How to Develop Your Investment Plan

Investing is one of the most powerful elements within the financial planning process. Investing is so important that any financial plan which omits it is doomed to fail. While you can pay a financial advisory firm a bunch of money to invest your hard earned money. I think you should learn how to develop your own investment plan. This way you can take full control of your financial future and avoid a bunch unnecessary fees.

When first starting out, many of us make the mistake of thinking that it takes tons of effort to become a successful investor. I used to spend hours researching companies and trying to craft the perfect portfolio. After a few years of traveling down that road I learned the truth; successful investors only need two things: an investment plan and consistency.

Starting Your Investment Plan

When making your plan, you will first need to understand where you are going. In a financial plan, investment decisions usually stem from the need to save for retirement. However, many couples also invest for their child's future education expenses. Your investment plan can be used to help you achieve any financial goal you have, however for simplicity we are going to use retirement as an example.

The first step when developing your investment plan is to answer the following questions. These are intended to help determine your financial goals and capital needs.

  1. When do you plan to retire (age and year)?
  2. How many years do you have to invest before you need to start making withdraws?
  3. How long do you think you will live after retirement (plan to live until 100)?
  4. How much money will you need a year in order to live well in retirement?

Once you have an idea about how your retirement (or other capital needs) will look, its time to figure out how much you will need to save and invest in order to achieve your financial goal.

Calculating Your Required Savings Rate

The calculation used to determine how much cash you will need to set aside every month is dependent on how much time you have until you need the capital and your anticipated annual return on investment (ROI). To determine your required annual savings rate, I recommend using the Excel spreadsheet function "payment" or PMT. It's simple, just follow these steps:

  1. Open any spreadsheet and enter "=PMT" into any cell.
  2. Enter your estimated annual return on investment (i.e. assume 8% or 0.08).
  3. Input the number of years you have until you need the savings.
  4. Enter a comma, this will bypass the present value parameter.
  5. Input your investment goal future amount (i.e. $1,000,000).
  6. Finally, input a zero for the last parameter.

Your final formula should look like this: "=PMT(0.08,30,,1000000,0)" which equals -$8,827.43. So in this example, we would need to save and invest $8,827.43 a year and receive 8% ROI annually in order to have $1 million in 30 years. Performing these calculations always highlights the power of compounding and starting early.

Crafting Your Investment Strategy

So you've completed the hard part; goals have been established and budget adjusted. Now it's time to put that hard earned money to work. The next step when developing your investment plan is to determine what investments strategies you will need to employ to accomplish your goal.

While portfolio creation doesn't need to be complex; it can get tricky if you let it. The development of a portfolio is beyond the scope of this post, however let the following core investment tenants guide your investment decision making:

  • Build a diversified portfolio (easily accomplished with Exchange Traded Funds)
  • Leverage tax advantaged accounts.
  • Use direct deposit to make saving automatic.
  • Remember why you are investing and your long term goals.
  • Ensure your portfolio's risk profile aligns with your needs.
  • Monitor your investments and adjust as necessary.

Finally, your investment plan is a living document, meaning it should be updated as circumstances change. If you develop and follow your investment plan, there is no doubt in my mind that you'll be better off for it.



The Tale of Two Stock Trades

Sometimes you win, sometimes you lose. The most important part of stock trading is that you remember that your losers should be smaller than your winners. If you can learn to manage your trades like this, your win to loss ratio can be less than 1:1 (meaning you can have more losers than winners overall). Over the years I’ve learned a few different ways to manage trades in this manner.

Below you’ll find a breakdown of a pair of recent trades that illustrate my point. Within the past week or so, I opened two positions. Both Palo Alto Networks (PANW) and Starbucks (SBUX) had solid fundamentals and technicals at the time. Unless I am looking for an oversold contrarian trade (such as oil right now), I mainly have my eye on growth stocks. Both of the companies passed my fundamental tests, thus my next step is to look at the charts to determine a good entry point.

At the time PANW had pulled back roughly 15% from its all time high in July. I like stocks that are off their highs since this increases the probability of the price action going my way. Additionally the stock had formed a bullish pennant which gave me the “green light” to put some capital to work.

