Lesson 4: Managing Your Investments

I.          Invest for the long run

For me there are four main tenants to a successful investment strategy:

1.       Long term investing

I am a growth/value oriented investor so I look for securities that I think will provide long term growth and good value.  I am a “buy and hold” style investor.  I tend to ignore the short term variations in the market and focus on sectors and segments where I think the long term value and growth will be and invest in those areas.  The practice of long term investing in areas that have performed well in the past helps to minimize costs (frequent buying and selling can quickly rack up significant costs for brokerage fees) and allows me to sleep well at night.  I am not worried that a risky investment I have made will suddenly crash and take my investment with it.

2.       Diversification

As I mentioned in lesson 3 mutual funds are an excellent way to get maximum diversification for the individual investor.  Diversification also helps me sleep well at night knowing that the odds of a mutual fund failing is much less than the odds of an individual corporation failing.  Mutual funds are my favorite investment vehicle and my preferred type of mutual fund is the ETF.  I like ETFs because they are easy to buy and they generally have relatively low fees.  Long term investing, which minimizes brokerage fees, and investing in funds with low fees are a couple of key components to successful investing.  Fees can significantly erode earnings on investments.

3.       Don’t try to time the market

Trying to time the market is simply gambling in my opinion and if you are going to gamble with your money the odds are better for you to play some game of chance in a casino.  Putting your money on a number on the roulette wheel, for example, with a 1 in 38 chance of winning has a much higher probability of success than trying to decide which stock or other security is going to go up or down in the market with millions of different choices available.  To me investing should be about finding a fund or other security that you think has long term value and investing in that security for the long term.  Gambling should be left to the casino.  It has no place, and should be kept out of the investment market in my opinion.

There are many different ways to “bet” on the market but I will mention only 2 here:

a.       Short selling

Short selling is the practice of borrowing securities for a certain length of time in anticipation that the price of the security will fall.  It is a form of gambling.  A couple of definitions will help you understand this form of gambling:  If you own a security (e.g. you own shares of Company X) you are considered to be “long” in that security as long as you own it.  If you have borrowed a security you are considered to be “short” in that security until you return it. 
The concept of short selling is that you sell the security you do not own today and then re-buy it later at a lower price and give it back to the owner while you keep the difference (less transaction fees) between the original sell price and the later purchase price.  For example:  you borrow (through a broker) 100 shares of Company XYZ and sell the shares today at the market price of $100 per share.  This “short sell” provides you with $10,000 of “borrowed” money.  Later (before the expiration of the “short sell” term) the market price of Company XYZ drops to $25 per share and you buy 100 shares at a cost of $2,500 and return the 100 shares of stock to the broker.  You have just made $7,500 (less brokerage fees) on the “short sale” of those stocks.  Short selling can generate good returns in a declining market, but can also result in huge losses if the price of the security increases between the time that the short sell is made and when the borrowed security is required to be returned.

b.      Options

There are two main types of options available on the market:

i.                     Option to Buy (call)

A call option gives the owner the right to buy a security (stock, commodity, etc.) at a certain price by a certain date. 

ii.                   Option to Sell (put)

A put option gives the owner the right to sell a security at a certain price by a certain date.

Options are often used as a way to “hedge” against market moves.  Call options can be used as a hedge against price increases and put options can be used as a hedge against price decreases. For example, a one year put option to sell 100 barrels of oil at $90 per barrel can be used to hedge against oil price declines in that year.  Conversely, a one year call option to buy 100 barrels of oil at $50 per barrel can be used as a hedge against oil price increases that year. Options can be allowed to expire without being exercised.  The reason for allowing an option to expire without exercising it is if the market conditions have changed so that the option is of no value.  In the example above the call option would have no value if the price of oil had dropped to $30 per barrel.  If options are allowed to expire you are out the cost of the option and options can be quite expensive depending upon when and how they are purchased. Options can be bought and sold over and over again throughout their life similar to bonds.  Options can also be held “long” or “short”.  Short selling options that then become worthless can result in huge losses.

Rather than partake in any of the above market timing techniques I use the “dollar-cost averaging” technique for my investing.  Dollar cost averaging is the practice of regularly investing a consistent dollar amount regardless of the market conditions.  The practice of regularly investing a consistent dollar amount naturally results in more securities being purchased during market down turns and less securities being purchased during market up swings.  It also naturally rebalances your portfolio over time toward lower cost securities because proportionately more of the lower cost securities are purchased than the higher cost securities.  In this way dollar cost averaging can provide a better return than the practice of regularly buying a set number of shares.

4.       Don’t take the advice of “experts”

Most “experts” have a profit motive for their recommendations so their guidance, in my opinion, is more geared towards helping themselves than helping you.  For this reason I chose to make my own investment decisions and manage my own money rather than seek the advice of a portfolio manager (this practice also avoids portfolio advisor/manager fees).  I also tend to focus on index funds rather than managed funds because the fees are less and I don’t have much confidence that the fund manager will be able to outperform the market, especially with a large fund (I tend to focus on large funds rather than small funds to reduce risk as a long term investor) so I don’t see the increased fees of the managed fund as justified.

