This guest post is from Andy Creak. Andy is the co-founder and director at the DIY investment platform rplan. He is passionate about helping self-investors make better financial decisions and turning the UK financial services industry on its head.
As the years of my life go by, I've been putting more and more effort to stay in a good physical shape. During my recent 6 a.m. jog around the woods I had a light-bulb moment when I realised that our bodies and investment portfolios are very much alike. It's simple: my portfolio's fitness depends on how much exercise it gets, just like my body. So, I devised a workout for my portfolio. Following my 6 Investment Workouts routine should help you get your portfolio back in shape.
1. Warming up: Figure out what you're paying for your investments
Cheaper investments aren't always better. In many cases, passive funds are a great option, but in others (such as emerging markets), actively managed funds can do much better. However, there's no denying that excessive charges consume the performance of your funds. I tend to look at the charges on my funds from a two-level perspective:
As with other goods and services, when choosing an investment broker, you should make sure that you get good value for money. Things to consider:
- Figure out how much your provider is charging for holding your portfolio. The charges will most likely include: initial fees, admin fees, dealing fees, ongoing commission and sometimes exit/account closure fees.
- Use comparison tools or spend some of your time on researching alternatives, which may give you better value for your money.
If you decide to go for the more pricey platform, make sure that you understand what additional services you are getting from them that make them worth the money
For the purpose of this post, I shall focus on mutual funds, however this also applies to ETFs (though shares work differently.) The charges for different funds can vary widely. I tend to follow a simple rule: if a fund has higher charges, I look for a justification in better-than-average performance. It's also worth keeping an eye out for other charges such as the performance fee (if the investment outperforms its target) or initial fees (very rare these days).
2. Push ups: Establish your risk level
The correlation between risk and reward is one of the foundations of investing; the more risk you're prepared to take, the greater the chance of higher investment returns or losses. On the contrary, the chances of big returns are as limited as your risk tolerance. I tend to use volatility to assess the risk of my portfolios.
Once you establish how much risk you are willing to take, your investment goal and the time horizon to achieve it, you should check whether the funds in your portfolio actually give you the risk level you set out for. In some cases, I had found that I wanted a low to medium level of
risk, but the funds in my portfolio were anything but. Make sure to adjust its overall risk level by adding (or switching to) more/less risky alternatives.
3. Squats: Work out your target asset allocation
The term asset allocation simply stands for “where to invest” – such as equities or bonds, for instance, or US equities, China equities, UK government bonds if you're going into more detail. The mix of sectors you choose will have a great impact both on the risk level of your
portfolio as well as its performance. Depending on your investment experience, you could either use a “ready-made” portfolio as a starting point, or construct your own from scratch. The key rule to remember is not to put all the eggs in one basket – diversify your investment.
4. Sit-ups: Measure your performance against a relevant benchmark
To see how your portfolio is performing in real-money terms, compare against a useful benchmark. Professional traders tend to use market indexes such as the S&P 500, however this is rarely relevant to an individual investor. You'll want to compare to a risk-adjusted benchmark – that is, a benchmark which matches the level of risk of your portfolio. There is no use comparing your high-risk portfolio to inflation – it might make you make you feel like Mr. Buffett's successor, but it won't help you figure out how well you're doing compared to others in the same space.
Firstly, find out how your portfolio has been performing over the last year and monitor the benchmark within the same date range (e.g., Sept. 1, 2012 to Aug. 31, 2013). Secondly, figure out your risk tolerance (see exercise above). Finally, carefully review your performance by comparing it against market portfolios of the same risk level. Remember that the benchmark has to have a similar risk profile. If you're beating the benchmark – congrats, you're all good. Otherwise, you might want to review your investment strategy (unless your are taking a bet on a specific market outcome, in which case sitting it through could be a good option).
5. Weightlifting: Rebalance
Another key exercise for your investments is to periodically adjust the proportion of assets in your portfolio. This process is known as rebalancing. Its sole purpose is to reduce the big ups and downs that markets experience by restoring the original asset allocation. It works by selling some of the investments that performed better, and buying those that have done less well. Rebalancing will keep your portfolio at its original risk level and help dampen the effects of market crashes. Vanguard done some research suggesting that investors rebalance every six to 12 months, when their asset allocation is off the target by 5 percent or more.
6. Stretching: Weed out any consistently underperforming funds
Although past performance is not an indicator of fund's future gains, it would take a great deal of convincing for an investor to keep buying into a consistently underperforming fund over a sustained period. However in some cases, you may have a very good reason for choosing it, e.g.belief in fund manager's strategy over the longer term. My rule of thumb is to take a closer look at any of the funds I choose which are consistently in the bottom 25 percent of their sector over a two-year period.
Is your portfolio feeling better already? Do this regularly, and it will become a reliable and regular performer with no extra fat.
If you have your own investment workout routine that you follow, make sure to share with us in