What’s the foundation for good investing?
It’s a good question. Because foundations are—well—foundational. They support everything else. If a building’s foundation isn’t sound, the structure itself won’t be stable. Joinings will fail, and eventually the entire building will come down. A good foundation goes below any disruptive influences—like frost—and keeps things true. It allows you to build a much more interesting structure.
In the same way, an investment portfolio needs to have a sound foundation. And the foundation of any portfolio is the investment policy—the document that specifies the required return, the risk tolerance, and various constraints: time-horizon, liquidity needs, tax considerations, the legal and regulatory framework, and any other considerations.
The required return is simple: money needed divided by money available over time. Yes, compound interest makes the required return smaller, but only over long periods—ten years or more. So, if you have $50,000 and need it to double over 20 years, that implies a 5% return. But the actual required return is 4% due to compounding. A simple spreadsheet can calculate this
Once you have your needed return, you should determine how much risk you can deal with. Risk is on most people’s mind these days. Stocks underwent a 50% decline in 2008, just as they did in 2001 and in 1974. If you can’t live with this sort of volatility, you need to pare it down by owning a proportional amount of bonds and cash.
Other constraints need to be specified as well. These things don’t change with the investing climate, and can serve as touchstones when market conditions become unsettling. The policy isn’t disrupted, because it doesn’t depend on market conditions.
A good foundation makes for a good structure. And a well though-out investment policy is more likely to lead to investment success than all the bull markets in the world.
Douglas R. Tengdin, CFA
Chief Investment Officer