Simple money management starts with understanding what you want from your money. What do you want? That is my favorite question to ask investors when discussing portfolio management, or position management. Define the goal first and foremost! Then manage the money to accomplish the goal. Making money is the implementation of money management in order to achieve the objective.
Make a strategy. For example, if you have a 401k plan or an IRA account, and you are accumulating money towards our retirement, how much do you need to earn per year to accomplish the end goal? For arguments’ sake, let’s say 10% per year for the next 10 years. This is a simple calculation you can perform in an excel spreadsheet or on a HP12C financial calculator. The important part of this calculation is often overlooked by investors, advisers and others. You made a compounding calculation of 10% per year for 10 years. If you are up 20% one year and down 10% the next year what happens to the compounding? If you started with $200,000 and earn 20% or $40,000, you then have $240,000 which loses 10% or $24,000 to net $216,000 at the end of year two. You are behind the pace needed to achieve the goal. Your simple goal is now getting complex. Why? Because now in order to accomplish your goal you will need to earn 11.54% for the next 8 years. Therefore, consistent returns are the key to achieving this goal.
Stop and think for a moment about the last 10 plus years in the markets. What has the average annual return been for the S&P 500 index? The answer is negative. What would that have done to achieve your goal? Take the last couple of years and factor the impact to your money. In 2008 the index was down 38.5%, in 2009 it was up 23.45%, and in 2010 YTD it is down 2.1%. Apply that to the $200,000! Your current balance would be $148,645 vs the $258,214 you should have in the account. Get the picture yet? Volatility creates complexity to your portfolio and most of the complexity comes from emotions, along with taking too much risk as you play catch up. Simplify the process of managing your money and you will find it easier to accomplish the goal with less stress.
Implement the investment plan. Going back to the original goal of earning 10% per year over 10 years. How do we manage this process along with market risk? First, if we break the goal down to a dollar figure, we need to earn $20,000 in the first year. If we break it down to a quarterly number it is $5,000 per quarter. Second, we need to evaluate the current market risk of putting our money to work. Assuming the market has the same risk regardless of when we start is a bad assumption. Looking at the market, the first question would be, what is the current trend? From there we can break the market into 12-15 sectors and define the trend of each. Fixed income (bonds), commodities, international and international bonds are the same exercise. Once we define the trend for each we can start assigning risk parameters to each. This is where the strategy for investing your money starts to take shape. Do you want to use technical analysis, fundamental analysis, or a combination of the two?
Let’s put our previous example into practice. The goal is to earn 10% per year for 10 years and limit the volatility or downside risk of the portfolio. We want the returns to be as consistent as possible. If the current trend of the market is up, we go with the flow and manage the downside risk of each position while managing the overall portfolio. If the trend shifts to a downtrend, we become defensive with the primary objective - principle preservation. We may shift a larger percentage of assets to fixed income during this period (assuming interest rates are declining or stable, versus rising.) The key is to manage the risk of the market in light of the goal. Too often investors focus on maximizing returns, versus managing the risk of the investment/market in light of the goal. Investing is all about the goal, not beating the market. If you beat the market, odds are you took more risk, and if you fail to manage the risk, you lose money. This takes us back to taking more risk trying to play catch up.
Keep it simple by managing your expectations in view of the market and relative to the goal. Simple money management begins with the end in mind, the goal. Setting a goal for your portfolio is first, building and defining your strategy for money management is next, and implementing the investment plan puts it all into motion. In the beginning it is hard work (remember I said money management isn’t easy), but once the plan is built, and the strategy defined, the process of implementation (money mangement) becomes simple discipline.