By Paul Gleeson BBS, QFA, CFP
This article also appears in the Celtic Connection, where Paul is a regular contributor.
Last month, I shared some of Jason Zweig’s findings from his fascinating book, “Your Money & Your Brain”. In short, neuroeconomic research is showing that we may be fundamentally wired to lose money when we invest.
At the end of that article, I promised to share some of the strategies I use with my clients that enable them to avoid mistakes that many people make when it comes to investing their money. Many of these mistakes are a result of our wiring as outlined in Zweig’s book.
Due to the size constraints of this article, I cannot go into all of them in detail, but here are three important strategic elements that I believe will help you invest more effectively and with less anxiety going forward:
1) Know Your Numbers
The reason most people save and invest money is to one day become financially independent; that is, accumulate enough investment assets to provide an income that funds their lifestyle for the remainder of their lives – without the need to work. Let’ use an example:
Bert wants to be financially independent by his 65th birthday. For Bert and his wife Lourdes, this means having $10,000 a month (in today’s dollars), after tax from age 65 for the rest of their lives. Both Bert and Lourdes are currently 45 years old and they have $500,000 of investment assets.
Assuming certain OAS and CPP benefits and a 3% inflation rate, if they can earn a 7% return on their investment assets (net of fees to their advisor) every year from now until age 65, they will need to save $36,000 each year to build up enough assets ($2.2 million in today’s dollars) to reach their financial independence goal. Fortunately for Bert and Lourdes, they run a successful business and anticipate being able to save at least $36,000 annually between now and age 65.
Bert and Lourdes know their numbers and use that information to build an investment strategy that will help them reach financial independence. Knowing the numbers establishes a goal and alleviates much of the fear and worry (which lead to poor investment decisions) triggered in your brain when it comes to investing for retirement.
2) Formulate a Well Thought-Out Strategy
Let’s continue with Bert and Lourdes, who know a 7% annual return will get them to where they want to be.
When it comes to the brain and investing, there is no single investment strategy that is “the best one” to use. It is the ups and downs of the market – what we call “volatility” – that the brain responds to, so in terms of investment strategy there are two key elements that I employ with all my clients, and that would benefit Bert and Lourdes:
First, create a portfolio that is well diversified across a variety of asset classes. Many investors rely solely on equities and bonds as their investment vehicles. And while they may own different stocks and bonds, they’re all eggs in the same two baskets. This “stocks and bonds” approach has likely not produced great results for investors over the past decade because of the type of investment market we are in (and are likely to remain in for the next 4 to 7 years). I would only have between 25% and 35% of Bert and Lourdes’ portfolio invested in traditional equity markets.
The key is to lower volatility by diversifying into other asset classes – different baskets – that are not directly correlated with traditional equity markets. Investments such as cash-flowing real estate, mortgages and alternative strategies including private equity investments, hedge funds and gold and precious metals. Having an investment portfolio that is diversified across a variety of asset classes not only relieves the brain by reducing volatility, it can improve returns and outperform equities and bonds, just as it has for my clients over the past decade.
Second, ensure the portfolio is generating cash flow. Steady income from investments is like owning a property that pays you rental income. You don’t worry about the price of the asset, because the cash flowing income appeases the brain. Bert and Lourdes need 7% a year to reach their goal. If we can get a 4% return from dividends, interest and rent produced by the assets they invest in, then we only need to grow these assets by a further 3% a year over a 25 year period for them to reach their goal!
3) Tune Out The Noise
We are bombarded on a daily basis with information from a multitude of media sources. Most evenings on the news, we will be given a certain reason why stock markets moved up or down or why the Canadian dollar appreciated against the U.S. dollar.
In my opinion, these news stories are meant to make headlines and induce emotion, and are highly speculative at best. It is true that global events may trigger certain movements in the markets, but so many moving parts and variables influence markets that it is irrational to say that a certain announcement or event in isolation caused markets to move.
We absolutely encourage our clients to be educated and stay informed, but it’s crucial to have the entire picture. What we read and hear in the media conjures up emotions in us because we are naturally emotionally attached to our money. And why shouldn’t we be, haven’t we worked hard enough for it? Nevertheless, making investment decisions fuelled by emotions is not a good thing.
Going back to our example:
Because Bert and Lourdes know their numbers, they were able to put together a suitable investment strategy that they believe will deliver the results they need. They don’t need to time the markets (which is virtually impossible for most people) and therefore they are happy to tune out the media noise, avoid making emotional knee jerk investment decisions and, instead, stick to a well thought out investment strategy.
What I have outlined here is a simple, effective approach that has a proven track record for my clients. There are many other investment strategies that can work, and of course a suitable strategy today may need to be amended in the future – nothing wrong with that at all. The point here is having a strategy to follow will help you avoid making many of the investment mistakes that our mental wiring can lead us to.
What strategies to you use to stay on course with your financial plan? Let us know in the comments below!