Although it's not rocket science, the basics of investing can be hard to stick to.
Experienced investors know what makes a portfolio work. The keys to success are contained in a few timeless concepts that, if followed religiously, will lead to the best outcome. These five “reminders” will help you focus on the big picture and avoid the noise.
These ideas are not new. You’ve seen and heard them before. I gathered these five tips from my All About Asset Allocation book and previous writings. I also found this white paper helpful: Vanguard Principles for Investment Success.
1. Asset Allocation: A portfolio’s asset allocation—the percentage invested in different asset classes such as stocks and bonds according to the investor’s financial situation, risk tolerance, and time horizon—is the most important factor in determining the expected long-term performance and return variability of a broadly diversified portfolio.
A sensible investment plan begins with an individual’s long-term financial goals. These include a savings and spending strategy, an assessment of risk tolerance and risk needs, time horizon, and an emergency fund. This information is used to determine a required rate of return, which in turn leads to a prudent long-term asset allocation between risky assets (stocks), less risky assets (bonds) and no risk assets (cash). See All About Asset Allocation for more details.
2. Rebalance: After selecting an asset allocation for a portfolio and implementing it, it’s vitally important to maintain that allocation through time. Different investments generate different returns over time and a portfolio will drift from its target allocation. This creates different risk-and-return characteristics that aren’t appropriate for your needs. The goal of a rebalancing strategy is to maintain targeted risk rather than maximize return. Rebalancing puts a portfolio back on track.
3. Control cost: “Costs matter!” John Bogle, the founder and former Chairman of Vanguard, has probably said this a million times. Every dollar paid for management fees, trading costs, and taxes is a dollar less of potential return. The cost of an advisor also matters. The more one pays for advice and investment management, the less one earns in one's portfolio.
Mutual fund costs can be a large component of overall expenses. Low-cost index funds and exchange-traded funds that track market indexes are an excellent way to keep fund expenses down.