.
5. Investing, rebalancing, and taxes
Once you've identified which products you wish to use in your portfolio, you are likely ready to invest, assuming you are funding your portfolio with cash. If you are looking to shift the investment strategy on an existing portfolio, there may be tax consequences if the assets are held in a taxable brokerage account. If your existing portfolio has a low cost basis and has experienced significant gains, you may want to shift the asset allocation over two tax years.
After your new asset allocation is in place, you will need to periodically rebalance your portfolio. Rebalancing is necessary because over time, as your assets gain or lose value in the market, your intended portfolio composition will shift over time and you may be invested much differently than you intended. Since stocks tend to fluctuate more rapidly than bonds, a 70/30 portfolio could become 90/10 if left unbalanced over time, which exposes you to much more risk and far less diversification.
At a high level, rebalancing is the process of selling a portion of securities in an asset class or sector that has experienced greater gains, and reinvest the proceeds in the other asset classes of your portfolio that may not have performed that well. It may seem counter intuitive, but rebalancing your portfolio is how to maintain your intended asset allocation over time. Also keep in mind that rebalancing may have tax consequences in a brokerage account, although you may have losses to offset a portion of your gains.
6. Putting it all together in one financial strategy
Having a solid investment management strategy is only one piece of the puzzle. Investors not only need to stick with the strategy over the long run, especially during market downturns, but they also need to develop a cohesive plan to tie together the various components of financial life. These issues may include college planning, strategies for stock options and RSUs, tax strategies now and in retirement, insurance coverage, estate planning and trusts, real estate, charitable giving, and so on.
Although it is certainly possible for individuals and families to manage these things on their own, there can be a very high cost if something goes overlooked. Many of our clients are so busy in their home and professional lives that they simply do not have the time or the desire to devote to managing this aspect of their life. If you're having doubts about whether you should manage your own investments or not, let's talk about Darrow's wealth management program and how we may be able to help.