The purpose of financial planning is to empower you to make well informed and mindful decisions because you understand the impact of your choices. Planning provides you with the “what” and “why.”
But you also need a “how” to make the system work. How will you go from where you are now in the present, to where you want to be in the future — while meeting your goals and growing your wealth along the way?
The most accessible mechanism for most people to use to increase wealth is strategic investing. A well-managed investment portfolio serves as the engine that can drive your financial growth.
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Once you have a financial plan in place (that informs questions like, “How much do I actually need?” “When do I need to access my money?” and “How much risk can I actually take — or not?”), then you need to choose the best investment strategy for you and successfully manage that over time.
To build your own investment strategy, you need to consider the following five factors:
1. Start with risk management
Great investment management relies on a deep understanding of risk management. Two critical concepts to understand here are risk tolerance and risk capacity.
Most people have at least heard of risk tolerance and understand the idea. Risk tolerance is a measure of your own emotional wherewithal when it comes to investing.
Knowing your own risk tolerance allows you to correctly answer questions including:
- How am I going to feel when the market tanks?
- Am I going to be able to leave my portfolio alone, or will I feel compelled to tinker?
- Can I commit to my strategy over time, or will I need to fight the urge to jump from one thing to the next?
If you have a low risk tolerance, that indicates you should stick with more conservative investments so that you do not expose yourself to greater potential for loss or the experience of extreme volatility in your portfolio. A high risk tolerance indicates that you are comfortable taking more risks and can handle seeing volatility, even losses, show up in your portfolio.
Risk tolerance is a fairly subjective measure, and again, it says more about your emotional and mental state than your financial reality. That’s where risk capacity comes into play.
Risk capacity is a measure of how much risk you can actually afford to take. It is about the money you actually have available to open up to risk of loss — money you can lose without disrupting your overall financial plan.
You may have a high risk tolerance, but that doesn’t mean you should go all in on a high-risk or speculative investment if your risk capacity is low. You might have a low capacity for investment risk if you have:
- Very little liquidity
- A short time line to when you need to access funds
- A limited balance sheet and are just getting started in building up assets
- Too much of your net worth tied up into a single stock or asset class
Understanding both your risk capacity and tolerance are important starting points that will inform the best investment strategy for you to adopt.
2. Use the right asset allocation
When considering your core portfolio strategy, ensure you take a comprehensive view. Your investment portfolio includes everything from retirement plans like 401(k)s and IRAs to taxable brokerage accounts. It could include income-producing real estate or equity compensation. It might include accounts like HSAs, assuming the cash you contribute is invested (and stays invested long-term).
When we look at this entire picture, we want to understand two important things in relation to asset allocation: How many asset classes does the portfolio touch? And do the included asset classes actually align with your risk tolerance and risk capacity?
Your asset allocation is more than just “80% stocks and 20% bonds.” Although we can roughly divide things by equities and fixed income, there is far more nuance that a good investment management strategy will consider when building the proper asset allocation for you and your portfolio.
When you look at your overall portfolio, which means considering every investment account or vehicle you have, you want to consider how many asset classes you are exposed to, how you are allocated to them and whether they are appropriate for your strategy.
Assets classes are specific pieces of any particular market — and those markets can include domestic equities, international developed markets, emerging markets, frontier markets and private equity and private credit markets.
From each market, you can drill into sectors and industries (for example, real estate) and use other criteria for choosing your allocation, such as company size (i.e., small, mid and large cap) and style (such as value and growth).
Overall, to set the right asset allocation, you must understand:
- What you are exposed to
- Why you include those assets in your portfolio (or why you don’t)
- What might be missing
- How you have divided up all of your assets across your portfolio to each specific asset class
Once you have your asset allocation and you understand what you should own, then you have to find the proper vehicles and vet them. Are you using the best-in-class options? Are you using the lowest-cost vehicles available?
Much like planning, this is not a one-time process. You can’t set and forget your asset allocation forever. What works today may not be the best option in three years. Every year, new vehicles come on the market, and you need to consider how that may or may not play a role in your portfolio. Existing vehicles change, too, which might mean periodically removing assets from your portfolio and replacing them with better fits.
You have to do the research and the due diligence to properly vet what’s in your portfolio — and you have to do it over time.
3. Diversify, diversify, diversify
Diversification is a critical component in being able to sustain the portfolio through good times and bad times in the economy (both at home in the U.S. and globally). Diversification also plays a role in managing volatility and securing a reasonable risk-adjusted return.
Securities in a single class tend to behave in like ways; diversification means holding a range of assets (in a variety of vehicles), which creates more balance of activity on average. The simplest example may be that stocks tend to be more volatile and riskier than bonds. Holding both in your portfolio can temper that volatility, which makes bonds a valuable feature even while they tend to return less than stocks.
You can diversify via the asset classes you use, from equities to fixed income and commodities to real estate. You can diversify within those asset classes (i.e., using mutual funds and ETFs to hold “baskets” of a wide variety of a particular asset to avoid concentration in just a handful of specific stocks or funds; within those funds, you could look for large cap vs small cap, growth vs value and so on).
