Too often, sell decisions are made based on the media. The first thing you need to do is tune out the talking heads on TV who purport to know what the market is going to do. Tune out the broker peddling the supposedly bulletproof securities to you, advises Christine Benz
Realise that no one knows where the market is headed. And no successful investment strategy revolves around trying to guess the market's direction. So I wish everyone would just stop acting like that's a productive activity. Now, may be there's some a fund manager or well-known stock market investor who has been able to call the highs and lows in this or that market with some regularity in the past, but I'd question his ability to do so in the future.
Simply follow these steps to maintain a sound portfolio.
1. Don't make hasty sell decisions based on macroeconomic news
Macroeconomic news, whether it's the direction of interest rates or GDP growth or news around the globe, often appears right alongside news about the market's trajectory. And it's true that what's in the headlines has the potential to move the markets up or down on a daily basis, or even over longer time frames. The trouble is that by the time a certain news item makes its way into the headlines, other market participants have already digested it and priced it in. If you decide to sell your fund based on that news, you're likely to be too late.
Instead, a better tack for investors, at least as it relates to their portfolios, is to keep their heads down and focus on factors that they can control: their savings and spending rates, the quality of their investment holdings, and the total costs they pay for those investments.
2. Find your true north
The bedrock of any sound investment strategy is creating a stock/bond mix that makes sense for you based mainly on your age, your years until retirement and your risk tolerance. Once you've come up with that, you batten down the hatches and make adjustments only if market action moves your allocation way out of whack with your targets; you'll also want to make your allocation more conservative as you get older.
True enough, most asset-allocation frameworks extrapolate the past risk/return profiles of various asset classes into the future -- for example, past data indicating that stocks historically outperform bonds (but with a bigger propensity for losses) leads most asset-allocation plans to favour stocks early in an investor's life. There's clearly no guarantee that asset classes will behave the same way in the future as they have in the past, but historical risk/return profiles are the best and most logical guide we have.
3. Select your investment approach
For individual investors, there are three viable strategies for selecting the securities that will underpin your asset allocation. Notice that not one requires that you spend much, if any, time thinking about what the broad economy or market will do. Also bear in mind that you don't have to "choose sides"; you can do just fine by combining these approaches in your portfolio. I've ranked them from the least labour-intensive to the most labour-intensive.
4. Invest in an index fund
The premise here is that you own the whole market or a market sector, then sit back and let other market participants do what they're going to do. Indexing can be a low-cost strategy that enables you to participate in the stock market. Moreover, indexing is the ultimate in low-maintenance, so if you'd rather spend your time on things other than investing, it's the right approach for you.
5. Invest in an actively managed fund
If you're not satisfied with the proposition of indexing -- which is that you'll match the market's return, less expenses -- you can buy a fund run by a manager who picks securities for you. In so doing, you'll gain a shot at besting the market over time, but you also run the risk of underperforming it, too.
6. Buy individual stocks
In reality, most stock-pickers probably do pay at least passing attention to what's going on in the broad market and economy. But most successful ones really skimp on that activity and instead focus on what they can truly analyse: namely, an individual company's business prospects and whether it's trading cheaply or dearly relative to what those business prospects are worth.
That's the approach employed by Morningstar's stock analyst team. Analysing and selecting individual stocks requires more day-to-day oversight than the preceding two approaches, but also has the potential for higher returns.
Alternatively, you may like to combine strategies. For instance, hold an index fund as a core holding. Or a large-cap fund as a core holding and an index fund (following a mid-cap index) as a periphery holding.
7. Save more than you think you'll need
This step is a far more important lever in determining whether you reach your financial goals than is your investment approach. If you know that you've lived within your means and consistently put some money aside for the future, you won't have to rely on your portfolio to do the heavy lifting by generating outsized returns, and you're less likely to be spooked when the market isn't cooperating. Knowing that you've done your fair share to shape your future is ultimately the most satisfying and calming thought of all.
This article has been written by Christine Benz, Morningstar's director of personal finance. It initially appeared on Morningstar.com and has been edited to suit an Indian audience.
Photograph: Chris Potter/Creative Commons