Having A Plan: The Basis Of Success

Courtesy : Investopedia

"To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework." Warren E. Buffett 

Any veteran market player will tell you that it's vital to have a plan of attack. Formulating the plan is not particularly difficult, but sticking to it, especially when all other indicators seem to be against you, can be. This article will show why a plan is crucial, including what can happen without one, what to consider when formulating one as well as the investment vehicle options that best suit you and your needs.

The Benefits
As the "Sage of Omaha" says, if you can grit your teeth and stay the course regardless of popular opinion, prevailing trends or analysts' forecasts, and focus on the long-term goals and objectives of your investment plan, you will create the best circumstances for realizing solid growth for your investments.

Maintain Focus
By their very nature, financial markets are volatile. Throughout the last century, they have seen many ups and downs, caused by inflation, interest rates, new technologies, recessions and business cycles. In the late 1990s, a great bull market pushed the Dow Jones Industrial Average (DJIA) up 300% from the start of the decade. This was a period of low interest rates and inflation, and increased usage of computers, all of which fueled economic growth. The period between 2000 and 2002, on the other hand, saw the DJIA drop 38%. It began with the bursting of the internet bubble, which saw a massive sell-off in tech stocks and kept indexes depressed until mid-2001, during which there was a flurry of corporate accounting scandals as well as the September 11th attacks, all which contributed to weak market sentiment.
In such a fragile and shaky environment, it's crucial to keep your emotions in check and stick to your investment plan. By doing so, you maintain a long-term focus and can assume a more objective view of current price fluctuations. If investors had let their emotions be their guide near the end of 2002 and sold off all their positions, they'd have missed a 44% rise in the Dow from late-2002 to mid-2005.

Sidestepping the Three Deadly Sins
 
The three deadly sins in investing play off three major emotions: fear, hope and greed. Fear has to do with selling too low - when prices plunge, you get alarmed and sell without re-evaluating your position. In such times, it is better to review whether your original reasons (i.e. sound company fundamentals) for investing in the security have changed. The market is fickle and, based on a piece of news or a short-term focus, it can irrationally oversell a stock so its price falls well below its intrinsic value. Selling when the price is low, which causes it to be undervalued, is a bad choice in the long run because the price may recover.

The second emotion is hope, which, if it is your only motivator, can spur you to buy stocks based on their past performance. Buying on the hope that what has happened in the past will happen in the future is precisely what occurred with internet plays in the late '90s - people bought nearly any tech stock, regardless of its fundamentals. It is important that you look less at the past return and more into the company's fundamentals to evaluate the investment's worth. Basing your investment decisions purely on hope may leave you with an overvalued stock, with which there is a higher chance of loss than gain. 

The third emotion is greed. If you are under its influence, you may hold onto a position for too long, hoping for a few extra points. By holding out for that extra point or two, you could end up turning a large gain into a loss. During the internet boom, investors who were already achieving double-digit gains held on to their positions hoping the price would inch up a few more points instead of scaling back the investment. Then, when prices began to tank, many investors didn't budge and held out in the hope that their stocks would rally. Instead, their once-large gains turned into significant losses. 

An investment plan that includes both buying and selling criteria helps to manage the three deadly sins of investing. 

The Key Components 

Determine Your Objectives
 
The first step in formulating a plan is to figure out what your investment objective is. Without a goal in mind, it is hard to create an investment strategy that will get you somewhere. Investment objectives often fall into three main categories: safety, income and growth. Safety objectives focus on maintaining the current value of a portfolio. This type of strategy would best fit an investor who cannot tolerate any loss of principal and should avoid the risks inherent in stocks and some of the less secure fixed-income investments. If the goal is to provide a steady income stream, then your objective would fall into the income category. This is often for investors who are living in retirement and relying on a stream of income. These investors have less need for capital appreciation and tend to be risk averse.
Growth objectives focus on increasing the portfolio's value over a long-term time horizon. This type of investment strategy is for relatively young investors who are focused on capital appreciation. It's important to take into account your age, your investment time frame and how far you are from your investment goal. Objectives should be realistic, taking into account your tolerance for risk. 

Risk Tolerance
 
Most people want to grow their portfolios to increase wealth, but there remains one major consideration - risk. How much, or how little, of it can you take? If you are unable to stomach the constant volatility of the market, your objective is likely to be safety or income focused. However, if you are willing to take on volatile stocks then a growth objective may suit you. Taking on more risk means you are increasing your chances of realizing a loss on investments, as well as creating the opportunity of greater profits. However, it is important to remember that volatile investments don't always make investors money. The risk component of a plan is very important and requires you to be completely honest with yourself about how much potential loss you are willing to take. 

Asset Allocation
 
Once you know your objectives and risk tolerance, you can start to determine the allocation of the assets in your portfolio. Asset allocation is the dividing up of different types of assets in a portfolio to match the investor's goals and risk tolerance. An example of an asset allocation for a growth-oriented investor could be 20% in bonds, 70% in stocks and 10% in cash equivalents.
It is important that your asset allocation is an extension of your objectives and risk tolerance. Safety objectives should comprise the safest fixed-income assets available like money market securities, government bonds and high-quality corporate securities with the highest debt ratings. Income portfolios should focus on safe fixed-income securities, including bonds with lower ratings, which provide higher yields, preferred shares and high-quality dividend-paying stocks. Growth portfolios should have a large focus on common stock, mutual funds or exchange-traded funds (ETFs). It is important to continually review your objectives and risk tolerance and to adjust your portfolio accordingly.
The importance of asset allocation in formulating a plan is that it provides you with guidelines for diversifying your portfolio, allowing you to work toward your objectives with a level of risk that is comfortable for you.

The Choices.
 
Once you formulate a strategy, you need to decide what types of investments to buy as well as what proportion of each to include in your portfolio. For example if you are growth oriented, you might pick stocks, mutual funds or ETFs that have the potential to outperform the market. If your goal is wealth protection or income generation, you might buy government bonds or invest in bond funds that are professionally managed.If you want to choose your own stocks it is vital to institute trading rules for both entering and exiting positions. These rules will depend on your plan objectives and investment strategy. 

You may also consider professionally managed products like mutual funds, which give you access to the expertise of professional money managers. If your aim is to increase the value of a portfolio through mutual funds, look for growth funds that focus on capital appreciation. If you're income-orientated, you'll want to choose funds with dividend-paying stocks or bond funds that provide regular income. Again, it is important to ensure that the allocation and risk structure of the fund is aligned with your desired asset mix and risk tolerance. Other investment choices are index funds and ETFs. The growing popularity of these two passively managed products is largely due to their low fees and tax efficiencies; both have significantly lower management expenses than actively managed funds. These low-cost, well-diversified investments are baskets of stocks that represent an index, a sector or country, and are an excellent way to implement your asset allocation plan.

Summary
 
An investment plan is one of the most vital parts for reaching your goals - it acts as a guide and offers a degree of protection. Whether you want to be a player in the market or build a nest egg, it's crucial to build a plan and adhere to it. By sticking to those defined rules, you'll be more likely to avoid emotional decisions that can derail your portfolio, and keep a calm, cool and objective view even in the most trying of times.