Over the next few days, PANW shot straight up (well, pretty much). So in order to ensure that this winning trade didn’t turn into a loser, I placed a stop order at the top of the gap to lock in my gains. At the time of this writing, the trade is up 18%. Keep in mind that most trades do not go in your favor this far and fast. An earnings release and reported projected growth rates had a lot to do with the price action shortly after I initiated the position. This one is still open.

The next trade didn’t go so well, it actually was a quick loser. I bought SBUX for most of the same reasons I bought PANW. The only difference being Starbucks growth potential isn’t as rapid as Palo Alto Networks. SBUX was off its highs and was consolidating in a ascending pennant. Additionally, SBUX had just bounced off the 50 day moving average twice before. Due to this price action and decent fundamentals, I expected price action similar to PANW.

Once the buy order was filled, I placed a stop order to sell the stock if the price sunk a dollar below the 50 day moving average. I figured that if price fell below that level, the chart and trade was broken and I didn't want to be in it. Well the very next day, SBUX sold off (with the rest of the market) and my stop order was triggered and filled. Over all I lost 2.3% on the trade; easily recoverable.

I hope this example illustrates the importance of trade and risk management. Before you get into a trade, know at what point the trade is broken and determine how much you are willing to lose if you’re wrong. Keeping your trade losses as small as possible will keep you in the market. If you spend more time trying not to lose money, the rest is will take care of itself.

Build an Easy ETF Portfolio

If you want to build an easy ETF portfolio, you're in luck! There are tons of financial products that will allow you to build a simple and efficient portfolio. Today's information rich environment will also allow you to turn the task of building a portfolio into an arduous and time consuming endeavor.

Building a portfolio shouldn't be difficult, and in my experience the time and energy it takes to build a complex portfolio isn't even worth it. Most mutual fund managers lag the market in terms of performance, chances are you will too. So if you're like me and don't want to waste a bunch of time, feel free to follow along and build your portfolio the easy way.

First, Determine the Right Asset Allocation

According to Modern Portfolio Theory, one of the key elements to consider when building an efficient portfolio is the mix of asset classes. Asset class mix can be described as the percent of your portfolio dedicated to particular asset classes.

In this first step we need to determine how much capital we should allocate to stocks, bonds, commodities, options, futures, etc. To keep this portfolio simple we will first look at a portfolio comprised of only stocks and bonds. Then we will discuss other assets classes, such as gold and real estate, that we can add to our portfolio to increase diversification.

The quickest way to determine a "good enough" asset allocation for an individual is the "100 minus your age" rule of thumb. To use this rule of thumb to determine what percent of your capital should be invested in stocks, just subtract your age from 100. The resulting number will be the percentage of your portfolio that should be allocated to stocks. The remaining balance should be allocated into bonds.

Second, Use ETFs for Diversification

Now that you know what percent of your portfolio should be invested into stocks and bonds, its time to find the specific assets to place into your portfolio. As mentioned earlier, the abundance of financial products makes this an easy task. To achieve a "good enough" diversification you only really need to purchase the following Exchange Traded Funds.

Vanguard Total Stock Market (VTI) - Including this fund in your easy ETF portfolio will allow you to track the performance of the U.S. stock market. This ETF includes large, mid, small and micro-cap stocks.

Vanguard Total Bond Market (BND) - This fund will enable you to track the performance of the Barclays U.S. Aggregate Float Adjusted Index. It includes both government and corporate bond issues with a maturity of more than one year.

    I told you this was the World's easiest portfolio! However, if choosing a stock allocation based on your age and only investing in two ETFs is too easy, you can choose to add a few more asset classes to increase your diversification. To add more complexity to your easy ETF portfolio, I would consider dedicating a small percentage of my portfolio to each of the following international, real estate and gold funds.

    Vanguard Total International Stock (VXUS) - This ETF will add international stock exposure to your portfolio. This fund tracks the FTSE Global All Cap and excludes U.S. stocks.

