The 10 habits of highly effective investors: Part 1

Governing is the big picture of how you invest ― managing investments based on your plan, thinking about risk and how each investment affects your portfolio.

The first habit of Governing is to have a plan. Many investors don't have a plan, at least not one they use or can explain to others. We've included an outline of an investment plan, which we invite you to review in this note.1 Following are two tests of a plan.

For example, you might get excited about a small tech company, while forgetting that your plan says you don't invest in stocks with a market capitalization of less than $1 billion. Or you might be tempted to buy long-term bonds because yields have gone up, while forgetting that your plan says you limit bond duration to five years. The planful investor would either not make these investments or make a very strong case as to why they would make an exception. 

Imagine you decided to spend a year on a desert island, without any phone, internet or connection to the outside world. If you gave your plan to someone else, say a family member or an advisor, would they know how to invest for you? This is not to say you want someone else to invest for you. Instead, it's a test of how clearly you've explained your plan.

While the plan can be as short as 1 to 2 pages, there's no substitute for having a written plan. A plan that exists in your head is not a plan you can use to make decisions or explain to others. Take the time to write down your plan. Don't let perfect become the enemy of the good. Start with a simple plan and go from there.

The second habit of Governing is to think risk. This means thinking clearly about the risks of companies, asset classes and the broader economy and market, as well as risks related to your goals.

Say you're saving for a home down payment. You plan to contribute $15,000 annually for 8 years, for a total of $120,000. You figure you need $175,000 for a down payment, based on today's prices. Maybe house prices will be higher in the future, so the down payment might be higher too. You need the funds to be safe and stable, especially in the last few years as you get closer to buying your home. But you also need some level of growth, to get from $120,000 in savings to a final balance of $175,000 or more. In this example, an investor may choose to balance growth in the early years with stability in the later years. Risk includes not just the risk of the investment, such as volatility, but also the risk of whether you might not achieve your investment goal.

Develop the habit of asking "Have I considered the risks of this investment and the risks to my goals?", not just asking "How much could this investment increase my returns?" Balancing risks and returns develops a planful way of thinking. In contrast, focusing too much on returns may neglect risks and reduce long-term returns through losses.

The third habit of Governing is to think portfolio. Say your stock position has a large weight in Canadian banks. You notice your fixed-income position in Canadian government bonds has not performed well recently, so you look at shifting this position into Canadian short-term corporate bonds for a potentially higher yield.

This decision looks different when you think portfolio. Some Canadian short-term corporate bond funds can have a large weighting in Canadian banks. Adding this to your equity position would give you a high level of exposure to a single sector in one country. When you think portfolio, you're going beyond thinking about each individual investment and instead thinking about the effect of the investment on your portfolio. The question to keep in mind when looking at any individual investment is: "OK, but what does this mean for my portfolio?"

This wraps up part 1 of the series on Governing. We invite you to continue with part 2 on Knowing. This is the detective work of investing ― gathering facts and opinions about an investment and testing your thinking about how an investment could perform.

The 10 habits of highly effective investors: Part 2

¹ It can be useful to get advice on your investment plan from a qualified investment professional, especially as your balance becomes larger and your portfolio spans multiple goals and time horizons. But to get started, investors can build a relatively simple plan for themselves.

Below is an outline of an investment plan. Sections 1 through 6 are core sections for all investors. We also include appendices 1 and 2 for investors who might have to explain their plan to another person.

• Investment goals (such as retirement, education funding, wealth preservation)
• Required rate of return
• Time horizon for each goal

• Assessment of risk capacity and risk willingness
• Maximum acceptable loss or portfolio volatility

• Liquidity needs
• Time horizon
• Tax considerations
• Legal and regulatory considerations
• Unique circumstances ― example: ethical preferences or restrictions

• Strategic asset allocation targets ― example: weights in percent for equities, fixed-income, alternatives and cash
• Permitted ranges and rebalancing thresholds ― example: 70% equity; review at end of June and rebalance at lower limit of 60% or upper limit of 80%
• Portfolio rebalancing process ― example: rebalance annually at end of December

• Guidelines for selecting individual securities, funds or managers
• Approved and prohibited investment vehicles or asset classes

• Frequency and process for reviewing portfolio performance
• Process for updating the plan in response to changes in circumstances

• Personal and financial background
• Current financial situation and net worth
• Income sources and expected cash flows

• Duties of the investor, advisor and any other parties involved
• Decision-making authority