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The 4 Habits Of Highly Effective Investors

(Click to enlarge)4 Habits of Highly Effective Investors

We have all been forced by circumstances to be investors. But how many of us know how to invest well?

Financial firms bombard us with investment strategies and services that offer can't miss, quick hit returns. While they certainly will deliver an adrenalin rush or two, more often than not, the investor ends with a caffeine headache, and a much smaller portfolio balance. In reality, effective investing doesn't require great intelligence or a degree from a prestigious university, nor well-heeled connections or insider knowledge. Successful long term investors tend to follow some version of these four simple investing habits with great success.

#1: Appropriate Asset Allocation

Effective investors understand the importance of establishing an appropriate asset allocation to ensure that over time they capture the maximum return for their level of risk. Modern Portfolio Theory provided the mathematical proof, illustrating the power of 'not putting all your eggs in one basket' by illustrating how a well-diversified portfolio can reduce risk and increase return compared a typical investor's portfolio which has too many eggs in one basket.

A landmark study published in 1986, conducted by acclaimed investors Gary Brinson, Randolph Hood, and Gilbert Beebower, found that asset allocation is the single most important factor in predicting a portfolio's performance.

Brinson and Hood-along with researcher Brian Singer-published a follow-up study in 1991 showing that asset allocation predicts more than 90% of a portfolio's long-term return. That study was validated a decade later by Yale finance professor Roger Ibbotson and Paul Kaplan in another study with the same conclusion.

How do great investors practice prudent asset allocation?

First, they focus on their investment goal. How much money do they need, how long is it until they need the money, what is their ability to and attitude towards absorbing losses, and more. Based on their answers, they decide how to split their investment portfolio across different broad classes of investments such as stocks, bonds, cash and cash equivalents. More experienced investors, or those with larger portfolios, typically include additional stock asset classes such as U.S. stock funds(representing large-cap, mid-cap and small-cap selections) and international stock funds. Their international holdings might be spread across developed and emerging markets stocks.

Similarly bond holdings are divided between treasury, corporate, municipal, international and federal agency bonds. They also allocate their holdings among short-term, mid-term, and long-term bonds.

Many investors include commodities, precious metals, or real estate investment trusts (REITs) as part of a broad asset allocation strategy to add further diversification.

The overarching goal is to insure that their mix of assets classes will perform, in combination, in a way that dampens volatility and maximizes returns to help the investor meet their investment goals.

#2: Disciplined Rebalancing

Managing asset allocation is an ongoing process that requires periodic maintenance. As the investor's needs change, or as they move closer to their goal, they tend to move towards a more conservative target asset allocation.

Over time, some assets classes (tech stocks) will grow faster than others. In addition, when the business cycle pendulum swings, some asset classes will grow faster than others, pulling the portfolio 'out of balance'. Effective investors periodically review their portfolio and rebalance back to their target by taking some of the gains from the asset that have benefited from the economic pendulum, while investing in other asset classes that will benefit as the pendulum swings back in their favor. Wouldn't it have been great if we had all followed this type of rule during the tech bubble of 2000 and periodically sold tech stocks on the way up and bought bonds? In many ways, this is an automated way to ensure that investors sell high and buy low.

For example: An investor who starts the year with a 50/50 mix of stocks and bonds, might end the year with a 60/40 mix because their stocks have risen, while their bonds have fallen. Investors might review this quarterly or as long as annually.

The investor's goal should be to maintain a consistent allocation-in this case, their 50/50 mix. To do this, they rebalance by selling the funds that rose in value, and using those proceeds to buy more of the funds that declined in value. This is a contrarian strategy that helps investors "lock in" gains and buy potentially undervalued funds.

Effective investors rebalance their portfolio at regular intervals. Many choose to rebalance quarterly, or at the very least once a year.

#3: Care in Selecting Assets

Not all stock funds and bond funds are created equal. Some carry hefty fees, which chip away at returns. Others take on excessive risk to achieve their returns, making them highly volatile. Thoughtful investors develop a selection point of view and focus on funds that fit their investing style. Some investors prefer mutual funds, while others invest in exchange traded funds (ETFs) or stocks. Another key element is investors' attitude to fund managers trying to beat the market with 'active funds' or a desire to invest in low cost passive funds.

Effective investors pay close attention to a fund's expense ratio which represents a guaranteed 'tax' on returns. Expense ratios are annual management fees that must be paid regardless of whether the fund is gaining or losing value. There is a strong argument to be made for focusing on low cost index funds as a low risk way to invest in most asset class, although the data are not definitive. Investors should also pay attention to whether or not the fund carries a purchase fee or redemption fee. Purchase fees and front-load funds reduce the initial investment, while redemption fees eat away at the gain.

At the end of the day, successful investors tend not to focus on any one measure (fees, return, risk etc) but rather balance these to ensure that the funds feed their needs and the asset class in which they are investing.

#4: Resisting Emotional Impulses

Research by Professor Terry Odean and others of typical investors' actual trading patterns indicates that typical investors are exquisitely good at buying high and selling low. As markets fall and the press trumpets the impending doom, investors looking at their dropping 401k balances feel squeamish and tend to sell when the drumbeat of doom and gloom is at its loudest, typically, close to the bottom. Similarly, they increasingly buy in as the good times drum-beat increases as the market rises. Effective investors resist the emotional impulse to sell when their portfolio is down, or to become exuberant when stocks are peaking. It is not that they are constitutionally stronger, but rather that they have a plan and use the rules described above to manage their emotions.

This Wall Street Journal article cites a great example of emotional investing:

"(In 2010), the 52-year-old director of alumni relations at a university in New Orleans moved about half of her 401(k) balance into a money market fund."

This investor held onto her stocks through the crash of 2008. But in 2010, she panicked and moved half her retirement portfolio into cash - missing out on the recovery.

An effective investor resists the lure of fear (during bear markets) and greed (during the good times). Effective investors chart a course and stick to it, regardless of the short-term ups and downs.

Effective investors also realize that in the big picture, one year, three years or even five years is "short-term."

Tell us…What are your most effective investment habits?

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.