TMCnet Feature
May 26, 2020

How to Build an Investment Plan That Works for You: 4 Steps to Success

When creating an investment plan
, there are a multitude of things that must be taken into account. With investing, you are looking at longer-term trends in the market and perhaps trends in society or industry in order to increase wealth over time. This is much different than shares trading, or even speculating, as both look at the short term profit and loss of your positions, while investing is trying to take advantage of the changing business environment over the longer term time horizon.

Step One: Understand your current situation

The first thing that an investor needs to do is understand the current situation that they are in. Furthermore, they have to understand the situation that the world is in. At this point, there are several questions to ask yourself. The first one of course is “How much capital do I have to start investing with?” Obviously, the more money that is available to invest with, the better the results should be, all things being equal. However, some people have to invest slowly over time, which also works quite well in a long-term environment.

The other part of the current situation that the investor finds themselves in will be based upon external factors. For example, is the economy growing, or is it slowing down? How are exports functioning? Is there more demand from China or other large economies such as the United States? All of these things come into play when trying to understand the environment that you will be investing in. Having said that, the longer-term investor can look forward towards years down the road, or even decades. This is where you do your research on global trends, as the economy is highly interconnected with other economies globally. Long gone are the days where one could simply by a local company based upon what is going on directly in front of them. Globalization has clearly changed the game, so what happens in places like Japan can have massive effects in places like USA. It is about trying to find the overall trend of consumption, demand, and innovation.

An example might be in the late 1990s, as the technological boom with all things Internet related really started to take off. While there were a lot of companies that went under at the end of that decade going into the 2001 fiscal year, the reality is that the trend had been firmly ensconced that the Internet was here to stay, and that business would certainly be looking to take advantage of this new commerce possibility. An investor could have looked into some of the leading companies, or even buying particular sectors within technology as an example.

Step Two: Establish your goals and timeline

Simply stating that you are “looking to make money” is not necessarily going to be enough as an investor. This is because as an investor you will have to keep in mind what your needs will be. For example, if you are 60 years old, you will be in a much different environment than a 23-year-old just leaving university. As a general rule, investors who are older will need to be much more conservative with their investments, as a significant loss in the account could put the investor in an exceedingly difficult position to be, as retirement will be coming much quicker than the younger investor. Quite frankly, the younger investor has much more time to recover from losses, and as is normally the case, has the ability to take much more risk as they may have 40, 50, or even 60 years for their account to grow.

If this is not a wealth building project for the possibility of retirement and simply an investment account, perhaps in order to build wealth, then you must sit and think about how long you plan on being invested. You also need to understand what the use of this account will be when you finally do pull your gains out of it.

Step Three: Know your risk tolerance

One of the most important things that an investor will do is to establish what their risk tolerance is. One of the most important things to understand about risk tolerance is that your timeline will have a certain effect on how risky you can be with your investments, as mentioned in “Step Two.” However, there are a few other things you need to pay attention to, such as the amount of trading capital that you are starting with, and of course what realistic opportunities are out there. Furthermore, and perhaps even more crucial, you need to understand what you can psychologically deal with.

While it seems relatively simple to buy a few stocks and simply wait for your gains, the reality is that you will see prices go up and down, and there is a huge psychological difference between the idea of buying stocks, and the reality that you may not necessarily make money on every investment. You need to understand how much you are willing to lose on a particular investment before it is time to close out the position. For an investor, it is a completely different situation than it is for someone like a day trader.

For example, a day trader, someone who buys and sells a stock during the same session, may only risk 0.5% of their account on each trade. This is because losses can ramp up rather quickly. However, an investor may be perfectly comfortable losing up to 10% of money invested in a particular stock. It comes down to what the individual investor is comfortable with, and therefore it is a very personal decision. However, keep in mind that interest does compound over time, meaning that if you lose 50% of an investment, in order to get back to break even, the market needs to produce a 100% return from that loss.

