Five essential elements to being a better investor

With realistic, disciplined, and forward-thinking behaviour, investors can experience higher returns and be more confident and comfortable in the process.

Timing the market is hard. Really hard. And studies show that investors are feeble at it. Yet, the dizzying flow of political and economic data, market forecasts and dramatic headlines convince us that we should constantly be adjusting our portfolios to be optimally positioned for any near-term rise or fall.

When it comes to investment performance, we are our own worst enemies. We buy and sell at inopportune times and tinker with our portfolios too frequently. A recent report published by investment research firm Morningstar quantifies the impact of poor behaviour on returns. It looks at the stated returns of all US-based mutual funds and adjusts for inflows and outflows to determine how the typical investor really fared. The study shows that the typical investor gained 4.8% (per year) over the 10-year period ended December 31, 2013, while the typical fund gained 7.3%.

This difference of 2.5% per year is significant. Consider an investment of $100,000 over the 10-year period. If invested in the typical fund, it would have grown to more than $200,000. Yet, the average investor’s portfolio grew to only $160,000. Morningstar suggests this performance gap is largely attributable to poor behaviour, most notably bad timing decisions — i.e., buying funds after they have performed well and selling them after they have done poorly.

Dalbar, an independent firm that evaluates investment companies and advisers, produces an annual report that comes to a similar conclusion. Known as the Quantitative Analysis of Investor Behavior (QAIB) ,the report measures the effect of investor decisions to buy, sell and switch into and out of mutual funds. The conclusion from the 2013 report: "No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market."

Put simply, behaviour is a crucial part of investing. If we realize this, however, and get out of our own way, we’re likely to experience higher returns and be more confident and comfortable in the process. This article highlights five essential and simple elements to being a better investor. In short, they are: being realistic, having a long-term plan, committing to a routine, being prepared for extremes, and being a good CEO of your portfolio. It’s a condensed version of a report titled The Five Essential Elements to Being a Better Investor, which was published by, and is available from, Steadyhand Investment Funds.

BE REALISTIC

Assess your investment knowledge and skills, the time you’re willing to spend overseeing your investments, and most importantly, your investing temperament. You need to design a process and support system and ultimately a portfolio that fits your individual makeup.

Ability to predict the markets

You not only need to be realistic about your abilities but also those of the professionals you work with. Advisers, analysts and economists are confident and well-informed, but they can’t consistently predict what’s going to happen in the short to medium term. No one can. The direction markets take in any given day, week, month or even year is virtually random. In other words, the experts are always sure, but often wrong.

To be clear, it doesn’t mean you shouldn’t read sound research and listen to learned opinion. Quite the opposite. But you should avoid people who confidently and repeatedly make short-term market calls and keep listening to people whose approach and experience you respect.

Future returns

In the short term, you should expect anything and everything from the markets. For growth-oriented investors, the ups and downs could be 15% to 25% or more in any given year. Even conservatively positioned portfolios will go down from quarter to quarter and year to year.

At the end of the day you can only take what the markets give you. No matter how your portfolio is structured or what securities you hold, the single most important factor influencing how you do is the performance of the bond and stock markets. You can do better than the market, but your returns are unlikely to be wildly different.

There will always be tradeoffs. A focus on safety and predictability will result in lower long-term returns. The pursuit of higher returns will come with more volatility and a greater risk of capital loss.

HAVE A LONG-TERM PLAN

A plan is important because as humans we tend to have short attention spans and investing for retirement is one of the longest endeavours we ever take on. Your plan doesn’t need to be lengthy or complex, but it should reflect your life situation and encompass all your financial assets.

Life considerations

Your portfolio needs to take into account your age and investing horizon, career opportunities and risk, retirement goals and spending needs, sources of income (now and in retirement), dependents, debts and other assets.

The whole picture

It’s important that you include all your investments when developing a plan. It makes no sense to come up with a strategy for your RRSP without considering your nonregistered investments. Every decision you make should be done in the context of your total portfolio.

It’s beyond the scope of this article to lay out a detailed outline for a financial plan, but it doesn’t need to be complicated. For all but the most complex situations, you should be able to design a plan on your own, or with the help of a financial planner. With that caveat, there’s one aspect of a financial plan that’s worth drilling a little more into — your strategic asset mix (SAM).

