A Framework for Successful Investing

Framework for successful investing
Mastering investment framework is primary element contributing to accomplishment of your investment success. This framework shows major steps in managing your investment that, in turn, will become an investment roadmap to achieve your financial objectives.

It would be wise if you pay off your credit card balance and set aside assets for emergency before put your excess fund into an investment. Emergency fund should cover three to six months of living expenses.

Know Your Investment Goals

Identifying each of your investment goals is the starting point of your investing process. You have to know exactly your financial needs; so you can construct your investment specific to each goal, as well as organize your various investment accounts into several groups based on that multiple needs.

You want to consider short-term goals for next investment move after emergency fund is established. Investing for a vacation or buying a car is an example of reserving fund for these short-term personal needs. 

Retirement may be your primary long-term need. In addition to retirement, you may have also assets invested for other long-term goals, such as your children’s or grandchildren’s college education or new business capital. Investing for retirement and education needs are common long-term goals.

If you have been investing, you may have accumulated some investment accounts. You should list the accounts in one group for each of investment goal. The purpose of the grouping is to simplify the asset allocation process elaborated in the next step, as well as to make easy keeping track of the accounts and reviewing the investment portfolio.

Recognize Your Risk Tolerance

Beside your investment goals, you need to recognize your risk tolerance before construct your investment portfolio. You want to know how you can handle the degree of uncertainty in regard to a negative change in the value of you investment portfolio.

Your risk tolerance varies according to various factors, such as age, income requirements, financial goals, etc. Investment portfolio of a risk taker will be different from that of risk-averse investor.

Establish Asset Allocations 

Once you have identified your goals and risk tolerance, the next step is to determine how your investment should be allocated. The combination of asset classes you choose determines overall portfolio volatility and return. This is because different categories of investment assets respond differently to economy dynamic and other external factor ranging from changes in interest rates to oil prices. By combining investments that are subject to varying types of risk, you increase your portfolio’s potential for gains under different market conditions, while keeping the portfolio matching with your goal and risk tolerance. 

Achieving the asset allocation that matches your investment goal is based on your investment horizon (the time you have until you begin using the assets), your drawdown period (the number of years that you will need to draw upon your investments), and your risk tolerance. 

To start, you should decide how to allocate your investment portfolio among broad categories of investment assets, called also as asset classes, for each financial goal. The following broad categories may be included in the portfolio.

  • Equity
  • Fixed income
  • Short-term investment

You may also choose to include other asset categories depending on your circumstances. Any additions could provide useful diversification benefits. Nevertheless, diversification cannot assure a profit or protect against loss in a declining market. 

You’ll then want to further diversify into different sub-assets within each broad investment category. For example, you would include exposure to the following sub-asset classes within equity.

  • Large-Cap Domestic Stock
  • Mid/Small-Cap Domestic Stock
  • International Stock

Diversifying your fixed income holdings by maturity and credit quality could mean to invest in, for example:

  • Investment-Grade Bond
  • High-Yield Bond
  • International Bond

To give you an idea of the asset allocation in your investment portfolio, here is an illustration of a simple portfolio. You might plan to invest for 3 to 5 years before you begin making withdrawal for funding your retirement that may last for more than 10 years; and you have average risk tolerance. The following asset allocation of your investment portfolio might be appropriate for the circumstance in this example.

  • Equity 60%
  • Fixed income 30%
  • Short-term investment 10%

If you are a risk-averse investor, you might choose to reduce the exposure to equity and increase the allocation for fixed income and short-term investment classes.

You have a few investment options to build a portfolio of asset classes mentioned in the above example. A simple and easy option is to build the portfolio of Index Mutual Funds or Index Exchange Traded Funds (EFT) that track market indexes of each asset category. For example, you may invest in the following index fund for each asset class.

  • Equity: Index fund that tracks Russell 5000 Index
  • Fixed income: Index fund that track Lehman Brothers U.S. Aggregate Index
  • Short-term investment: Money market fund

You might have established an investment portfolio and plan to add new investment. Any new investment should complement others that you already own in order to ensure proper diversification. You should think that the new investment would be part of your overall portfolio and how its unique characteristics may prove beneficial when exposed to different risk factors and varying market conditions. 

Evaluate the Current Investment 

You need to outline your current holdings, if any, to see how the investments in each group, which you have identified in the first step “Establish Asset Allocations”, are allocated to broad categories as well as diversified within each of those categories. Having figured out both your target allocation and your current allocation, you would be able to compare them and identify any differences or areas of special concern. 

You may discover investment overlap, where two or more accounts hold assets in the same individual security, mutual fund, market sector, or sub-asset class. Overlap shouldn’t be always harmful. For instance, it’s fine to divide your small-company stock holdings between two different accounts as long as the total amount doesn’t exceed your overall target allocation for a particular goal. However the overlap might cause too much exposure to a given security or sector resulting in an over concentration in a particular market sector. There’s also the possibility you may find gaps in your portfolio where you don’t have enough exposure to certain asset or sub asset classes. 

Review the Investment Portfolio 

The last step of your investment process is to regularly evaluate your investment portfolio at least once a year. Your portfolio may no longer matches your investment goal due to various factors. Changes in your lifestyle, the financial markets, or other circumstances might distort the balance of your various accounts over time. Your portfolio market risk would increase or the growth potential would be reduced if the portfolio doesn’t longer match your goal. By reviewing your portfolios, you can ensure your investment mix remains aligned with your financial objectives.

You may also want to measure your investment performance of a specific asset category within the broad portfolio against a benchmark. A market index that track performance of specific asset category is commonly used for this performance evaluation. You should choose market index that correspondent to the investment category being evaluated. Underperformed investment is worthy for further evaluation and proper action. 

When making adjustments to your portfolio, you should be aware the tax ramification. However, tax considerations should not override a strategic investment plan. You may decide to sell shares of stocks or mutual funds, for instance, to achieve the appropriate investment allocation for a particular portfolio. Such action could result in taxable gains. Alternatively you may want to wait for future investments at the sub-asset class level to rebalance the portfolio allocations. 

In conclusion, an appropriate investment mix is a critical component for investing success. It is easier to decide how to allocate your investments in specific accounts within each asset category by deriving your overall strategy from a goal perspective. Continuing building the assets in your portfolio by investing on a regular basis is also important. You’ll find that it easier to evaluate and keep track of your investments by consistently focusing on the goals you are trying to achieve.