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March 18, 2009

A Checklist for Everyday Investing

Andrew Ang
Professor, Finance and Economics
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If you’re in the market to beef up your investment portfolio — and have the stomach to ride the Dow roller coaster — Andrew Ang, professor of finance, says to follow this checklist before you decide to buy or sell.

1) Know your risk tolerance
This seems obvious. If you’re very risk averse, don’t hold a lot of risky assets. Unfortunately, a lot of people have learned the hard way that they overestimated their risk tolerance. Equities fell in 2008 by a lot — around 50% worldwide. You need to be very comfortable with the proportion of risky asset holdings and then stick to this. Making adjustments to your portfolio right now by selling equities could be one of the biggest mistakes you can make. You don’t sell stocks when stock prices are really low and future-expected returns are very high.

2) Diversify widely
The large negative returns that have occurred in many asset classes doesn’t mean that diversification has failed. In fact, it’s quite the contrary. If, like James Barrow, you bought 10% of Bear Stearns in 2007, you would have lost close to everything. He would have been much better off buying the S&P 500. Similarly, if your employer allows you to buy company stock, don't build up a large position. Your salary comes from that firm, and you add to that risk by having savings in that same firm. Buy the S&P 500 or something else instead. Diversification means not bearing the specific risk of an individual firm. Diversification also means recognizing your investment property in the Hamptons looks a lot like your equity portfolio.

You want to diversify widely. Hold many different asset classes. In 2008, Treasuries were one of the few asset classes to increase in value. If you didn’t hold them, you missed out. Note that diversification doesn’t mean that owning many different asset classes will shield you from many of those asset classes having simultaneous downturns, which we’ve seen over the last few months. Diversification doesn’t guarantee this. If you’re uncomfortable bearing risk, see (1).

3) Rebalance regularly
Every year, or at some regular interval, rebalance your portfolio. Suppose you hold 60/40 equities and bonds. At the end of the year, if equities increase relative to bonds, you sell equity to buy bonds. After 2008, you bravely buy equities and sell bonds. Rebalancing is inherently contrarian. You buy assets with declines in prices and pare back your exposure to assets with increases in prices. An investor doing this from 2001 to 2007 would have sold equities and bought bonds almost every year. If you didn’t do this, your portfolio by the end of 2007 would be heavily weighted into equity and you would be bearing enormous equity risk. Rebalancing tempers that risk and makes sure you are bearing only as much exposure to risky assets as you can tolerate.

4) Save, save and save
There is no such thing as a free lunch. High returns only come with high risk. For saving towards retirement, you must save, save and then save some more.

5) Keep your costs to a minimum
Avoid active mutual funds and other active management like the plague. The average active mutual fund loses money. Hold index funds instead. Keep things simple. Structured assets simply chop up positions of underlying assets with leverage and charge you a lot of money. Minimizing costs means you get to reinvest more and that means more money for you at the end.

Photo credit: Bill S.