Developing Your Personal Investment Plan
April 5, 2002
One of the parts of developing a sound financial situation is the development of an investment plan. While research has shown time and again that a plan will make your strategies easier to follow and remove the emotion from the investment process, many investors still go at it without one. There are six basic steps to consider when undertaking the investment process.
1) Should you be investing at all?
In order to even begin the investment process, you must determine that you are ready to save. Do you have a cash reserve? Most industry insiders recommend at least three-to-six-month’s net expenses prior to committing a dime to the financial markets. If you’re using next month’s rent money, how good a decision can you make if things turn against you? Emotion will almost certainly get in the way of sound judgment.
2) Determine your investment time horizon.
In this step, you will be determining how long you plan to invest and when you will need the funds to meet your financial objective(s). You must decide, based on the time horizon of your objectives, among short-term investments, long-term investments or some combination. Obviously, the sooner the money is needed, the lower your overall risk tolerance will be when choosing investments. By determining what you are saving for, you should be able to approximate an appropriate time horizon.
3) Risk and Return
You will need to determine what your level of risk tolerance is. As the level of risk tolerance increases, so does the potential for higher returns as well as larger losses. Options offer stellar returns with limited risk in many cases. That explains why there have been many fortunes made in options trading. According to the Chicago Board Options Exchange (CBOE), options traders have a higher average net worth and larger accounts than stock and mutual fund investors do. Did I mention that options have a downside? They do. All investments have a downside when uneducated investors jump into with a get-rich-quick mentality. It’s simple, but certainly not easy.
4) Investment Selection
Based on the first three topics above, investments should be selected to meet your goals. These investments must satisfy your time horizon and your risk tolerance. If you’re willing to put in the time and effort, options offer the best risk/reward ratio I know of. I believe that anyone, given the proper tools and education, can succeed in the options market. Obviously, mutual funds appear safer because you have a manager with an MBA or CFA designation doing the work for you. However, did you know that less than 10% of all money managers who work for mutual funds beat the S&P 500 index each year? Less than 1 out of ten! I know there are thousands of individual investors who do it year in and year out without the Ivy League education and years of experience. Only one manager has managed to do it consistently: Bill Miller, manager of the Legg Mason Value Trust fund. I believe that true wealth comes not from diversification, but from smart choices. As Bill O’Neill, publisher of Investor’s Business Daily, says, “Diversification is a hedge against ignorance.”
5) Evaluate Performance
Once investments are chosen and expectations are established, the performance of your investments should be determined by comparing the actual realized returns against the expected returns. The returns should also be compared to a benchmark, such as the S&P 500 index, or the Dow Jones Industrial Average, the two most common barometers of the stock market. You can track your returns against both of these by indexes by tracking the symbols SPY and DIA at the same time you begin your investment program.
6) Adjust Your Portfolio
Your portfolio should be adjusted to maintain your goals and your investment criteria. If your goals change, your investments should be reviewed to determine if they continue to meet your objectives. Growth, income, or capital preservation can all be achieved through options trading once you master the fundamentals. Think of it this way. It takes an absolute minimum of nine years education and training after high school to become a doctor. Yet, many people expect to become wealthy investors or traders in a matter of a few months. Ask most doctors, and they’ll tell you they’d rather be successful full-time traders because the income potential supersedes that of even the most highly specialized physicians; and given the malpractice insurance and health insurance problems in this country, trading offers a lot more autonomy. Look at some of the wealthy physicians you may know. Chances are they got that way through investing their income in businesses, real estate, or the financial markets, not from earning it.
To summarize, once you have determined that you are financially able to begin investing (or saving), you should evaluate your investment goals and set out a plan to accomplish these goals. Once you have begun your investment plan, you must periodically review the performance of your investments and re-evaluate your objectives and investments to make certain there is a good fit. Educate yourself so that you are armed with a basic level of understanding about the investment process, and keep in mind that losses are inevitable. They are the tuition that all successful investors pay along the way to becoming successful, and in many cases wealthy!
Good luck and great trading.
David Bickings
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
dbickings@optionetics.com
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