A 3-Part Fundamental Investment Strategy Anyone Can Follow

“Success is neither magical nor mysterious. Success is the natural consequence of consistently applying the basic fundamentals.” – Jim Rohn

Getting Back to Basics

As head coach of the Green Bay Packers, Vince Lombardi led his team to victory in the first Super Bowl. The first thing he did the following year was huddle his team around him, hold up a football and say, “Gentleman, this is a football.” He prepared his team for the coming season by focusing on the basic fundamentals of football: blocking, tackling and running.

And it worked. They won the second Super Bowl too.

Lombardi’s team had just proven they were the best football team in the world. But his focus the next year was the basics too — the ABCs of football.

As investors, we need to regularly bring our focus back to the fundamentals too. We’ve talked a lot about patience and discipline in investing, but there are also 3 fundamental investing tactics for building and managing an intelligent portfolio over time.

1. Asset Allocation

This is just a Wall Street way of describing the mix of stocks, bonds, cash, and real estate you own. Your asset allocation decision is responsible for the majority of the returns you get (or don’t get) over your lifetime as an investor.

In some ways, this is obvious – historically, stocks have produced 10-12% annual returns while bonds have earned 3.5-5.5% returns, cash even less. The more of your portfolio you invest in stocks and the less you have in bonds, the higher the returns you can expect over the long term. This is why, for long-term investors, we want to see a portfolio mostly made up of stocks.

Where it gets complicated is in balancing the different goals people have for different chunks of their money. Stocks may generate higher returns over the long term but for shorter time frames they are unreliable. The stock market could be much higher a year from now…or it could be much lower.

The way we navigate that is to break the money into two buckets.

Money Bucket #1

The first bucket is the money you will likely need to spend in the next 5-10 years. For that money, stocks aren’t appropriate. For short time frames, we really can’t count on stock trading to give us good returns. 

There are lots of five-year time frames where the stock market lost ground. There are even (although fewer) ten-year time frames where the stock market went backward.

So, for the money we know you’ll need to spend within 5-10 years, our first goal is not growth potential, it’s stability. We need to have at least the same number of dollars, when the time comes to spend it, as we have now. If we can get a bit of growth on those dollars in the meantime, great. But not at the risk of it going backward by the time we need it.

Money Bucket #2

The second bucket is the money you’re pretty sure you won’t need to spend in the next 10 years. For that money, the biggest risk we’re trying to overcome is inflation, not the short term gyrations of the stock market. Each year we’re able to buy less and less with each dollar we have.

Since 1980, inflation has averaged 3% per year. At that rate, inflation will eat away more than 26% of the purchasing power of each dollar we have every ten years. What that means is, we need to get at least a 3% return each year just so our dollars will be able to buy the same amount of stuff they can buy today.

Historically, stocks and real estate have provided the best performing investment opportunities and, therefore, have done the best job at outpacing inflation. That’s why we like to see any money we know you won’t need to spend in the next 10 years invested in a diversified portfolio of stocks and/or real estate.

2. Diversification

Because we can’t know for sure if any one investment decision will be the best, we want to diversify. Putting all our money in just one investment puts our entire financial life at risk if that one investment fails. The more investments we have, the more we eliminate the risk that any one of them could derail our financial life.

Imagine if 80 years ago we owned stock in the ten best typewriter companies in the world. How much protection did that “diversification” give us when typewriters went the way of the buggy whip?

True diversification means no one company, sector, industry, country, or idea can blow us up. True diversification means owning thousands of companies all around the world in all kinds of sectors and industries.

It has nothing to do with the number of mutual funds you own.

I’ve seen portfolios with a single fund that were thoroughly diversified and I’ve seen portfolios with 15 funds that all invested in the same part of the stock market. To know if your fund portfolio is diversified, you have to look “through” the funds to see what actual stocks and/or bonds it holds. That way you can see what gaps and redundancies actually exist in the portfolio.

3. Rebalancing

This tactic ensures that your portfolio maintains the asset allocation you set out originally – it doesn’t accidentally become more and more aggressive (or more and more conservative) over time. It also helps the portfolio stay diversified rather than becoming increasingly concentrated on whatever investment has done the best.

Think about rebalancing as a reset button for your investments. When you build your portfolio the right way, every investment is carefully chosen to work in harmony with every other investment. Each one has its own unique part to play in the overall portfolio.

Over time, investments that do the best gradually become a larger and larger piece of the portfolio. The longer this goes on, the less the portfolio resembles how you set it up to begin with. When we rebalance, we take the portfolio back to the original design.

But how do we know when to rebalance?

In much of the investment industry, rebalancing is thought of as a calendar to-do item – it’s January 1st? Must be time to rebalance! Rebalancing might also be done on a quarterly or monthly basis. I think rebalancing should happen only when things get out of balance.

As portfolio managers ourselves, each investment in each of our clients’ portfolios is tracked on a daily basis so we know when any get out of balance and can take action to put it right. 

The beauty of strict discipline in rebalancing is that it forces you to follow the age-old investing formula: buy low, sell high. When a fund drops more than everything else in the portfolio, it will drift out of balance and we’ll be prompted to buy more of it – buy low. When a fund outperforms everything else in the portfolio we’ll be prompted to sell some of it – sell high.

Repeated consistently over years and decades, the rebalancing discipline can enable investors to even outperform their own investments simply because they are buying more of the stock when the stock price is low and selling a bit of the stock when it’s price is high.

To start exploring asset allocation, diversification and rebalancing in more depth for your own portfolio, sign up for our Retirement Income Academy course and download a free copy of our eBook, “How to Retire with Confidence and Clarity”.