    Vanguard REIT (VNQ) - This ETF will allow you to diversify into real estate investments by tracking the performance of the MSCI U.S. Real Estate Investment Trust (REIT) Index. This index represents roughly 85% of the publicly traded REIT market.

    SPDR Gold Shares (GLD) - Investing in a gold fund will introduce a commodity into your portfolio while providing a good hedge against inflation. The SPDR Gold Shares ETF seeks to track the price performance of gold bullion (net of management fees).

      If you want to get a little more complex and tailor your portfolio's risk and reward profile, you can choose to allocate your stocks based on different sized companies (i.e. small, medium and large capitalization). The following funds can help you customize your easy ETF portfolio based on your individual risk and reward preferences.

      Vanguard Large-Cap (VV) - Include this fund in your easy ETF portfolio if you want an additional allocation to large companies. This fund has a moderate risk and reward profile.

      Vanguard Mid-Cap (VO) - Investing in this mid-cap ETF will increase your exposure to companies with a higher risk and higher reward profile than larger companies.

      Vanguard Small-Cap (VB) - If you want to increase the potential to outperform the S&P 500 and the Dow Jones Industrial Average, increase your allocation to small-cap stocks. Keep in mind that small companies are historically more sensitive to macroeconomic performance.

        Third, Maintain Your Easy ETF Portfolio

        Once in a while you will need to measure how "out of balance" your portfolio has become; in most cases once a year fine. Your easy ETF portfolio will need to be adjusted for two reasons. First, your portfolio's positions will gain and lose value at different rates over time. This will throw your allocation percentages off. Second, as you near retirement you should be reducing your exposure to riskier assets, such as stocks and increasing your allocation to bonds.

        To re-balance your portfolio, determine what percent your stock and bond allocations should be by using the "100 minus your age" rule. Once you have determined where your allocation percentages should be, calculate the size of your current allocations.

        If your positions are larger then they should be you need to "trim the positions". In other words, you will need to sell enough shares to reduce your allocation to where it should be. The gains from trimmed positions should be used to increase allocations (buy more shares) of positions that are smaller than they need to be.

        Why Do We Sell in May and Go Away

        Starting in April of each year, professional and retail Investors ask themselves "should I sell in May and go away"? Although many point to Stock Trader's Almanac statistics that illustrate the stock market's tendency to provide lower returns in the period between April and October, the explanations behind the phenomenon are often missing. Market statistics only show what happened in the past, they don't provide any explanation of why the event occurred.

        Calendar effects, such as "sell in May and go away", are not uncommon in the stock market. Such trends can be seen at the end of the year with the "Santa Claus rally", beginning of the year with the "January effect" and every few years during U.S. election cycles. Despite the fact that some market participants deem these market timing concepts (or adages) as credible, academia does not.

        The concept of "sell in May and go away" contradicts established market philosophies such as Efficient Market Theory. As academia shifts towards the study of behavioral finance these calendar effects may be justified through psychological concepts such as herd behavior. This type of behavior can be characterized by the tenancy of individuals to act collectively and to mimic the actions of a larger group. So if we think that the group is planning to sell their positions in May, why shouldn't we follow the herd?

        If the masses believe a May sell off will occur, it will. If the market has more sellers than buyers, the market falls. The falling market will trigger other market participants to sell their shares. Given our tendency to anticipate a May sell off, we sell our shares (or at least raise our stops to lock in profits). In my opinion, this is how adages concerning market timing become self-fulfilling prophecies.

        Should I Sell in May and Go Away, or Not?

        Making the decision to lighten your exposure to equities should be based on your financial plan. First, understand or remember why you are investing in the first place. If you are trading, the decision to exit a positions should be based on price action of the asset, not time of year. Your trading strategy (entry and exit points) should dictate the time to sell. In addition, if you are a long-term investor whom is seeking capital appreciation to fill financial planning gaps you should avoid the temptation to sell during short-term stock market fluctuations. In simple terms, just stick to your original plan.

