Investing Order of Operations

Investing has an order of operations. Occasionally I’ll get an acquaintance or a new potential prospect ask me point-blank what they should invest their money in. Perhaps they show me a statement and ask, “What changes would you make to this? What funds should I invest in?”

They want a definitive answer. Precisely which companies, bonds, or mutual funds should they invest in?

They are asking about “investment selection,” the process of choosing specific investments. I understand where the question comes from, but the question is out of order. We need to lay a foundation before we can answer anything other than, “It depends.”

It depends on what we establish in the planning process. And we need to arrive there using the correct order of operations. We will lay the foundation this week and discuss investment selection next week.

Before we can invest in anything, we need to know why. Thus we need a goal.

Order of Operations 1: The Goal

We must clearly establish what we are trying to accomplish. Are we trying to fund kids’ college? Are we trying to retire with independence and dignity? Are we trying to outperform our friend in the YMCA locker room over the next month? What’s the goal? Money is not the goal, nor is investing for investing’s sake. Money and investing funds the goal. If we don’t know why we are investing, we can’t answer how we should invest. After we have the goal clearly in mind, we must create a plan.

Order of Operations 2: The Plan

A goal without a plan is just a wish. We need a plan to achieve the goal. Investing (and the specific investments we choose) will be a component of that plan. But far too many people have a portfolio with no plan. A portfolio is not a plan. We would do well to remember that, always. When the goal is established, and a plan is formulated, we fund the plan with a portfolio.

Order of Operations 3: The Portfolio

A portfolio is a collection of investments that will give us the best chance of achieving our goal. Investing is uncertain, and past performance does not guarantee future returns. However, there are principles and disciplines we can use that have historically granted success and that we believe will grant similar success in the future. Before we can select specific investments in constructing our portfolio, we must first determine our:

Order of Operations 4: Asset Allocation

Asset Allocation is the amount of money we allocate to specific asset classes. Most notably, it is our allocation toward buying ownership shares of the best businesses in the world (equity or stock investing) versus lending to those companies and governments (buying bonds, bills, and CDs).

Asset allocation absolutely cannot be done without a goal and a plan. What is the money going to be used for (the goal)? If we need the money in six months for a downpayment on a home, we aren’t going to invest in Chinese startup companies. However, if we are trying to create a retirement income that outpaces inflation, outlives us, and outperforms others, having a significant portion in assets that barely grow faster than the cost of living isn’t going to work.

If we are investing for the long term, for the day we retire plus the two or three decades we are likely to live beyond that, we must have a high portion invested in the best businesses in the world. The percentage of your money invested in equities is the largest technical determinant of your long-term investment growth. What that portion is depends on your plan. It also depends heavily on this overarching caveat:

Behavior

Your financial behavior is the number one factor in whether you achieve your financial goals and succeed in investing. It’s not talked about enough. But no investment selection is going to make up for poor financial behavior. Owning the best-performing fund doesn’t matter if you got in at the top and panicked out at a low.

I called asset allocation the largest technical determinant. Behavior is the largest overall factor in your success. Behavior is more challenging to measure than historical investment performance. But it is undoubtedly more important. And the greater your percentage in the superior long-term asset of equities, the more your behavior matters.

Assuming your behavior is perfect (likely through the guidance of an empathetic and tough-loving behavioral investment advisor) and your asset allocation is chosen, we’ll then want to examine our diversification within those asset classes.

Order of Operations 5: Diversification

If you determined you want 80% of your money in equities, you wouldn’t have a perfect portfolio if you put all 80% in Apple stock. We all know we need to spread it out more than that. You could own many styles of companies and buy many lengths of company and government debts. Each has its historical performance and volatility. How do we want to diversify? Before choosing a specific investment, we need to know the categories we should be in. Then we’ll want to sort by expenses.

Order of Operations 6: Fees

Fees are a drag on performance. If a collection of companies averages 10%, and you have a 1% fee on the fund, you will get 9%. There’s a big difference between 9 and 10% over your lifetime. Now, fees aren’t the only thing that matters. Which of the following is better?

• Investment Strategy A charges a 1.0% fee and grosses an 11% average return.
• Investment Strategy B charges a 0.1% fee and grosses a 9% average fee.

Clearly, option A is better (10% net is better than 8.9%). Fees alone don’t determine if a fund is worth selecting. But all else being equal (which they rarely are), choose lower fees.

Pay attention to who you’re paying those fees. Look at your all-in fees. Are your fees going toward superior performance or a financial planner helping you with all aspects of technical finance and the behavioral side? Or are those fees going to middlemen (broker-dealers), insurance companies, or Wall Street big-wigs providing no direct value to you?

First, you need a goal, a plan to get there, and a portfolio to fund the plan. When constructing the portfolio, you first look at asset allocation (dictated by the plan and your behavior), then diversification and fees. When all that has been evaluated, and only after it has all been decided, do you look at investment selection.

Order of Operations 7: Investment Selection

Time to select your investments. How do we do this? That’s the subject of next week’s episode. We’ll see you then. Cheers.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.