It’s advice we hear time and again–stick to your asset allocation plan. Whether the stock market is reaching new highs are new lows, don’t change your investments apart from rebalancing. It’s the kind of advice that is simple to understand, but difficult to follow.
In fact, a lot of investors don’t follow this advice. In my column at Forbes, I recently published an article on the benefits of a falling market. The research I did for that article underscored just how much investors lose out of fear (selling when the market is down) or greed (buying when the market is up).
For example, a Morningstar report demonstrated the cost of investor behavior. Written by Russel Kinnel, he found that over the past 10 years stock funds returned 7.9%. Unfortunately, the average investor in these funds earned far less–4.8%!
Why? Their timing was really bad. Investors pulled money out of stocks at the bottom in 2008 and 2009. When stocks were up, they piled back into the market. The bad timing cost many investors dearly.
In this article and podcast, we are going to provide some tips on how to deal with this problem. It’s one thing to know you should avoid market timing. it’s another thing to actually stick to an asset allocation plan when the market is down 30%. The following 9 tips will help you do just that.
9 Tips to Help You Stick to Your Investment Plan
1. Set the right expectations
Recognize that whatever your asset allocation is, it will lose money from time to time. Significant market declines are normal and should be expected. There should be no surprises when a portfolio of 70% stocks is down by 30% or more. Over the course of decades of investing, this will happen several times.
One article from Vanguard does a great job of setting these expectations. It shows the historical performance of different asset allocations ranging from 100% bonds to 100% stocks. For each allocation, it shows you the average annual return, the best year and the worst year (based on data from 1926), and the number of years that experienced a loss.
Let’s using as an example a portfolio of 70% stocks and 30% bonds. Here’s what the Vanguard chart shows:
So if you’re at a 70/30 allocation, it should no longer come as a surprise to you if your portfolio is down 20 to 30% in a year. It will happen. You need to understand what you can expect given your asset allocation. Especially if you’ve got more equities than fixed income investments, then this should at least prepare you for what’s to come.
2. Write down your asset allocation and rebalancing plan
Write down your asset allocation plan and your rebalancing plan. It can be a simple email to yourself. You can also use a spreadsheet or other tools like Morningstar, Personal Capital or quite simply, a piece of paper and a pencil. Bottom line: Write down your asset allocation plan and your rebalancing plan because they are both critical.
3. Favor Index Funds
If an index fund is down, it is because the market is down. If an actively managed fund is down, it may be because of the market or perhaps because of poor management. It’s often difficult to know for sure. With index funds, because you know that poor performance is never due to bad management, you are more likely to stick with the investment.
Don’t just take my word on this. The same conclusion was reached in an article by Wealth Front (a robo advisor). The research found that in bad markets, there are fewer redemptions from index funds then there are from actively managed funds. I believe the reason for this is that investors in index funds understand that sometimes the market will be down; it’s not because of poor management. Here are the details:
Personally, index funds were a big part in helping me stick to my investment plan.
4. Keep your debt low
Have a holistic approach to your personal finances. Don’t look at your investments in isolation from the rest of your finances. If you have no consumer debt and are able to save money each month, you are more likely to withstand a downturn in the market. The more secure and solid your personal finances are, the easier it will be to deal with the ups and downs of the market.
If you are struggling with your finances, here are some key articles to help you get on the right track–
5. Keep your fees low
One reason to keep your investing fees low is obvious–it keeps more money in your pocket. But there is another reason to keep fees low–it can help you stick to your investment plan. It’s one thing to see an index fund go down because the market goes down and you’re paying 5 to 20 basis points. But it’s quite another thing to watch an actively managed fund tank that costs you 1 to 1.5%. The high fees will make it even harder to stick with the fund.
This is especially true if you’re paying a heavy advisory fee. The more you pay in fees, the harder it is to stick with those investments when the market is down. Thus, keeping your fees low in good markets and bad markets all the time can help you stick to an investment plan.
6. Diversify your income streams
Your ability to generate income goes a long way to your ability to withstand a down market. If you’re confident in your job, career, or business and your ability to generate income, it becomes easier to deal with the down market. So what are some of the ways to diversify your income streams?
While starting a side business is an option for some (it’s what I did), it won’t appeal to everybody. For those focused on their jobs, continue to take steps to make you more valuable to your employer and industry. This may take the form of additional education or training. In some industries, such as IT, certifications can also be extremely valuable. The more confident you are in your ability to generate income, the stronger you’ll be to withstand any downturns in the market.
7. Don’t look
When the market is down, do not look at your portfolio. Ignore it. If checking your investments is going to keep you up at night, then ignore your portfolio during down markets. Of course, you’ll need to monitor your portfolio for purposes of rebalancing. But for most, rebalancing occurs just once or twice a year.
8. Become an historian
This is, in some ways, one of the most important in this list. The more you know about the history of investing and the history of the stock market, the more prepared you are for both the good years and the bad years. Learning the history of the market will help you work through those difficult time,s which will absolutely come.
Here are three good reads to help you enrich your knowledge of stock market history:
A Random Walk Down Wall Street – Burton Malkiel: It has a good perspective on investing generally and a history of asset prices in the stock market.
Security Analysis – Benjamin Graham: This is a book that Warren Buffett recommends. It is more designed for fundamental analysis of individual stocks. This was written at a time and following a time when the markets went through significant upheaval. Here, you will get a sense of what the markets can do over a decade or more and how they can be brutal for a period of time.
Berkshire Hathaway letters: These are the letters that Warren Buffett has written to Berkshire Hathaway shareholders every year. They are arguably the best wisdom on investing you’ll ever read. And they are free.
9. Make changes to asset allocation slowly and deliberately
It’s interesting to me that investors (myself included) often want to make changes to our asset allocation plan in times of market extremes. When the market or asset class is up, we think about increasing our exposure to those investments. When the market is down, we think about adding to bonds. Here we have to be very careful.
Are we considering a change to our asset allocation because it’s the right thing to do? Or, are we motivated by the market? These questions are one reason I’ve yet to sell my commodities ETF. Commodities are down, and although I’m convinced they should not be a part of my portfolio, I’m slow to make the change just yet. I’ll likely wait for commodities to come back, which may take years, and make the change then.
Sticking to an investment plan is critical to success. While it’s not always easy to do, one or more of the above tips may help you stick to your asset allocation plan in any market.