        In the past five years there were only two periods in which stocks were lower in September then they were in April. Thus selling in May and going away until October would not have been wise. In hindsight, it would have been better to maintain your current stock positions, and added to them during the summer sell-off. The two "May sell-offs" are annotated by the red boxes in the following chart:

        sell in may and go away
        sell in may and go away

        In summary, the decision to sell or lighten stock positions should be based on price action and macro-economic assessments. While statistics do support a "sell in May and go away" approach, it's not significant enough to warrant the blind abandonment of positions. Take these anticipated calender driven stock market events with a grain of salt. Stick with your financial plan, keep your eyes open for changing trends and adjust as needed.

        Investing Services: Betterment vs. Wealthfront

        Recently two investment management companies, Betterment and Wealthfront, have gained an impressive amount of popularity. As you might already be aware, I'm quite skeptical of investment management firms as I've seen the dark side of the financial planning industry. Regardless, I wanted to research both offerings and compare the two in a "Betterment vs. Wealthfront" robo-advisor death match. I wanted to do this review mainly because I'm open to selecting one of these for my own personal use. Before we get into the details lets discuss the fundamental concepts that these services are based on.

        What is a Robo-Advisor?

        Despite what the investment industry will assure you (mutual and hedge fund managers, commission based financial advisers, stock brokers, etc.), investment allocation decisions can be made solely using various mathematical models. Sure, in the investment allocation decision process you will need to identify risk preferences (subjective assessment), but those are quickly quantified for use in portfolio construction. All other required data (such as investment time horizon, retirement needs, age, current income, etc.) is numerical.

        With that said, a robo-advisor is a mathematical model that uses your data and individual circumstances to create a "personalized" portfolio. While a robo-advisor can eliminate the need for professional help to construct a long-term retirement portfolio, it will not satisfy the investment needs of everyone. If you require savvy arbitrage or hedging strategies in your portfolio then a robo-advisor is not for you. Additionally, you will not be able to choose what assets (stocks, funds, bonds, etc.) you invest in, the machine will do that for you. Betterment and Wealthfront are both robo-advisors and utilize mathematical models to automate asset allocation.

        Passive Management and Modern Portfolio Theory

        Both Betterment and Wealthfront are built on Modern Portfolio Theory (MPT) concepts. Harry Markowitz founded this theory with the understanding that portfolios can be constructed to maximize expected return based on a defined level of risk. Modern Portfolio Theory also suggests that efficient portfolios (optimized based on risk and return) can be constructed by varying allocations to asset classes (i.e. stocks and bonds). This leads to an emphasis on choosing the right blend of stocks, bonds and cash verses choosing one stock over the other.

        In addition to utilizing Modern Portfolio Theory to drive asset allocation decisions, Betterment and Wealthfront both take a passive approach to portfolio management. Eventhough they take a passive approach to investing, they will step in and rebalanced the portfolio as needed. Taking this approach keeps transaction costs and fees low. It's wise to take advantage of dollar cost averaging when using these service by setting up automatic investments.

        Betterment vs. Wealthfront: The Duel

        Now that we have a fundamental understanding of Modern Portfolio Theory and robo-advisors, it's time for Betterment vs. Wealthfront!

        betterment vs. wealthfront
        betterment vs. wealthfront

        When comparing these two services it is clear that they are both extremely similar. The only differences that will matter to the majority of main street investors is cost and initial deposit requirements. The advantages of choosing one over the other truly depends on your individual circumstances.

        If you are looking to start building a retirement portfolio from scratch, Betterment will allow you to open an account with no initial deposit. This is as long as you agree to automatically deposit $100 per month into your account. This is a huge advantage for those just starting out. However, the downside to starting out with Betterment is that their fees are higher for accounts under $10,000.

        I would personally take advantage of Betterment's low deposit requirement if I didn't have the $5,000 Wealthfront requires as an initial deposit. Additionally, I suspect if you have the $5,000 to use as an initial deposit when using Wealthfront, you won't stay in their "free" account status for long.

        I'm attracted to these services for the automatic allocation of investment funds. I'm a advocate of paycheck allotments used to contribute to investment accounts, however in practice it can become burdensome to manage. Thus paying a service like Betterment or Wealthfront to execute the transactions for me is a nice option to have.