We’ve all heard the saying, “You are what you eat,” but when it comes to investing the best advice I can ever give is “You should invest how you are.”
All too frequently individual investors and, yes, professionals, get caught up in the trap of buying stocks and other investments for their high-price targets or yields without considering how each new investment affects their portfolios. If the only question you ask about an investment is, “How much can I make?” well, you’re doing it wrong.
There are two questions you need to answer before you can even consider the potential return or income from an investment.
Will this increase or reduce my portfolio’s risk?
The more you concentrate your investments into one asset class, industry, country, or investment style, the more your portfolio’s performance will depend on you being smarter and more informed than everyone else. Yes, that can work out well, but a growing pile of behavioral finance research indicates we human beings tend to overestimate our likelihood of being right.
Diversification will help cancel out a big chunk of risk but you should also ask yourself whether the stock might be too volatile for your comfort.
One quick measure of a stock’s volatility is beta. Beta is a ratio of a stock’s volatility to a group of other stocks (usually the S&P 500 Index). A beta of 1 means the stock is, over time, as volatile as the rest of the group, while a beta of 1.42 means it captured 142 percent of the market’s volatility. A beta of .82 means it is only 82 percent as volatile as the rest of the market.
Because cash doesn’t change in price, its beta is zero. Unfortunately, it pays close to zero as well.
Do I have enough time for the investment to work out?
If you feel very unlucky in the markets, chances are there’s a rational explanation. It usually comes down to too few attempts. The probability of a stock (or a market) going up on any given day is slightly better than a coin flip. You need to flip that coin often enough to get results similar to the rest of the market. Over a period of many years, the S&P 500 Index has averaged close to 10 percent total return. But you need to allow for enough time for your experience to resemble long-term averages.
If you aren’t willing to give an appropriate amount of time for a stock to earn its expected return, there are plenty of other investment options out there that will match up better with your time frame.
Your portfolio should be a portrait of you
Ideally, any knowledgeable investor should be able to review your investments without knowing you and get a good sense of the rate of return you are pursuing and how you feel about risk.
If your portfolio leaves you frustrated or scared, step back from “how much money can this make me” and ask first about whether the investment complements your portfolio and suits your needs. If it does, only then should you begin to think about the upside.
Evan Guido heads a wealth management team in Sarasota focused on retirement planning. He is a director in the Private Wealth Management Division at Robert W. Baird & Co.
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