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Topic: Wealth Management

Investor Toolkit: Why most investment "plans" and "systems" thwart investors

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Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific investment advice that will help you develop a successful approach to investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “Instead of getting trapped in the narrow focus of most investment ‘plans’ and ‘systems’, you’re better off with a balanced approach that helps you make effective decisions instead of automatic ones.”

One of the most common investment platitudes you’ll ever hear is that investors should, "have a plan (or system) and stick to it". This is good advice if your alternative is to invest without any sort of plan — that is, to invest at random or do something different every time you make an investment decision. However, many investment plans in use today are not worth sticking with.

Of course it’s wise to have long-term investment goals, but depending on a narrowly focused plan to achieve them is simply not realistic.

When they first set out to formulate a plan, many investors determine that they want to base investment decisions on a handful of financial or investment measures. For instance, they may want to see a p/e ratio (the ratio of a stock price to its per-share earnings) below 15.0, say, along with an earnings growth rate of 20% or more annually, and perhaps a 2% dividend yield.

This approach worked a lot better in the pre-computer age, when investing was far more labour-intensive. Few people wanted to dig through piles of old newspapers, annual reports and other material to get at the data. So more gems were left to be found by those willing to do the work.

Today, if you find a stock with this (or any comparable) combination of favourable ratios, it may come with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system may steer you toward them.

Invest in your Financial Future for FREE

Learn everything you need to know in '9 Secrets of Successful Wealth Management' for FREE from The Successful Investor.

Secrets of Successful Wealth Management: 9 steps to the life you've always wanted, before and after retirement.

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Beware of favourite stocks that get overpriced

Something similar happens with momentum investing, which involves buying stocks that are going up, particularly if they are rising in response to earnings reports that beat forecasts. These kinds of criteria are easy to track electronically, so momentum favourites tend to get over-priced quickly. When a momentum favourite reports an unexpected earnings downturn or warning, however, it can drop 25% to 50% instantly.

Other kinds of systems or plans aim at avoiding risk by buying put options to give you a way to avoid losses on your holdings, or using stop-loss orders to sell falling stocks before they drop too far. Plans like these are sure-fire ways to generate commission income for your broker. They do cut risk substantially, but they are even more effective in cutting profit. They leave you with meagre returns at best.

The best investment plans or systems revolve around choosing high-quality investments and diversifying your holdings. Our three-pronged program takes that general description a little further. We advise you to invest mainly in well-established companies; spread your money out across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; Utilities); and focus on companies that are outside the broker/media limelight.

Our investment advice: When you follow a program like ours, you still need to make your own investment decisions. But the three-part framework we use tempers the effects of bad decisions and helps you cash in on your good ones.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

Have you tried more than one investment plan since you began investing? Has one worked better than the others? Which was the worst? Are there any investment plans or systems you simply didn’t try because you didn’t trust them to work?

Note: This article was originally published on August 22, 2012.

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