Advice on what it means to be a Disciplined Investor

I am re-blogging yesterdays excellent post from Rick Ferri. Rick is the author of All About Asset Allocation and The Power of Passive Investing. 

The Disciplined Investor

June 20, 2011 By Rick Ferri

Investment discipline is misunderstood.  Too many investors, both individuals and professionals, say they are diligent at running their portfolios when they’re really not. Portfolio performance data proves it. Turnover rates in portfolios are high, mutual fund performance chasing is the norm, and investor sentiment shifts much more rapidly than good discipline would infer.

In my business, it’s common for investment advisors to claim they are disciplined in their strategy but also add that they’ll “adapt to changing market conditions.” This loophole leaves the door wide open to just about any change the advisor deems necessary and they use it to change strategy all too often, particularly when clients get anxious in bear markets. Loopholes in discipline statements may allow an advisor to retain skittish clients, but their actions usually hurt more than they help.

A disciplined investor follows these six guidelines:

1. Have a long-term investment philosophy.
2. Create an investment plan that follows this philosophy.
3. Form a prudent asset allocation around the plan.
4. Maintain this allocation through all market conditions.
5. Don’t change the allocation due to recent market activity.
6. Don’t hold back on new investments while waiting for market clarity.

I’ll briefly explain these six actions as they pertain to my own account to clarify each point:

Long-term investment philosophy:  My belief is that the markets are more efficient at pricing securities than I could ever hope to be.  I do not have enough skill to consistently add value to my portfolio by picking mispriced stocks or bonds, industry sectors, country selections, or entire markets. So, I don’t try.

Create an investment plan that follows this philosophy: Certain index funds and exchange-traded funds (ETFs) provide broad market diversification at a very low cost. Building a select portfolio of index funds and ETFs provides the highest probability for meeting my long-term financial goals.

Form a prudent asset allocation around the plan: I am a 53-year-old military retiree with a pension that begins at age 60, plus two smaller pensions from private businesses, and whatever Social Security my wife and I receive. Given this expected cash flow from pension sources, the asset allocation in my retirement account is more aggressive that a typical 50-something-year-old who has less in pension assets. My allocation is 80 percent equity and 20 percent fixed income, and I intend to stay that way for at least 10 more years.

Maintain this allocation through all market conditions: My retirement portfolio is rebalanced to 80 percent stocks and 20 percent bonds annually. Rebalancing is done when I receive an annual pension contribution from my company.

No changes to the allocation due to recent market activity: My portfolio is being managed for the next 30 years, not the next 30 days. It doesn’t matter what the market has done — or what others say it will do — the allocation stays 80 percent in stocks and 20 percent in bonds. I bought stock index funds in early 2009, stock and bond index funds in 2010, and all bond index funds in 2011.

Don’t hold back on new investing while waiting for market clarity: I have no desire to time entry points for new contributions. Money is invested as it comes in. If we change our pension so that money comes in every month, then my portfolio will be invested in the asset class where it’s needed every month and I will do one major rebalancing per year.

Some critics of my methods say these rules are too rigid and don’t offer any flexibly for what’s happening in the markets today.  Well, THAT’S what discipline means!

I’m not so rigid as to say never change. Investment plans have to change on occasion as unknown circumstances occur in life and as new information about old circumstances becomes available. These circumstances can be health, career, retirement date, and even wealth if an inheritance or bull market puts your savings at a higher level than you planned. How you deal with these new circumstances is also part of good investment discipline.

For more information on this topic, please read All About Asset Allocation, 2^nd edition, McGraw-Hill, 2010.