Have you ever invested in a stock or mutual fund because it was recommended by a friend or relative? Or maybe you read about it on a financial web site or blog.
Think about the investment choices you’ve made in your workplace plan. Why did you make those choices? One recent study found that when workplace retirement plans list the mutual funds that are available in alphabetical order, those at the top of the list tend to get chosen most often.
When the market gets a little crazy, like this week, have you ever sold an investment out of fear? Or, when the market is growing, have you ever made an investment that’s riskier that what you would normally choose?
Process over picks
One of the problems with these types of investment decisions is there’s no process behind them. Do those investments really make sense for you, given your age and risk tolerance? And how will you know if or when you should sell, or what you should buy next?
A good stewardship approach to investing is to focus on the investment process rather than the investment picks. In other words, don’t be too quick to ask, “What should I invest in?” Instead, ask, “What investment strategy should I use?” And the strategy you choose should be marked by four criteria:
1) Objectivity. Steer clear of any strategy that depends on someone’s predictions or opinions about where the market is headed or what sectors are likely to perform best. Instead, opt for a strategy that’s guided by objective, mechanical rules. In good times and bad, you don’t want human emotion involved in your investing. You want a trustworthy, rules-based process.
2) Demonstrated effectiveness. While a strategy’s historical performance doesn’t guarantee its future performance, it should have been around long enough to see how it has performed under various market conditions. And it should have a proven track record of delivering the average annual returns you need to achieve your goals. (Last week’s article, Two Steps Toward a Biblical Approach to Investing, recommended a calculator that can help you clarify your investment goals.) That doesn’t necessarily mean going with a strategy that has the highest possible returns. It means finding one designed to deliver the level of return you need, and, as the next point describes, at a level of volatility you can live with.
3) Emotional acceptability. This means two things. First, you’re willing to do whatever it takes to follow the strategy (some require more work than others). And second, you’re comfortable with the volatility that can be expected from the strategy. Where I work by day, Sound Mind Investing, our strategies have “relative risk” scores ranging from 0.6 to 1.85. That means they range from 40% less volatile than the U.S. stock market to 85% more volatile. The various strategies are appropriate for different types of investors and can be especially effective when blended. (Read Higher Returns With Less Risk, Re-Examined.)
Again, the ideal is to choose a strategy that has a demonstrated track record of delivering the level of returns you need in order to meet your goals and has an expected volatility level that enables you to sleep at night.
4) Ease of understanding. How well could you explain what’s in your investment portfolio and why? Could you explain all of that to a middle school student? If you’re married, both of you should be able to give at least a general explanation. That way, no matter how your portfolio performs, you’re in it together.
Think about your investment approach. How well does it meet the criteria above?
Take it to heart: “The plans of the diligent lead to profit as surely as haste leads to poverty.” – Proverbs 21:5
Take action: Try explaining how you’re now investing to someone, preferably a young person. See how easily you can do that.