II.        Track your investments

It is important to track your investments regularly, but as a long term investor it is wise not to track them too closely.  Watching the daily, hourly or minute-by-minute ups and downs of the market and your portfolio may encourage you to buy or sell frequently due to fear, anxiety or a desire to time the market.  Statistics have proven that long term investors who stay in the market through its ups and downs have better returns over the long run than do “day traders” or those who try to time the market.  This is mostly due to lower costs associated with long term investing (less brokerage fees) and the virtual impossibility of getting market timing right consistently over time.  I recommend reviewing your investments monthly to track progress against your goals but only make changes to investment direction (what you are investing in) or amount on an annual basis (semi-annual at most).

III.      Calculate your Personal Rate of Return (PRR)

To me one of the most exciting things about investing is watching my investments grow.  An important part of watching those investments grow is to calculate my annual personal rate of return so I can compare the growth rate of my portfolio to the market or other indices.  Calculating your annual personal rate of return is very easy; it is the difference in the value of your portfolio at the end of the year compared to the value of your portfolio at the beginning of the year divided by the value of your portfolio at the beginning of the year, expressed as a percentage:

PRR = (Y-X)/X*100%

X = the value of your portfolio at the beginning of the year

Y = the value of your portfolio at the end of the year

PRR is my primary goal for investing.  I have a long term goal for my PRR and I calculate my PRR every year to see how I have done against my goal that year.  I also calculate my 5 year, 10 year and cumulative average PRR to see how my PRR is trending with time against my goal.  My investment decisions are primarily geared toward achieving my long term PRR goal.

IV.      Reinvest your earnings

Dividends and interest are the two primary sources of earnings from investments in stocks, bonds and money-market securities.  Earnings are normally automatically reinvested in 401Ks, IRAs and other company sponsored investment plans.  However, for investments held in brokerage accounts earnings are not normally automatically reinvested.  For brokerage accounts, and most ETFs or mutual funds held outside of 401Ks or IRAs, you must sign up for their Dividend Re-Investment Program (DRIP) if you want your earnings to be automatically reinvested.  One of the simplest and easiest ways to increase your PRR is to ensure that all of your earnings are automatically reinvested.  The regular reinvestment of earnings is another source of dollar-cost averaging for your portfolio. 

V.        Rebalance as necessary

When you are young and starting your portfolio your investment objective should be primarily growth.  As you get older and closer to retirement your investment objective should slowly shift toward capital preservation and income.  Rebalancing your portfolio to meet your changing objectives should, in my opinion, not be done more often than once a year.  For me, rebalancing involves changing the direction of future investments.  As a “buy and hold” investor I do not sell my existing assets to rebalance my portfolio.  When I was young I invested virtually all of my money in stock funds.  Now that I am closer to retirement I am investing more of my money in bond and money-market funds, but I have not sold the stock funds that I purchased when I was young.  Over the long run stocks have always provided a better return than bonds or money-market securities so it is important to me to keep invested in stocks even though I am older.

VI.      Avoid common pitfalls

In my experience the six most common pitfalls that derail the best laid investment plans are:

1.       Failure to get started – Most people say they want to invest, but few actually do.  Start now!  If you don’t think you know how ask for help from me or someone else who knows about investing.  It is really much easier than you think.

2.       Failure to invest regularly – It is easy to allow other “wants” or “needs” to consume the money that could be used for investing.  Use the strategies discussed in lesson 1 to develop and stick to a budget that allows for regularly investing in yourself first (dollar-cost averaging).

3.       Failure to stay invested – Everyone knows that selling assets is one way to not stay invested.  Fewer recognize that borrowing against assets is another way to not stay invested.  Borrowing against assets can reduce the return on the asset to below zero, which is worse than selling the asset.  There are many reasons for selling assets or borrowing against them and they should all be avoided.  Make “buy and hold” your motto for investment.

4.       Trying to time the market – Getting out when you think the market is going down, buying in when you think the market is going up, or using the methods discussed in Section I.3 above to try and bet on the market have all been proven to be less effective in the long run than having a simple investment program that keeps you in the market and investing regularly.  My recommendation:  buy and hold and use dollar-cost averaging.

5.       Failure to reinvest earnings – Don’t be tempted to use the earning for other purposes.  Take advantage of automatic reinvestment programs offered by most funds and brokerages to make your earnings work for you.

6.       Failure to track and rebalance your portfolio – They say “what you fail to track you fail to improve on”.  You should use a tracking spreadsheet or some other tool to monitor your portfolio and set targets/goals for yourself.  If you don’t know how to set up a tracking spreadsheet, ask me or someone else who knows about such things for help.