Warren E. Buffett offers the following advice on the qualities of a successful investor. Buffett suggests that a successful investor does not need an extraordinarily high IQ, exceptional business acumen, or inside information. To enjoy a lifetime of successful investing, you need a solid decision-making framework and the ability to maintain your emotions.
A successful investment strategy requires a thoughtful plan. Developing a project is not difficult, but staying with it during times of uncertainty and events that seem to counter your plan’s strategy is often difficult. This tutorial discusses the necessity of establishing a trading plan, what investment options best suit your needs, and the challenges you could encounter if you don’t have a plan.
The benefits of developing a trading plan
You can establish optimal circumstances for experiencing solid investment growth if you stick to your plan despite opposing popular opinions, current trends, or analysts’ forecasts. Develop your investment plan and focus on your long-term goals and objectives.
Maintain focus on your plan.
All financial markets can be erratic. It has experienced significant fluctuations in business cycles, inflation, interest rates, and economic recessions throughout the past century. The 1990s experienced a surge of growth due to the bull market pushing the Dow Jones industrial average (DIJA) up 300 percent. Low interest rates and inflation accompanied this economic growth. Many Internet-based technology firms were created during this time due to the increased popularity of online commerce and other computer-reliant businesses. This growth was rapid, and a downturn occurred just as fast. Between 2000 and 2002, the DIJA dropped 38 percent, triggering a massive sell-off of technology stocks, which kept indexes in a depressed state well into the middle of 2001. Large-scale corporate accounting scandals contributed to the downturn. Then, in the fall of 2001, the United States suffered a catastrophic terrorist attack that sent the nation into a high level of uncertainty and further weakened the market’s strength.
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These are the kinds of events that can tax your emotions in terms of your investment strategies. In times like these, you must have a plan and stick to it. This is when you establish a long-term focus on your objectives. Toward the end of 2002 through 2005, the DJIA rose 44 percent. Investors who let their emotions govern their trading strategies and sold off all their positions missed this upturn.
The three deadly sins and how to avoid them
The three emotions that accompany trading are fear, hope, and greed. When prices plunge, fear compels you to sell low without reviewing your position. Under these circumstances, you should revisit your investments’ original reasons and determine if they have changed. For example, you might focus on the short term and immediately sell when the price drops below its intrinsic value. In this case, you could miss out if the price recovers.
An investment strategy based on hope might compel you to buy certain stocks based on the hope that a company’s future performance will reflect on its past performance. This occurred during the surge of Internet-based dot-com companies during the late 1990s. This is where you must devote your research into a company’s fundamentals and less to its past performance when determining its stock’s worth. Investing primarily in hope could have you ending up with an overvalued stock with more risk of a loss than again.
The greed emotion can distort your rationale for certain investments. It can compel you to hold onto a position for too long. If you plan to hold out a little longer to gain a few percentage points, your work could backfire and result in a loss. Again, in the late 1990s, investors enjoyed double-digit gains on their Internet-company stocks. Instead of scaling back on their investments, many held onto their positions, hoping the prices would keep going up. Even when the prices were beginning to drop, investors held out hope that their stocks would rally. Unfortunately, the rally never happened, and investors experienced substantial losses.
An effective investment plan requires that you properly manage the three deadly sins of investing.
The key components of an investment plan
Determine your investment objectives
The first component in your investment plan is to determine your investment objectives. The three main categories involved in your dreams are income, growth, and safety.
If you plan to establish a steady income stream, your objective focuses on the income category. Investors in this category tend to be low-risk and don’t require capital appreciation. They use their investments as an income source.
If you focus on increasing your portfolio’s value over the long term, your objective is growth-based. In contrast to the income category, investors strive for capital appreciation. Investors in this category tend to be younger and have a longer investment time frame. If this is your preferred category, consider your age, investment expectations, and tolerance to risk.
The final category is safety. Investors who prefer to prevent loss of their principal investment. They want to maintain their portfolio’s current value and avoid risks common with stocks and other less secure investments.
Risk tolerance
While the main reason for growing your portfolio is to increase your wealth, you must consider how much risk you are willing to take. If you struggle with the market’s volatility, your strategy should focus more on the safety or income categories. You might favor the growth category if you are more resilient to a fluctuating market and can accept some losses. This category has the potential for higher gains. Nevertheless, it would help if you were honest with yourself and the level of risk you are willing to take as you set up your investment plan.
Asset Allocation
As discussed in the previous sections, part of your investment plan is to determine your risk tolerance and investment objectives. After establishing these components, you can choose how you will allocate the assets in your portfolio and how they will match your goals and risk tolerance. For example, if you are interested in pursuing a growth-oriented category, you could allocate 60 percent in stocks, 15 percent in cash equivalents, and 25 percent in bonds.
Make sure your asset allocation reinforces your objectives and risk tolerance. If you focus on safety, your goals must include safe, fixed-income assets such as money market securities, high-quality corporate securities (with high debt ratings), and government bonds.
If your strategy focuses on an income category, you should concentrate on fixed-income strategies. Your investments might include bonds with lower ratings that provide higher yields and dividend-paying stocks.
If your focus is on the growth category, your portfolio should focus on the common stock, mutual funds, or exchange-traded funds (ETF). With this category, you must be vigilant in managing your portfolio by regularly reviewing your objectives and adjusting them according to your risk tolerance and goals.