Strategic asset mix

Your SAM is the long-term asset mix that best fits your circumstances. It’s an educated guess as to what blend of asset types have the best chance of achieving your goals. For example, an investor in her 50s might have a SAM of 30% bonds, 40% Canadian stocks, and 30% US and International stocks, while the SAM for an investor in his 70s might be 10% cash, 50% bonds, 25% Canadian stocks, and 15% foreign stocks.

Your SAM is the starting point for building your portfolio and the baseline from which decisions are made and investment returns are compared. It should be simple and easy to calculate. Your SAM will evolve over time with age and/or major life changes, but shouldn’t be altered based on what’s happening in the market in the short term.

COMMIT TO A ROUTINE

After your portfolio has been set up, there’s still important work to be done. On-going management includes rebalancing and cash flow management.

Rebalancing

This involves bringing your portfolio back in line with your SAM. It’s preferable that your rebalancing routine be automatic. In other words, no matter what’s happening in the markets, you’ll rebalance based on a preset trigger such as a regular date (semi-annually or annually), a set limit that triggers an adjustment (e.g. bonds are more than 5% above/below the long-term target), or a contribution or withdrawal. There are two primary benefits to automatic rebalancing: it prevents your portfolio from straying from your SAM inadvertently and it takes the emotion out of the process.

Cash flow management

Whether you’re in the accumulation phase of your investment life cycle and contributing new money to your portfolio or retired and in the de-accumulation phase, you need a cash flow strategy. We’re referring to a plan that lays out when you’re going to contribute (or withdraw), how much and to (from) which account.

In most cases, contributions are easy — new money is simply allocated to the holdings that bring your portfolio in line with its SAM. Regular withdrawals, on the other hand, require more thought. You need to determine which account the money is coming from (investment or registered) and which securities to sell so as to minimize taxes and maximize flexibility.

PREPARE FOR EXTREMES

It’s not a matter of if markets skyrocket or take a sharp drop, but when. Capital markets move in mysterious ways and are rarely in tune with your day-to-day life. It’s important to be prepared for big moves. How you manage through extreme periods will go a long way in determining how successful your portfolio returns will be over the long run.

Down markets

Down markets are inevitable and a necessary part of long-term investing. Not only should you be prepared for down markets, but also the negativity and hyperbole that goes with them. Investors, advisers and the media become very vocal and short-term oriented at market extremes.

Temperament

Having the right temperament (or working with someone who does) is of paramount importance. If you’re going to behave well in extremes, you not only need IQ, but EQ (emotional quotient). It’s good to know whose shoulder you’re going to lean on.

(In) Action

When markets and investor sentiment are at extreme highs or lows, it’s not a good time to make significant changes to your portfolio. It’s during these highly charged, emotional times that the biggest mistakes are made. Perversely, you need to rely on your investment plan the most at times when you trust it the least. As Warren Buffett says, "Wall Street makes its money on activity. You make your money on inactivity."

Market extremes are an opportunity. You can dread the jolts and volatility and try to hide from them, or you can embrace them and use them to your advantage.

YOU’RE THE CEO

Like a good CEO, you need to be an effective delegator. Unless you’re a pure do-it-yourself investor, you’ll be assigning at least some activities to another person or a firm. In doing so, it’s important to find a balance between getting the help you need and not involving people needlessly.

You’re in charge of hiring and firing, which means you need to find a person who has experience, expertise and is a proven money-maker — someone you trust and are willing to rely on during challenging times.

Managing costs

Just like a company, your portfolio’s return (profit) is the result of both revenue and expenses. CEOs don’t focus on one to the exclusion of the other and neither should you. When you’re paying fees for fund management and advice, make sure it’s something you need and if so, make sure you’re getting value for money.

Monitoring

One of the most important roles of a CEO is monitoring progress and assessing performance. We strongly recommend that you do an annual review to reconfirm your plan, assess performance and do a general checkup on your portfolio. A thorough, annual review is better than multiple glances over the course of the year.

No matter how engaged you are in the investment process, you need to know what you own, how each holding fits into the plan, the reasons for deviations from your SAM, how you’ve done (in absolute terms and compared to your SAM), what and who had the most impact on your returns, and how much you’re paying.

It’s our belief that better investors will experience higher returns, and be more comfortable and confident in the process. For the full version of this report, visit steadyhand.com.

Tom Bradley is president and cofounder of Steadyhand Investment Funds Inc./Scott Ronalds is Steadyhand’s manager of research and communications.

Technical editor: Garnet Anderson, CPA, CA, CFA, vice-president Tacita Capital Inc.

About the Author

Tom Bradley and Scott Ronalds


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