Creating an Investment Strategy

In developing an investment strategy, start by asking where you want to end - what are your goals? Establishing goals and setting funds aside to accomplish them are the first steps on the road to financial freedom. By working through your financial goals and setting and sticking to a budget, it is possible to establish realistic, achievable goals. The time associated with each goal will be one of the factors that affects your investment strategy.

You should start by grouping your goals by time period:

  • short-term: less than one year
  • medium-term: one through four years
  • long-term: five years and beyond

Once you do this, you can match investment vehicles to the time period. For long-term goals, for example, you can choose a class of investments that works well for the long term: short-term volatility doesn't matter, and you want good appreciation.

Asset Allocation

Establishing an asset allocation is the process of determining the proportion of funds allotted to different classes within a portfolio. An asset class is a grouping of investments with similar characteristics or features. Three broad classes would be: stocks, bonds, and cash.

Clearly, the most important decision is not which securities or funds to select, or when to get in or out of the market, but how to allocate holdings among asset classes. Most popular investment publications have countless articles on security and mutual fund selection and market timing strategies, yet very few on asset allocation (although fortunately, this is changing).

As a result, many believe that investment selection and market timing are the most important aspects of their investment decisions. In truth, they are only minor issues. Even the Wall Street Journal trivializes the ability of portfolio managers to pick individual securities by pitting these managers' selections against a dartboard selection of stocks; more often than not, the dartboard wins!

Within the three broad asset classes depicted of stocks, bonds, and cash, there are other asset classes that can be used to divide your investment portfolio, as shown in the table below:

Cash Bonds Stocks Other
Treasury bills Savings account Money market funds CODs Treasury notes Treasury bonds Municipal bonds Mortgage-backed bonds Corporate bonds High-yield corporate bonds International bonds Small company growth stocks Small company value stocks Medium company stocks Large company growth stocks Large company value stocks International stocks Emerging market stocks Balanced funds Real estate Precious metals Commodities

How do you decide the proportions of funds to allocate to different asset classes? To a large extent, this determination is based upon the timing of your financial goals.

Because of when the funds might be needed, you would not want to take much risk with money you have saved to achieve short-term goals. After working for several years to save enough for a house down payment, it would be a shame to see those savings cut by 30 percent right when you need them because of an unexpected downturn in the stock or bond market. Since few people can predict such downturns correctly (and none can do it consistently), the safe thing to do is to put the money for short-term goals in an investment that will provide a high degree of principal safety. In this case, the extra return that might be earned by leaving it in the stock or bond market over the next year is not worth the risk that the market might take a dip at the very time you want the money. The asset classes listed under "Cash" in the table above would be suitable for the funds targeted toward short-term goals. In addition, these vehicles are the right place to invest your emergency fund, since you don't know when you might need it.

For medium-term goals (one- to four-year time horizon), it is prudent to take some risk to keep pace with the negative effects of taxes and inflation. Still, stock market downturns can be sharp and last for a number of years. It would be sad to think that a well-deserved second honeymoon cruise would be delayed or cost 18 percent more (on credit cards) because of a gamble for a few extra percent return. In this case, short-term bonds, longer-term CDs, and Treasury notes make sense as investment alternatives. Once a goal is only a year away, it then becomes a short-term goal, and you should move the funds into a cash equivalent investment.

For long-term goals (greater than five years), the greatest risk to increasing wealth and achieving the desired goal is failing to outpace inflation and taxes. Stocks offer the best chance to achieve that purpose. Considering the discussion of diversification above, you should divide your long-term funds among different investments to take advantage of the fact that different investments react differently to economic conditions. A simple technique for the funds associated with long term goals is to put one-quarter of the funds into large company stocks, one-quarter into small company stocks, one-quarter into international stocks, and divide the remaining one-quarter among the bond or other asset classes shown in the table above. Using this portfolio as a baseline, you can adjust the proportions to accept more risk (by increasing the amount in small company and international stocks) or less risk (by increasing the amount in bond or large company stock investments). As long-term goals become medium-term goals, the funds needed to meet the medium-term goals should be moved into an appropriate medium-term investment. For example, as a daughter enters ninth grade, it is time to shift enough funds out of the investment portfolio to fund the first year's college costs and put them into one of the medium-term investment vehicles. Similarly, when your daughter enters tenth grade, you should transfer the second year's college funds into a medium-term investment. A similar process continues each time a long-term goal becomes a medium-term goal.

You can now see the importance of starting out with a list of achievable goals. If you do not, you'll find that you will not have enough funds accumulated to meet your long-term goals, because you will have been continually pulling from the portfolio to satisfy unplanned short- and medium-term goals.

Next: Selecting Investments

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