In addition to the diversity of your investment portfolio, you should also consider the diversification of the types of investment accounts you use. Each account or vehicle for investments has different tax rules. You could have a taxable brokerage account that is not tax advantaged, meaning there's no deferral of taxes. You're paying dividend taxes and interest taxes and capital gains taxes as they happen in your portfolio year to year.
Compare that to a traditional IRA, which defers all those taxes into the future. And you can compare that again to a Roth IRA, where you contribute money that’s taxed in the current year — but the money grows tax-deferred, and you can withdraw it tax-free.
The tax implications of various accounts mean you might want to own a particular asset in a particular account. There are certain things that might be wise to hold within an IRA that you wouldn't want to own in a taxable account, and vice versa.
For example, you probably don’t want to own corporate bonds and Treasury bonds in a taxable account. You might want to own municipal bonds instead, because you gain some tax advantages, and you don't pay taxes on certain parts of the interest paid by municipal bonds. You wouldn’t want to hold that municipal bond in your IRA or traditional 401(k) because you don't get any tax advantages for doing so.
4. Employ tax-loss harvesting
Tax-loss harvesting is an important strategy to deploy in taxable accounts. It becomes more important the higher you climb in terms of income tax brackets and the larger your portfolio grows. The idea here is that you sell certain investments at a loss. You capture that loss while not disrupting the diversification of the portfolio to offset future capital gains.
If you’re earning a high income (like $500,000 or more per year), your long-term capital gain rate is currently 20%, plus the net investment income tax of 3.8%, making 23.8% the expected amount you’ll pay in long-term capital gains tax. Meanwhile, your marginal tax bracket might be at least 35%, if not 37%. That’s where your short-term gains will be taxed.
With these high rates, any capital loss that you can use to offset your gains will help negate some tax costs. During periods where markets are down — like we’ve been experiencing in the recent past — tax-loss harvesting can hugely benefit your current-year tax situation. But even if you don’t use tax-loss harvesting to offset gains this year, you can carry forward to future years for significant tax savings.
Tax-loss harvesting is an important strategy to consider — but it’s not going to provide a huge advantage to everyone, and it’s not something you can expect to do every year. This is where working with a CFP to help with your investments can provide a lot of value, because they can help sort through nuances like these to identify opportunities and cost savings around your tax planning to keep more of your investment returns in your own pocket.
5. Stick with your strategy long enough for it to work
Setting up your own investment management strategy takes a lot of research, expertise, decision-making and implementation work — all of which are reasons to consider working with a professional to help you get it right. The more assets you build, the greater your responsibility to act as a good steward of your financial resources. Part of that stewardship is in recognizing where you are the expert and where you need the support of one.
And choosing and establishing an investment strategy is only step one. Once you create a rules-based system for managing your investment portfolio…you have to stick with following those rules.
When talking about investing, that typically means “sticking with it” for multiple decades. Not only do you want to put rules in place for how you will manage your investments, but you also want to lay out guardrails for how you’ll manage your own behavior and decisions.
What systems will you use to stay consistent? To stick with the plan you built? To do due diligence to determine when a change legitimately needs to be made for practical purposes (and not emotional ones)? What will “keep you in your seat” when times feel unnerving or markets look challenging?
With any strategy, it’s reasonable to expect periods of underperformance over your long-term time horizon (meaning, your portfolio may perform below the expected rate of return compared to a benchmark). It’s tough to go through that and stick with your strategy through those short-term bumps in the road to get to your long-term goal.
The biggest mistake I see individual investors make is in constantly looking for “the next best thing” and abandoning a sound strategy to chase returns that don’t actually materialize.
You have to first be confident that the strategy that you choose is the right one. And when I say “the right one,” I mean a good-enough one — one that is reasonable, sound and will get you to a rate of return that will satisfy your personal needs and goals.
For me, I feel confident in strategies that are research-backed, have some historical evidence and offer many different pieces of data that explain “why this works so far and why it will continue to work into the future.”
Knowing the best approach requires hindsight
Ultimately, It doesn’t matter if you use the absolute best approach or not; no one can tell you that you did it “wrong” if you have enough money to live the life you want while being able to fund your needs along the way. Who cares if you got 8% returns instead of 10% if you were able to get to everything that was important to you?
Plus, no one will know what the ideal strategy was without the benefit of hindsight. It is impossible to know right now what the optimal path is until we’ve walked it and can look back and see if there was a cut-through here or an easier way there. Trying to repeatedly guess at “best” will leave you with a worse outcome than sticking with “good enough” for long enough.
Eric Roberge, CFP®, is the founder of Beyond Your Hammock, a Boston financial planning firm that provides wealth management strategies to couples and young families. To jumpstart your financial planning journey, get a free copy of Eric's ebook on 5 Strategies to Optimize Your Finances.
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