Three Requirements for a Successful Stock Portfolio
Prefer to listen rather than read? Pair this post with our Deliberate Money Moves Podcast: Portfolio Management Done Right.
Imagine if you could have someone else go to work and send you the paycheck.
Wouldn’t that be great?
Now, what if that person were brilliant, and a leader in her field?
What if she was an undiscovered talent who ended up making it big, and when her earnings rapidly grow over a short period of time, a portion of those earnings go to you?
How about instead of just one person, there was a whole gaggle of people working for you? In all industries, in all parts of the world, pooling their knowledge and talents just to make enough money to fund your lifetime of expenses?
Wouldn’t that be just dandy?
Well, welcome to dandy.
By investing in stocks of companies around the world, you’ve tapped into the world’s workforce who is going out there every day to make money for you, the company’s owner. Not only are they putting forth physical and mental effort, but they are using their human ingenuity to gain an advantage for their employer so they can make even more money to send you.
You see, stocks are the only financial instrument designed to capture the value of human ingenuity and effort. By investing in stocks, you are tapping into an untold number of people around the world who are working on your behalf.
While this is all pretty great, there is more than one challenge to this notion, and that’s what we are going to talk about today: what is required for a successful stock portfolio.
Now, before we get into the details, let’s define what we mean by a “successful” stock portfolio. This one does not win over a short time or one that provides the absolute highest performance possible in the future.
Instead, a successful stock portfolio funds your planned spending needs through the rest of your life. That’s it – that’s all we are trying to do with our portfolio. We are not trying to beat the markets (whatever that means), and we are not trying to beat our neighbors. We don’t use our portfolio for bragging rights with our friends, and we don’t judge ourselves by how our portfolio is doing at any moment in time.
The only thing that matters when it comes to your portfolio is something that cannot be answered until you are dead and gone: did it fund all the expenses you planned for and help you achieve all your financial goals in life? With that in mind, let’s define and discuss what is required to make your portfolio successful (in no particular order).
Diversification
I’m sure you’ve probably heard this term before as it gets thrown around a lot in investment circles. Instead, let me offer a different definition – one that you may not have heard before.
Diversification means holding investments in your portfolio that are not working.
Of course, you should also have investments that are working, but to be diversified, you will never have a portfolio of stuff that is all doing the same thing.
If you are properly diversified, you will always have segments of your strategy that are not doing what you want them to do.
This comes directly from the fact that we cannot predict what markets (or stock sectors or individual stocks) will do over any short period of time. Because of this, we must hold investments that aren’t so hot right now.
That said, because stock markets go up over time, we will earn a positive and above inflation return over time if we continue to hold a properly diversified portfolio. We get the benefits of a portfolio that rises over time without getting completely trounced and driven from the game when markets crash.
Risk Management
That’s a two-dollar word for minimizing potential regret before maximizing return.
If we structure our portfolio so that it will not fall enough to drive us from our strategy, only then can we think about maximizing return within that constraint.
In other words, let’s make sure we don’t get killed before we try to live the best life we can.
This is akin to buying insurance on the planning side. The reason you insure your home is not that you believe there’s a good chance it will burn down – there most definitely is not. It’s because the ramifications of it burning down and you not having insurance are so horrible that you must get rid of that scenario entirely by paying an insurance company a small premium each year.
You have minimized potential regret first by paying that money out of pocket.
We also do this with your investment portfolio through risk tolerance assessment, which leads to an appropriate mix of assets, and we check this by reviewing what your portfolio would have done in past market crashes.
If you find those downsides acceptable, then we can move on to maximizing your returns within that constraint.
Behavior
Once we have our long-term strategy figured out, and our portfolio created and running, what could go wrong?
The answer? Us.
Most of this entire game of investments is about our personal decisions, fiddling with a beautiful strategy that will work over time. My advice: don’t do it.
But that’s easier said than done. And I would say a good portion of the value I provide as a financial advisor is talking clients out of temporary portfolio moves that could kill their long-term goals.
Managing your portfolio is not about beating the markets or achieving a certain return. It’s about putting your assets in a position to take what the markets give you so you can achieve what you want in life.
Someone once said, “Investments are like a bar of soap. The more you touch them, the more they go away.”
If you’ve taken the time and effort to create a brilliant investment strategy designed to fund your expenses throughout your life, then that statement is most certainly true.
You can only make the strategy worse by fiddling with it.
What Gets in the Way?
Similar to the answer I gave in the recent blog on Avoiding the BIG Mistake, and what we just discussed above, the answer is “us.”
We get in the way of our success by acting on something the news is telling us or the feelings that we have about the markets. Managing your portfolio that way will lead to disaster because you only have to be wrong once to completely blow yourself up
The Good News
We are all human, and we will make mistakes. Accepting and knowing this is an important step on the way to a successful investment portfolio.
This is true because once you know this – once you truly believe it – your focus will shift from trying to do everything you can to control the markets and earn a higher return to trying to make sure you do not make a fatal mistake.
And that is the trick to a successful stock portfolio – don’t ever do anything that can be fatal.