If you are like most individual investors, your portfolio is built and designed around a method of pure luck and good intentions. Some investors do not take the time to consider the overall, big goal and as a result the portfolio is constructed to meet the needs or desires of the moment.
The primary issue, and absolute must, in building or designing a portfolio is to determine what you are trying to accomplish. Is the overall goal to fund your children's college account, buy a car in 4 years, or the ultimate goal of retiring? The simplistic approach of investing to 'make it grow' or to 'succeed in the market' is much too vague and leaves far too much opportunity for emotionally driven mistakes. Having a defined objective and time horizon in mind can help to eliminate some of the emotion in investing.
The individual investor must understand their own risk tolerance and put that into perspective with how they have constructed the portfolio. In other words, how much value fluctuation can you bare and still put your head down each night to sleep? Understanding the types of risks associated with an investment, be it stocks, bonds, mutual funds and even cash (yes there are risks associated with cash equivalent investments) is critical in establishing a sound portfolio.
A great number of investors have discovered, the hard way, the reality of risk and their portfolio over the course of the past few years. The major market indices, DOW, S&P500 and NASDAQ all have shown significant movement and none of it in the desired direction for investors wanting to watch assets grow.
The dartboard approach to investing seems to be the method the majority of the investing public followed during the `90s. The internet/technology bubble continued to expand and positive returns seemed to be everywhere. It did not matter where you threw the dart; you were able to make the portfolio grow. As easily seen in the chart below, comparing the DOW, S&P 500, and NASDAQ index movements over the past 5 years, the tech bubble of the `90s made the NASDAQ index behave in a manner different from the norm. The likelihood that an investor jumped on the bubble at the wrong point is high, thus realizing a larger amount of volatility than expected. Buying high and riding it out or selling low was the end result. Many of the portfolios had a high degree of risk associated with them. The term we use is Standard Deviation: simply how much movement, or price volatility, occurs around the average rate of return for an asset or portfolio. This risk evaluator was not strongly considered by many since the returns were strong and continued to be readily available risk was what someone else experienced.
The majority of the tech portfolios had standard deviation values well into the double-digits. Those same portfolios today are worth considerably less than their value from the `90s due to the risk associated with the holdings. We have all seen and heard the stories from other investors about how much they have lost in the market over the past couple years. This process is not surprising to me since most investors do not look at the big picture but rather follow the trends of the general market.
The emotional side of investing is our biggest enemy. We can study, analyze, track and chart markets and assets all we want, but we are wasting our time if we do not use sound logic and reasoning in which ones to buy, sell and avoid all together. Chasing returns has never been a good answer and only a very lucky few have ever been able to pursue this philosophy and win. Luck is the primary determinant here, not choice or skill. The market is based upon logic and statistics but it is driven in large part by investor emotion. This emotional process supports the market theory known as Random Walk Hypothesis, which basically states that the movement of the market is no more predictable than the next step of a drunken man.
Sound portfolio management is an on going, continual process of making well thought out decisions based on the desires of the investor. If you have a specific goal in mind when beginning your investing and create the proper mix of assets the likelihood of achieving your goals are much improved over simply picking a few stocks or mutual funds at random because they have increased in value over the past year. The old adage that if it sounds too good to be true----it is, holds true to all things in life, especially money management. It is not reasonable to expect and plan on excessive growth on a long-term basis just because we were in an environment where that WAS the case. It is as equally unrealistic to expect the long-term prognosis for the current market environment to be negative. Use realistic expectations when building the portfolio and understand that at times it will move in the opposite direction than is desired. If the portfolio was well thought out and researched from the start, it will likely come back and continue to grow, allowing us to achieve our goals.