Nov. 16, 2011 -- Maintaining a successful investment portfolio is a vexing endeavor that can befuddle even the most seasoned professional. It involves mind-numbing complexity, and each decision can be second-guessed amid a never-ending stream of regrets.
Yet there are some guidelines you can use—with or without an advisor—to keep your portfolio on a steady, profitable course. Here are some pointers:
Develop a mental process for sell decisions. Selling can be a tougher decision than buying because once you own a stock you're invested emotionally as well as financially.
The key to making selling decisions is to have a consistent sell discipline — a set of principles to guide you in deciding when to sell. A sound sell discipline can protect against big hits, enable large gains and minimize costly turnover. And if followed faithfully, it can reduce or eliminate second-guessing.
The two emotional bugaboos of investing—fear and greed—can make it difficult to stick to your sell discipline. So it's critical to insulate these decisions from excessive emotion.
Cut your losses — precisely. The most important item for your sell discipline's toolbox is a stop-loss: the price you will sell at rather than suffering further losses. You should establish a stop-loss for each investment you own right after buying.
Stop-loss orders are instructions you leave with your broker or set up in your online brokerage account to sell if an investment falls below either by a pre-set percentage or a dollar amount. The order or setting depends on the type of investment. For example, you should establish a lower percentage figure for fixed-income (bond-related) investments than for emerging-market stocks; a 10-percent loss in fixed-income is much more severe.
Lock in gains. By gradually raising your stop-loss levels as your investments rise in value, you can lock in gains. In a casino, this is like putting cash in your pocket as you go along while playing with house money.
When you're ahead, take another look. When should you sell winners? If you buy a stock hoping for a 10 percent return over one year, and it ratchets up 20 percent in one month, should you sell?
If the company's sales are rising, perhaps it's worth more than its current price. Consider key aspects of the stock, much as you should have done before buying it.
Don't buy on the way down. Avoid the temptation to double down on your declining stocks by buying more shares as the price drops. People who do this are clinging to the idea that they were necessarily right to buy the stock in the first place. They think they're smarter than the market, but the market may know something they don't.
Stick to your plan. One of the most difficult things about maintaining a portfolio is that, even if you don't touch it, it's always evolving. A change in the value of one type of investment (called an asset class) tends to affect the dollar-value proportion of other asset classes.
Suppose that when assembling the stock portion of your overall portfolio, you put 50 percent of your stock budget in small-company stocks and 50 percent into large companies. This was your original asset allocation for stocks—your original balance. You set it up this way because you saw too much risk in having more than 50 percent of your stock money in either large- or small-company stocks.
Yet over time, the value of your small-company stocks has increased to where they now account for 70 percent of the dollar value of your stock portfolio and large companies, 30 percent. Your stock portfolio is now way out of balance.
What do you do? It's a good idea to periodically rebalance portfolios, by selling and buying, to restore them to their original asset allocations. Assuming you set up your portfolio correctly, this can help you stay within your risk tolerance.
Some might view rebalancing as selling winners to buy losers. But you can also view it as selling the most overpriced investments to buy undervalued ones. Using this logic, you might have sold tech stocks before they plummeted in 2000. Many investors rebalance quarterly. I recommend rebalancing annually. This way, you can allow your winners to run, but not to run amok.
Instead of rebalancing at regular time intervals, some do so when the proportion of asset classes in the portfolio has changed significantly. For example, you could rebalance after an asset class is 10 percent out of kilter.
Be aware that risk levels change. There is a standard set of asset allocations that many investors use. Conventional wisdom holds investors only need to subtract their age from 100—or, now that people are living longer, from 110—to get the percentage of their portfolios that they should have in stocks, given an average risk tolerance.
This method has been recommended for decades. The problem is that the risk levels of different asset classes change substantially over time—sometimes in only a few years. Let's say you're 50 years old. Having an average risk tolerance, you do the subtraction and determine that you should have 60 percent of your portfolio in stocks.
But after doing some research, you might find that you're taking too much risk because risk levels of stocks may now be far higher than the traditional allocation assumes. In that case, you would want to trim down your stocks and add more bonds, which carry lower risk.
If portfolio maintenance sounds horrendously complex, that's because it is. But by having a sound plan and following it with discipline, you can reduce your would-haves, could-haves and should-haves.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group (http://capstoneinvest.net). He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at email@example.com.