Investment discipline isn’t easy. Despite best intentions and claims to the contrary, many investors chase performance, react emotionally to market moods, and generally incur far more trading costs than good discipline would suggest.
Even when there is a long-term plan in place, if it’s not followed, the plan is useless. Over the years, I’ve seen good intentions go by the wayside time and again because discipline was not followed.
These observations aren’t limited to individual investors.
‘Adapting’ Advisors’ Red Flag
I’ve seen similar conduct from investment advisors who claim to have a disciplined strategy, only to add that they’ll “adapt to changing market conditions” when warranted. This loophole leaves an ample opening for ever-shifting adjustments based on what seems to be the right move at the time. It’s particularly common in bear markets when clients become anxious and hint that they may be looking to take their business elsewhere.
Loopholes in discipline statements may allow an advisor to retain skittish clients, but lack of discipline is rarely in a client’s best long-term interest.
I’ve put together six rules to disciplined investing. They will help you (and perhaps your advisor) make better long-term decisions:
- Have a long-term investment philosophy.
- Form a prudent asset allocation based on this philosophy.
- Select low-cost funds to represent asset classes in the allocation.
- Maintain this portfolio through all market conditions.
- Don’t change the asset allocation due to recent market activity.
- Don’t hold back on new investments while waiting for market clarity.
Have a long-term investment philosophy: There are two investment philosophies in the world. You either believe you have a high probability of beating the markets or you don’t. I decided a long time ago that the markets are more efficient at pricing securities than I could ever hope to be. I do not have enough skill to consistently add value to a portfolio by picking mispriced stocks, bonds, industry sectors, countries, or entire markets. So I don’t try. Market returns are all I need to achieve my long-term financial goal.
Form a prudent asset allocation based on this philosophy: Asset allocation is how a portfolio is diversified among asset classes. A prudent asset allocation should be based on each person’s own long-term financial goals. This gives you a personalized beacon to follow through turbulent market conditions. The allocation should be in fixed percentages that you plan to stick with over time, rather than floating or tactical reactions to the ongoing turbulence.
Select low-cost funds to represent asset classes in the allocation: Implement the asset allocation using an appropriate mix of index funds and exchange-traded funds. These products provide broad diversification within an asset class for a very low cost. Building a select portfolio of index funds and ETFs that tracks the markets will help you receive your fair share of the markets’ returns.
Maintain this portfolio through all market conditions: Markets do not remain at their current levels for long, yet a portfolio should be maintained at roughly the same asset allocation through all market conditions. Rebalancing helps control the portfolio allocation. An annual rebalancing can serve as the method to maintain a portfolio. Cash contributions and withdrawals also provide an occasion to rebalance.
Don’t change the asset allocation due to recent market activity: Since a portfolio is based on long-term needs, it should be maintained for the long term. If you’re not willing to hold an asset class or fund for the next 10 years, then you shouldn’t own it now. It doesn’t matter what’s going on in the markets today; build and hold your portfolio for the long haul, giving it the greatest chance to fulfill its intended purpose.
Don’t hold back on new investments while waiting for market clarity: It’s not easy to invest new money in a portfolio that has recently lost money, but that’s what you have to do. If your plan is to invest every month, then invest every month regardless of recent market activity. Discipline in investing is about forming good habits and then practicing them consistently.
Some critics of these methods say these rules are too rigid—they don’t offer flexibly for what’s happening in the markets today. Well, that’s what discipline means! It’s discipline that makes a plan work. Create a plan and stick to it.
Part of your plan may be to make an asset allocation change at the appropriate time in the future when your own life’s circumstances have changed. These circumstances can be related to your health, career, retirement, a lump-sum windfall or a similar life-changing event.
Life Changes, Discipline Shouldn’t
The shift may result in a different allocation, but it remains just as important to maintain discipline.
Investment discipline is easy to read about. It’s the same as a doctor telling you to exercise regularly, eat right and get plenty of rest. It sounds so easy when someone else says it! Yet in real life, it’s not so easy to do. That’s why we have to be reminded to be disciplined.
My advice is to revisit this post whenever you may doubt your discipline.
Remember, a well-balanced portfolio works if you actually follow it—in good times and in bad. For more information on this topic, please read All About Asset Allocation, 2nd edition, McGraw-Hill, 2010.
For a full list of relevant disclosures, click here. Rick Ferri, founder of Michigan-based Portfolio Solutions, is a widely recognized index investor and the author of several books on index investing.