The Complete Guide to Creating an Investment Plan

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Step 1: Determine the right stock-bond split.

Rebalancing from stocks into bonds reduces your returns on average since bonds have a lower average return. However, the goal of a bond allocation is not to boost returns but rather to support portfolio withdrawals and limit risk.

There is an optimum allocation between stocks and bonds for a given withdrawal rate, and the optimum allocation has nothing to do with an investor’s risk preferences. Finding that allocation requires running tens of thousands of scenarios that include historical and theoretical returns.

That being said, in general, you want to keep approximately 5-7 years worth of your necessary withdrawals in bonds. The farther you are from needing to withdraw from your portfolio, the more liberty you have to expose yourself to the volatility of stocks. The closer you are to withdrawals, the more you need to ground yourself in the stability of bonds.

An all-bond portfolio or all-stock portfolio can be projected and the difference between them measured, but the value of not running out of money when making withdrawals cannot be measured. For more information on this, read “Your Asset Allocation Should Be Priceless” or “Does Every Client Get Put Into One Of A Few Investment Allocations?

Your Asset Allocation Should Be Priceless
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The value of not running out of money when making withdrawals cannot be measured.

Step 2: Define your asset classes.

There is a complex formula by which you can compute the bonus produced by the discipline of regularly rebalancing your portfolio. This bonus is increased when the correlation between the two investments is low and the volatility of each of the assets is high. For more information on this, read “The Science of Rebalancing.”

The greatest rebalancing bonus comes from investment categories with a correlation below 0.85, but correlation varies significantly based on the time period measured. While most categories do not have correlations below 0.85, there are several that do. Too many, in fact, for all of them to be asset classes. This makes the selection of asset classes somewhat of an art.

By measuring the historical correlation, we can determine which low correlation asset class candidates move the most distinctly and make them separate asset classes.

For more information on this, read “Use Correlation to Define Asset Classes.”

The Asset Allocation Within Your Asset Allocation
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It is good to take the two categories which are most similar and use them as underlying sector divisions within the same larger asset class.

Step 3: Define your sectors.

Sectors are divisions within your larger asset classes which act as reminders of your strategy. They can be used to remind you of low correlations within your asset classes as well as other strategic decisions.

The first step to defining your sectors is to draft your sector partitions. A strategy of investing more in the categories with historically higher returns and less in those with less desirable returns is one of the best strategies for sector selection. Superior expected performance should be evaluated in relation to greater than normal volatility. And of course, correlation of various sectors should be taken into account.

After you have developed your sector partitions, you are ready to determine a system you can use to categorize all future holdings. There are four questions to ask in this process:

  1. Are there indexes which obviously represent this sector?
  2. Do there exist any indexes which, when combined together, can represent the sector?
  3. Is there an easily discernible method of identifying securities that fit this categorization?
  4. Do you need an “undesirable sector” definition?

This process of defining your sectors is an attempt to identify the quintessential features of your strategy and formalize your selection criteria. For more information on this, read “Defining Your Sectors” or “The Asset Allocation Within Your Asset Allocation.”

Defining Your Sectors
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The process of defining your sectors is an attempt to identify the quintessential features of your strategy and formalize your selection criteria.

Step 4: Select securities.

The next step is to select specific securities you will purchase to implement this strategy. We call this list of securities our “Buy List,” because it is what we would ideally purchase if a client came to us all in cash. We regularly review our Buy List as we are always looking for even better securities to implement our investment strategy. We use three criteria to judge securities.

  1. The investment should be diversified within its sector.
  2. The expense ratio should be low.
  3. Ideally, it should have low trading costs.

Although it is not easily appraised, we believe a curated list of funds is extremely valuable. Our investment committee meets regularly to reevaluate and adjust our Buy List. Even if all you use to select funds is expense ratio, this might boost returns by as much as 0.42%. We can only imagine the value of fund selection also based on strategic fit, diversification, index followed, and trading costs.

For more information on this, read “How to Select Securities.”

How to Select Securities
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Your investment strategy is critically important but the implementation requires wise fund selection.

Step 5: Rebalance periodically.

Rebalancing is the most helpful when it is most difficult. Rebalancing involves selling the investments that have appreciated and buying the assets that have recently gone down. We are biased to believe that recent occurrences will continue. When it comes to the markets, this instinct must be overcome.

This is one area where either an investment advisor or automation can add value. Yes, you could do this yourself, but many investors don’t. A few investors buy and hold investments while an even greater number chase returns, moving in the exact wrong direction. Even an advisor who only keeps you from chasing past performance might significantly boost your returns.

For more information on this, read “The Art of the Rebalancing Bonus.”

The Art of the Rebalancing Bonus
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Portfolio design and rebalancing is both a science and an art. Knowing that rebalancing boosts returns is useless unless you as the investor follow through.

Step 6: Don’t give up.

Even the most brilliantly crafted investment plan has to be given time to work. The markets are inherently volatile but also inherently profitable. And when you start investing in the markets you are very likely to see many highs and lows as the market gyrates before you see permanent gains.

If you are building a portfolio to last you to age 100, you have a long time horizon for the investment to rebound. After setting aside 5-7 years of safe spending in bonds, the remainder of your portfolio has 8-year or longer time horizon.

We know from behavioral finance that many people give up on a brilliant investment plan too soon. We don’t want to be the foolish investor who sells at the bottom only to reinvest at the top of the next bubble.

As a result, to help you discriminate between a brilliant investing strategy and a mistake, ask: Do you have sufficient data to justify the long term mean returns you want? If you have used the steps above, chances are you can easily answer that question with the affirmative.

For more information on this, read “How Long Should I Give An Investment Plan?

How Long Should I Give An Investment Plan?
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Even the most brilliantly crafted investment plan has to be given time to work.

The following photographers photos are used here under Flickr Creative Commons: Silvia Sala, bangdoll, Bianca Moraes, Floriane Legendre, Ericllee_wu, and r. nial bradshaw as the featured image of related articles.

Follow Megan Russell:

Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.

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