My sons’ basketball coach, George, has a favorite expression: He talks about “working through the uglies.” When you’re developing a new skill, he says, you shouldn’t expect it to be perfect the first time, or even the second. But, if you keep working at it, over time there will be progress, “from ugly to not-so-bad to decent to good and then, eventually, to great.” The message is clear: When something is a process, you can’t rush it, you can’t skip steps, and you have to start with the basics.
If you’re building an investment portfolio, I’d think about it the same way. At first, don’t worry about trying to make it perfect. Instead, recognize that it’s a process and focus only on the most fundamental questions. Later, you can fret about the details — which particular stock or bond or fund to purchase — but don’t let those details distract you at first.
Admittedly, this can be difficult. Investors have always struggled with the “brother-in-law problem” — that is, the friend or relative who always seems to be bragging about their latest grand slam stock pick. For folks like this, the route to success consists of exactly one step: finding the next Apple or Google or Netflix. And, each time you see them, they can’t wait to tell you that you should be doing the same. It can be hard to ignore folks like this.
Even within the relatively quiet world of index funds, distractions now exist. Recently, for example, Fidelity Investments made headlines when it announced a new line of index funds that are completely free. Is this a good thing? In theory, yes, but if you are already invested in another low-cost index fund, you’d be splitting hairs to worry about it. It’s as much of a distraction as your brother-in-law and his no-lose stock picks.
How do you sidestep these kinds of distractions? Before purchasing any investment, I would ask yourself these four questions:
“What am I trying to accomplish?” Are you saving toward a goal, such as retirement, or have you already saved as much as you need? It seems like an obvious question, but the answer will dictate how you allocate your funds among the major types of investments: stocks, bonds, real estate and cash. According to academic research, this is the most important investment decision you can make, so I would think hard about it, I would stress test it, and I would revisit it whenever there’s a change in your financial situation.
“Am I effectively diversified?” The key word here is effectively. Remember that investments that are similar in nature tend to move together. Apple and Google, for example, will move in tandem far more than Apple and Hershey or Harley-Davidson. So, when you build an investment portfolio, remember that it’s not just the number of investments you own; it’s the number of different types of investments that will make the biggest difference.
“Are my investments tax-efficient?” Remember that there is no such thing as a universally “good investment.” There are only investments that are good for you. If you are evaluating an investment, especially on the bond side, be sure that it aligns with your tax status.
“Do all of my investment actually make sense?” Wall Street loves building complex investment products, but in my view, complexity is your enemy. If someone is trying to sell you something — whether it’s a stock or bond or fund or an insurance policy or an annuity — ask lots of questions. Ask them to explain it to you in plain English. Ask them to explain why they think it’s right for you. Ask them what alternatives they considered and how they chose the particular product they are recommending. Ask them to spell out all the fees. And, finally, ask the salesman if he owns the same thing for himself.