Investment Decisions Need a Strategy

by George B. Thompson

Your investment decisions need a strategy to be successful. Without a strategy, you will be subject to your emotions and the thousands of 'investment idea' voices in the marketplace. Instead, you should have a plan that fits your specific situation and goals, rather than the latest 'hot idea'. As a financial advisor, I can only give specific recommendations to clients, but what I can provide to help you get better as an investor is a framework I generally use to structure investments.

The framework is based on three concepts:

  1. Diversify your portfolio
  2. Manage your buckets
  3. Manage your risk

Diversity is the Foundation

As you develop more financial resources and have more options for where to put your money, it is important to have a simple way to evaluate your entire portfolio. One of the key values when doing this evaluation is making sure that your investments are appropriately diversified to suit your goals. This chart shows how I generally explain the different layers that your investment portfolio should contain.

  • Bonds - this layer contains three types of bonds: short-term, medium-term, and long-term. I put it at the bottom because it acts as a steady foundation for your overall portfolio.
  • Real Estate - at a minimum, you should own your own home as the starting place for this layer. Over time, this can include investment properties and real estate investment trusts (REITs).
  • Alternative Investments - this includes investments like gold, silver, hard assets, and even some types of real estate. These types of investments don't fluctuate as much with the markets and sometimes go in the opposite direction. You always want these types of investments in your portfolio to provide you with a hedge against market fluctuations.
  • Stocks - this is the bread and butter of your portfolio: small, medium, and large companies that you own through buying shares. Within this category, it's also important to diversify, so I recommend spreading your money across the different sizes of companies, as well as splitting it between growth and value stocks. Value stocks are companies that are mature and dividend-paying. Growth stocks can grow at 20 percent per year or have a pattern of growth and are consistently expanding. They have more risk than value stocks but get you bigger returns in the long run. So it is important to balance out between these two types of stock.

Investment Decisions Using Buckets

In addition to diversifying your portfolio, it is important that your money is ending up in the right 'buckets'. This managing of your 'buckets' has two components: time horizon and asset-use.

Time horizon buckets give you a framework to think about shorter vs. longer-term investment goals. As per the figure below, the time horizon maps to whether or not you are making a conservative vs. risky investment. It is also connected to the level of liquidity the investment vehicle should have. So for example, if you need the funds from your investment in the next 6 months, the vehicle you invest in should be one where you can access the funds within that time frame, and it should be a relatively conservative vehicle because you cannot ride out much fluctuation in the market.

Asset-buckets are a way to think about the life goal purposes of the money you are investing. You should have three general buckets that you categorize your investments with consumption, contingency, and custodial. Consumption assets are the ones you use to live and enjoy life. Contingency assets are your funds to help deal with any unexpected financial needs that come up. And custodial assets are those that will outlive you and can be for family, friends, or charity.

Risk Should Be Managed, Not Feared

The last component of my investment framework is designed to deal with an inevitable aspect of investing: risk. It's important not to make investment decisions based on fear of risk without really understanding how to handle it. The way you respond to risk can have a significant impact on how successfully you invest.

There are only four ways you can deal with risk:

  • Ignore it - you can pretend there is no risk. This is similar to driving a car with no car insurance.
  • Avoid it - you can take no action because of your fear of risk. This is similar to wanting to get from point A to point B, but staying at home instead because you don't want to get a car.
  • Manage it - you can become knowledgeable about the risk and learn how to operate in its presence. This is like learning how to drive and then driving according to the rules on the road so that you don't have any accidents.
  • Transfer it - you can let somebody else take on the risk. This is when you buy car insurance so that when something happens, the financial burden is covered by a third party. There are ways in which you can structure your financial portfolio so that some of the risks are transferred to a third party.

Structure Yourself for Success

In my book, The Wealth Cycle, I go into more detail on how to set yourself up for success with investing. The key idea is to make sure you have a plan that is based on an overall strategy that has some success principles built into it. The framework I provide here is a great place to start and can help you have richer conversations with your financial advisor about the best way to distribute your money across your investment portfolio.

© George B. Thompson 2021