Simple principles to help you stay focused through market ups and downs
Becoming a good investor is a lifelong pursuit that requires study, diligence, persistence and a little luck.
While it is impossible to condense all the knowledge you need to manage your portfolio into a few bullet points, here are eight best practices for long-term investing that can help you stay the course and avoid costly mistakes as you pursue your financial goals.
1. Understand the Fundamentals
Your investments are more than just numbers on a screen, they are a real claim on some type of value. Stocks give you partial ownership of a business; bonds are an obligation that must be repaid by the borrower. Understanding the fundamentals behind investments is the first place to start. Is the business you own growing sales? What is happening with profitability? Is the management team capable? Are investor expectations for the fundamentals of a business reasonable, are they too low, or have they gotten way ahead of what the business can actually produce?
Over a long period of time, the fundamentals drive the performance of investments while the short-term narrative fades away. At Berkeley we strive to understand the fundamental economics of a business, the predictability, and the people who run the companies we invest in.
2. Focus on Value and Price
Once you understand the value being created by a company you can ask: how much are we willing to pay for this?
For example, if a business earns $1 per share and trades at $10, investors are paying 10 times its earnings, a 10x multiple. If another company trades at $100 per share for the same $1 in earnings, investors are paying 100x earnings.
Why such a wide range? Multiples reflect investor expectations about the future. A company trading at a low multiple may be growing slowly, losing market share, or facing uncertainty. Perhaps its industry is at a cyclical peak, or recent leadership changes have shaken confidence.
On the other hand, a company with a high multiple might be experiencing rapid growth, operating in a hot sector, or launching an anticipated new product. Sometimes, though, lofty valuations are fueled more by hype than fundamentals and you should avoid it.
Judging a fair price to pay is the essence of being a good investor. Warren Buffett says “price is what you pay, value is what you get”. At Berkeley we seek to understand valuation, understand what it implies about the future fundamentals of a business and compare potential returns across different sectors and asset classes, thinking about risk and opportunity cost to try to maximize how much our clients earn for the risks they take on.
3. Understand your risk tolerance
Risk is an inevitable part of investing, and market declines will happen in the future. Market risk is also not the only risk investors have to think about, there are myriad risks to consider including the risk of losing purchasing power due to inflation, credit risk, interest rate risk and liquidity. Risk tolerance is understanding the amount and type of risk you are comfortable with and may change based on the time horizon of your goals.
Your risk tolerance will help guide your asset allocation—the mix of stocks, bonds and cash in your portfolio. For example, investors with a higher risk tolerance might hold a greater proportion of stocks, which offers more potential for growth but also are more likely than bonds or cash to lose value. On the other hand, investors with a lower risk tolerance or short time horizon might prefer a greater allocation to bonds, which offer smaller returns, but are less likely to decline in value.
Building an asset allocation that factors in your risk tolerance can make it easier to stick with your plan during more challenging market environments. In turn, you’ll be more likely to avoid emotionally driven decisions such as panicking and selling when the market drops.
4. Accept Uncertainty and Embrace Diversification
Uncertainty is an unavoidable factor in investing, no one can accurately forecast everything all the time because of the incredible complexity of life. Owning a diversified portfolio is how we mitigate the fact that we don’t have a functional crystal ball.
Diversifying your assets can help reduce the chance that the performance of any particular investment will have an outsized effect on your portfolio. For example, if you hold five stocks and one of them does poorly, your portfolio may take a big hit. But if you hold dozens of different stocks, bonds and cash investments, you’ll be better protected if one of your assets goes south. Incorporating a mix of stocks, bonds, and other assets can help you mitigate risk and weather the market’s ups and downs.
5. Manage Costs
Costs are a key driver of investment performance and one factor that is easy to measure and manage. At Berkeley we use a mix of low-cost index funds and higher cost active funds. The ability to get market exposure at a very low cost is a fantastic innovation in financial markets. However, there are market sectors and environments that are inefficient and prime territory for smart managers to really add value, making the expense of active management well worth taking on. We balance the desire for low costs with the mandate to look for compelling opportunities in select areas.
6. Avoid trying to time the market
Nobody knows where the market will go in the short term; it is a complex adaptive system where participants are trying to anticipate both fundamentals and the reaction of other market participants.
It can be tempting to consider pulling money out of the market if you predict a market setback, but doing so can hurt your returns in the long run. Market downturns are notoriously hard to predict, as are market rebounds. Successful timing also requires getting back into markets or out of trades at the right time, which is very tough to implement in reality. Research firm DALBAR says investors’ tendency to try and time the market—particularly during market downturns—is a major reason why the average equity fund investor underperformed the S&P 500 over time.
7. Rebalance as needed
Market shifts can have an impact on your asset allocation. For example, your equity allocation may balloon following a stock market rally, exposing you to more risk than you’d planned. Rebalancing your portfolio on a regular basis can help bring your portfolio’s asset allocation back in line with your goals and timeline.
Risk and return expectations change over time. Neither the potential for return nor the risk of an investment is stable across time, and rebalancing can help keep your portfolio in line with your goals.
Rebalancing regularly also helps you have the anchor to stick with your plan over time. The right time for reconsidering your allocation and portfolio positioning is before a major move in the market rather than in reaction to changes.
People tend to think they will be able to make changes to their portfolio just before a big market moves, in more than two decades of professional investing I’ve never met a single person who could consistently do that.
You can rebalance periodically, or you may choose to rebalance when your asset allocation changes by a predetermined percentage. Your advisor can help you choose the best rebalancing strategy for your situation.
8. Remember your goals
Your portfolio was built with your long-term financial goals in mind. Making short-term decisions can disrupt your financial plan and reduce your chance of meeting these goals in your chosen timeframe. Our focus on a long-term plan helps guide our response to changes in economic or market conditions and judge what the right path forward is.
The Berkeley Perspective
At Berkeley we strive to build portfolios following a disciplined framework with a customized approach. We have a well-defined investment philosophy but implement it in a way that matches the goals and needs of our clients.
Sources:
https://www.sec.gov/investor/pubs/tenthingstoconsider.htm
https://www.investor.gov/introduction-investing/getting-started/assessing-your-risk-tolerance
https://money.usnews.com/money/personal-finance/mutual-funds/slideshows/10-long-term-investing-strategies-that-work?slide=10
“Quantitative Analysis of Investor Behavior, 2020,” DALBAR, Inc. www.dalbar.com
Learning about investing, #Investing Basics, #Learning About Stocks