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Four Steps of Successful Investing

Wells Fargo Investment Institute - June 2020

A person’s hands and a tablet

Investors invariably have to deal with an element of uncertainty. We believe the biggest risk they face is not a market downturn but the risk of not meeting their financial goals. We have identified four steps we believe will help investors meet those goals.

Step 1: Start with a plan

An investor should work with an advisor to develop an investment plan that is compatible with their personal financial needs. The plan should be durable enough for the long term — stable enough not to abandon out of fear when times get tough. And while the plan should be flexible enough to accommodate big life changes, it should stay focused on the investor’s goals.

  • Determine your goals
  • Build a cash reserve for the unexpected
  • Select investments appropriate for your goals
  • Prepare to manage emotions amid changing circumstances
  • Control emotions in decision-making

Investor returns have substantially lagged the markets, 2000–2019

Bar chart showing average annual return for the average equity fund investor and the S&P 500 Index.  Y-axis:  Average annual return; x-axis, Average equity fund investor return 4.25%, S&P 500 Index return 6.06%.

Source: Dalbar, Inc., 20 years from 2000–2019; “Quantitative Analysis of Investor Behavior,” 2020, DALBAR, Inc., www.dalbar.com. For illustrative purposes only. Dalbar computed the average stock fund investor return by using industry cash flow reports from the Investment Company Institute. The average stock fund return figure represents the average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model. All Dalbar returns were computed using the S&P 500 Index. The S&P 500 Index is a market-capitalization-weighted index composed of 500 stocks generally considered representative of the U.S. stock market. The fact that buy and hold has been a successful strategy in the past does not guarantee that it will continue to be successful in the future. The performance shown is not indicative of any particular investment. An index is unmanaged and not available for direct investment. Total returns assume reinvestment of dividends and capital gain distributions. Past performance is not a guarantee of future results.

Step 2: Construct a portfolio

Studies have shown that asset allocation is often the most important investing decision, accounting to as much as 79% of portfolio performance.  

The capital markets offer a variety of investments that perform different functions. In general, growth = stocks, income = bonds, stability = short Treasury bonds, and inflation protection = gold. But this oversimplified view ignores the potential benefits of broader diversification. For example, income can come from a variety of sources beyond bonds, such as high-dividend stocks, including real estate investment trusts, and commodities beyond gold can provide a hedge against inflation. For this reason, we recommend a wide range of asset types for a portfolio.

Step 3: Globalize the portfolio

Some exposure to faster-growing emerging markets can add another layer of diversification to a portfolio. Rapid population growth combined with a younger population’s desire for a higher standard of living should lead global consumption and production in the coming decades.

The more informed an investor is about the spectrum of investments available to them as an individual investor, the more confident they should become about embracing a variety of asset classes for a diversified portfolio. Becoming more informed about different types of investments and their roles in a portfolio can also help establish reasonable expectations and plan accordingly.

Step 4: Maintain alignment to the plan

A change in economic conditions or large market moves, upward or downward, can significantly alter a portfolio’s risk/reward profile. Failing to rebalance during a bull market can lead to overexposure to equities, drastically changing the risk profile of the intended allocation, leaving the portfolio more at risk when a bear market starts. 

A good way to realign a portfolio is to periodically trim those asset classes that have grown beyond target levels and invest in those that have dropped below target levels to bring the asset allocation back to its original targets. This is an effective version of the “buy low, sell high” principle. But it is important to recognize that rebalancing a portfolio may trigger capital gain taxes, so tax-sensitive investors need to take this into consideration. A more subtle way of rebalancing is to direct any new funds into asset classes that are underweighted and to fund any cash needs by selling asset classes that are overweighted.

Despite the importance of maintaining alignment to your investment plan, there are legitimate reasons to reevaluate. Life changes such as getting married, buying a home, and starting a family are a few examples. They offer an opportune time to revisit investment goals and determine whether any changes are warranted to the overall investment strategy. Material changes in net worth also provide a reason to reevaluate the investment asset mix.

A well-constructed investment plan based on an investor’s unique circumstances that is implemented, adhered to, and rebalanced as necessary can help alleviate the anxiety that market gyrations often cause investors. This can be especially helpful in times of increased volatility.

Read the full report (PDF)