When the market gets crazy, you’re itching to trade your portfolio, or just want to act on the latest breaking news, the decisions you weigh matter in the long run.
Of course, not all portfolio decisions are equal. Sometimes it’s the decisions you don’t make that matter most.
In fact, Charley Ellis made this case two decades ago. He broke down portfolio decisions into five categories:
In making investment decisions, there are five separate levels of decisions for each investor to make individually:
- Level One: Asset mix — The optimal proportion of, e.g., equities, bonds, private equity, for the policy normal of the investor’s portfolio. This is where investment counseling usually concentrates.
- Level Two: Equity mix — Policy normal proportions in various types of stocks: e.g., growth versus value; large-cap versus small-cap; domestic versus international.
- Level Three: Active versus passive management — Deciding on the appropriate method of implementation for the policy normal mix of investments.
- Level Four: Specific manager selection (where most investors and most investment committees concentrate their time and effort) — Deciding which firms will manage each component of the overall portfolio, firing the most disappointing, and hiring the most promising.
- Level Five: Active portfolio management — Changing portfolio strategy, security selection, and trading.
Investors should recognize that the game of investing is not necessarily a single, bundled package, but can be divided into separate parts or levels and that investors can engage in or ignore each level of the game. And investors are free to choose.
Ellis ranks the levels by order of importance. Levels one and two are the most important, levels four and five the least.
Yet, thanks to innate biases like overconfidence and overoptimism, many investors prioritize the opposite. The active part of investing, levels four and five, receive the most time and attention, with levels one and two getting the least.
Investors have it backwards and it’s costly. Each level also comes with a cost, not just in fees but potential mistakes. Levels four and five being the costliest.
Choosing active funds that underperform an index, chasing returns, trading your account, and other active decisions increase the chance of underperforming a simple portfolio with the appropriate asset mix to fit your goals, objectives, and risk tolerance.
Choosing to put all your time and attention into levels one and two, while avoiding levels four and five is Ellis’s key to winning the loser’s game. A focus on asset allocation while minimizing costs and mistakes means winning at investing.
How do investors avoid the mistakes that result from the active decision levels? You can choose to be less active in your portfolio. A low-cost passive approach has proven results, but even it can be difficult to stick with at times. Of course, not everyone wants to be purely passive either.
The simple solution, for both cases, is to have an investment plan, written out, to review anytime. It should include your investment philosophy, objectives, asset mix, and strategy.
Your plan sets boundaries to limit portfolio decisions to only those that matter. Does the decision fall within the limits of your plan? If the answer is no, you skip it and do nothing.
A regular reminder of how and why you invest, ensures your decisions are less emotion and more reason. That instills discipline. It’s the difference between winning and losing at investing.
Source: The Winner’s Game
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