Investing can be complicated at times, especially if you are managing your portfolio on your own. But the keys to building a solid, long-term investment strategy are relatively straightforward, and can provide you with a framework for decision-making that can help you avoid the common pitfalls and stay focused on achieving your goals.
Here are 6 important steps to building a well-thought-out investment strategy that is flexible, suited to your unique situation, and built to withstand the most difficult market conditions.
1. Start with a firm understanding of your goals and needs
Before you can invest effectively, you need to have a solid understanding of why you are investing. Take some time to explore and evaluate what your objectives are. Be clear about what motivates you. Clearly articulate both your long-term investment goals and your short-term financial needs. Get specific about timing: For each of your goals, when do you expect to need this money? All investing involves risk—be honest with yourself about how much risk you feel you can tolerate given your current financial situation.
With this information at hand, you can begin to devise an appropriate asset allocation and a tax-sensitive investment strategy that can help you invest in the asset classes and accounts that best fit your goals.
2. Build and maintain a well-diversified portfolio
How your assets are allocated across different asset classes provides a solid foundation upon which your portfolio may be able to grow over time. It can be a major factor in long-term performance: In fact, up to 90% of the variability of a fund's return over time can be explained by how its assets are allocated.1
Over the long term, holding a diversified portfolio has historically been shown to reduce risk. Developing a portfolio allocation with a thoughtful balance of asset classes may provide you with both the return potential necessary to make progress toward your long-term goal and the stability to help you navigate choppy markets without feeling compelled to abandon your plan.
Regular rebalancing is necessary to ensure that your allocation stays close to its target, as over time the distribution of value among the various asset classes may drift due to changes in the market. "Investors who don't rebalance their portfolios may experience more volatility than they anticipated after a period of rising stocks," says Naveen Malwal, institutional portfolio manager for Strategic Advisers, LLC. "Whereas investors who don't rebalance after a period of stock market volatility may miss out on some or most of an eventual recovery. Rebalancing may help clients feel more confident in their plan over the years." Additionally, it's important to stay vigilant to ensure that you are not overallocated in any single security, as that can present a significant risk to the health of your portfolio.
3. Take advantage of tax-smart investing techniques
The amount you pay in taxes can make a significant difference in your long-term investment returns. A study of pre- and after-tax investment returns from 1926 to 2022 showed that investors who didn't account for taxes when making investment decisions saw their annual returns reduced by 2% on average.2
Tax-smart investing techniques such as asset location, selecting tax-efficient securities, and tax-loss harvesting may have a substantial impact on your portfolio's long-term growth. But beyond these important considerations, it's important to also keep an eye out for any unexpected tax exposure. For example: In some circumstances, an investor may be required to pay capital gains taxes on a mutual fund investment that they may not have even sold and that perhaps even declined in value. There are several options for investors interested in ways to help mitigate this risk, such as swapping out existing, tax-inefficient mutual funds for tax-managed equivalents or replacing them with a separately managed account (SMA).
"Investors can't control what markets will do, but they can take steps to invest more tax-efficiently," says Malwal. "This may help investors keep more of their gains after taxes."
4. Stick to your plan and stay invested
In tough markets, it's easy to fall prey to your fears and end up making an emotional decision about your money. It's not uncommon for investors to move their money to cash or switch to a more conservative asset allocation. However, these moves may be counterproductive. Historically, many investors who moved out of stocks during down markets didn't fare as well as those who stayed the course, as they often missed out on subsequent rallies.
"Periods of market volatility may be some of the most challenging for investors," says Malwal. "Yet if you look back at 2020, or 2008, or other big market corrections, stocks eventually recovered and went on to make new all-time highs. Investors who stayed invested through the downturn were more likely to fully participate in the recoveries than those who shied away from stocks after the decline."3
Sticking to your plan and staying invested can be advantageous even when things seem dire. For instance, missing just the 5 best days in the market between 1980 and 2022 could have reduced portfolio returns by as much as 38%.4 This can be easier said than done, however. Thankfully, there are some steps you can take to help yourself weather the emotional and financial stress that comes with challenging market conditions. You can:
- Learn about common investing biases and how to combat them so you don't overreact in periods of volatility.
- Explore defensive investing, which may help protect your portfolio from steep market declines (at the expense of some potential returns). A defensive portfolio may seek to include more conservative stock investments, high-quality bonds, and alternative investments that are less correlated to the performance of traditional asset classes.
- Consider developing a steady stream of reliable income that isn't dependent on market-based sources (e.g., bonds, dividends, or fixed income annuities), so you aren't stressed about covering your necessary expenses and can better weather near-term volatility.
5. Involve your family when planning and making decisions
If you and your partner have multiple accounts across multiple firms, it can be difficult to develop and maintain a shared vision for your financial future. Working together to create a holistic, all-inclusive plan could be beneficial and may help you identify opportunities to potentially reduce your overall tax burden and help to enhance your long-term investment returns. It may also help you stick to your plan when things get challenging.
If you have young children, it may be wise to get them involved as well—to a degree that is appropriate for their age. That way, they can begin to build the skills necessary to manage their own finances, or act as responsible stewards of the family's money, when the time comes.
6. Consider partnering with a trusted financial professional
If you enjoy managing your own finances and feel confident in your investment knowledge and capabilities, you may be happy to play the role of investment manager for your portfolio. There are, however, other options that can relieve you of some (or most) of these responsibilities, should you prefer it, including full professional management or a more balanced division of responsibilities, such as through a separately managed account (SMA).
While professional management often comes with a cost, industry studies estimate that professional financial advice can add up to 5.1% to portfolio returns over the long term, depending on the time period and how returns are calculated.5 Good financial professionals will work with you to create a personalized investment plan and identify opportunities to help grow and protect your assets. They may also act as a sounding board during times of uncertainty, helping you maintain focus and composure when markets are volatile.
Keep it simple
A good plan is one you understand inside and out and can stick to, even when times are tough. By following these 6 steps, you may be able to develop an investment strategy that will serve you and your family well into the future.