Because of this, understanding your risk tolerance is going to be crucial in order to keep you from making emotional decisions. Furthermore, it can help you in order to build up a diverse portfolio, something that is going to be crucial for the longer-term investor. Simply putting all of your money into one particular stock is a dangerous way to invest, because there could be a specific event in that company that causes massive losses. If you understand your risk tolerance, you can start to look at which companies to invest money in, which of course is decided when you build your portfolio.

Step Four: Build your portfolio

Now it is time to start thinking about building your portfolio. The initial thing that you will need to do is research on what type of marketplace you are entering. For example, if it is a very highly charged growth environment, then riskier assets tend to perform quite well while household names may be a bit more static. This means that people are comfortable buying some of the newer and perhaps fresher technology types of companies. However, if the economy is slowing down, people tend to buy companies that represent “needs” for the average person, such as household items.

There are a lot of different ways to determine your portfolio of companies to invest in, which is referred to as “allocation.” An investment portfolio should have enough diversity that while some of your stocks may wilt, others will gain simultaneously. The idea is that some will make up for the losses of others. A typical portfolio of an investor may look something like the following:

  • Large cap equity: 40%
  • Small cap equity: 20%
  • REITS: 10%
  • Cash: 5%
  • Fixed Income: 25%

Keep in mind that these levels can be moved back and forth, as the “Large cap equity”, or large capitalization companies (think largest companies listed) are considered to be much safer investments than smaller companies. REITS, or “Real Estate Investment Trusts” can produce income in the form of dividends for the investor, but obviously if there is an issue with the real estate market, that is the last place you want a lot of your investments in. One should always keep a little bit of cash on hand in case and another opportunity presents itself, and of course some exposure to fixed income for safety and interest payments will help stabilize the entire portfolio.

Step Five: Monitor your investments

The investor will also need to monitor their investments and pay attention to performance. They will also need to monitor the performance of the economy, showing what sectors may provide the most performance for their investments. However, one should be extremely cautious about fiddling too much with the portfolio, as this can lead to unnecessary losses, and of course emotional trades, one of the killers of performance. By allowing your investments to grow over time, you will find performance to increase. However, monitoring each investment occasionally is crucial in order to protect your account. At the end of the day, it is crucial to know when it is time to get out of an investment and take a small loss.

Let us take an example: You have a portfolio of five stocks. The economy is growing relatively strong, and Australia seems to be running on all cylinders. In this scenario, you may have a portfolio that looks a bit like this:

Shares of Altium, Ansell, BHP Billiton, Bank of Queensland, and AGL (News - Alert). In a growing economy, one would expect BHP Billiton to do well because of demand for raw materials from other countries around the world. By paying attention to the GDP figures of multiple economies, you can get a bit of a feel for demand. Furthermore, there will also be quarterly earnings reports from BHP Billiton that show sales, etc. In a growing economy, Altium should do relatively well also, as it is an IT company. Again, paying attention to the earnings call probably will be your biggest guide.

However, companies like Ansell and AGL may not do as well, because they are healthcare and utilities. Those are considered to be “safer investments”, which might do better in a shrinking environment as these companies will get there earnings based upon “need” and not necessarily “wants.” Furthermore, a lot of the healthcare and utility companies are known for paying dividends, which also will help a portfolio in rough or economic conditions. In other words, the dividend paying large healthcare and utility companies provide a little bit of a cushion for your portfolio if the economy has a bit of a downturn.

Furthermore, if the economy does go from growth to slowing down, and investor can also do things along the lines of trimming some of their exposure to Bank of Queensland, and perhaps adding to their position in AGL utility. Traders do not necessarily have to close out the entire position when things do not look quite right, they can simply take some of those profits and slide them over to another allocation.

Obviously, the combination of how your portfolio can be constructed and the number of companies is large, but as a general rule traders break down their portfolio into growth and safety sectors. Obviously, if the economy goes from a slow growth economy to a growing one, then the exact opposite could be done, perhaps trimming some of your position in AGL and adding it to BHP Billiton as an example. All that being said, economies do not tend to turn around immediately, and there is more of an economic cycle that takes quite some time to move things around. Meddling with your account on a daily basis will only make your job is an investor much harder. Remember, you want your money to work for you, not the other way around.

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