DEVELOPING A SOUND INVESTMENT STRATEGY

Welcome to this third post in our six-part series on investing.

It’s never too early to begin to put in place a strategy for your investments. At some stage, as your earnings grow, you will have money to begin investing. At that point, I’d encourage you to take as serious an approach to investing as you did to making money.

When it comes to developing an investment strategy, a good place to start is by answering a few key questions: What size investment portfolio do you want at retirement? What is your personal tolerance for risk? Is your focus income or appreciation?

As you build your portfolio and opportunities are presented keep in mind: How much work will this investment require? How much of your time will it take? How much income will it produce? What are the time horizons, and do they match with your strategy of what you are trying to achieve? Do you fully understand how the money is made? I share more about this and other key investment strategies in my first blog in this six-part investment series titled An Investors Perspective. If you haven’t read it yet, I encourage you to start there and then return here.

In today’s blog, I would like to share with you key steps I have followed to build my investment portfolio and strategies I use to grow and maintain it. I have included two handouts titled Asset Return Report and Investment Review/Forecast Report. I would encourage you to open them both and refer to them as we continue.

ASSET RETURN REPORTS

One of the key exercises I do is take a detailed look at my investment portfolio regularly; I get a high-level report that tells me how each investment is doing. You will potentially get to the point where an individual or company will be doing the heavy work of reviewing investments on your behalf; at all stages of investing, the aim is to stay on top of things.

Tracking your investments and staying updated takes some work and discipline. As you set up a new investment, develop a system right from the beginning and log in updated information as it comes, then track it over time. When you initially start, you may only need to track your investment annually, but as your portfolio grows and becomes more diversified, you will want to increase the frequency based on the number of investments and how close you need to pay attention to them. Even if it’s just one investment, set up your system and start reviewing it regularly. 

My team generates an asset return report based on my investment portfolio. It has one page for each asset or type of investment. We look at any activity within an investment and it all gets logged into the report. This way, I can tell what the return was that month, what the year-to-date return was, what the last 12-month return was, what income is being generated etc. The report also gives me information based on all investments in each asset class – such as real estate, oil and gas, venture capital, stocks, bonds, etc.

Annually we set asset allocation goals and we also set asset allocation ceilings; so, when we bump up against a ceiling we stop and talk about it. These parameters have helped us with decision making – including saying no to some potentially good investments – simply because I was already above my allocation ceiling. Be prepared to say no when it makes sense. Working within set parameters is a discipline I believe in. 

A rule that we’ve held onto is we do not invest more than 5% of our portfolio in any one asset. This is because even great looking investments don’t always pan out the way you expect them to. It goes back to diversification. My team and I don’t just consider 5% for single investments, but it also covers a group that we may be investing in. You may put your money with a sponsor or company who may invest your funds in more than one investment. The way we see it, is you’re dealing with the same people, so you have similar risk, even if the investments are spread. My 5% ceiling however generally applies with a larger and more diverse portfolio. As you start out, 100% of your investments may be in one or two areas; but over time, as it grows, you want to reduce the amount invested in that one area – and spread it to other opportunities. Five percent (5%)  as a general rule has served me well. Occasionally there may be a star opportunity where you do go above; because of an exceptional low risk profile and a good return – but diversification and asset allocation generally work well together.

RATING YOUR INVESTMENT PORTFOLIO

Let us take a look at the Investment Review/Forecast Report handout. Starting with the first page titled Detailed Forecast – Current Year; within this report, is information that allows us to look in detail at every single investment in my portfolio. 

We take all our knowledge from the previous years actual performance and whatever knowledge or expectations we have of the current year, and we rate each investment based on the following main criteria:

LIQUIDITY

This is the first column on the report – under Current Ratings. Using the key shown, we use four different categories for liquidity: 1 means I have access to the funds in 3 days, 2 means I have access within a year, 3 means 13 to 36 months and a 4 is over 36 months. Simply understanding the liquidity makeup of your portfolio is very valuable as it helps ensure you have a good balance and cash when you think you’ll need it. You don’t want to end up with an il-liquid portfolio and neither do you want to be too liquid. You need a certain amount of liquidity for surprises in life and for opportunities that come along.

RISK

The second column under Current Ratings is Risk. Again, using the key, we look at each investment and rate all perceived risk on a 1 to 3 basis. 1 = acceptable risk, 2 =concerned, 3 = watch list – which means we keep a close eye on it as something is going on that’s causing issues. Rating the risk this way allows us to see the overall risk profile of my portfolio and whether things are improving or declining annually.

PROJECTIONS: RETURN AND CASH FLOWS

The next two columns under A. look at Income. Here we establish any income we project we will receive that year from each investment as a percentage and as a dollar amount. Following that we look at column B. which shows Principal back as a percentage and as a dollar amount. These columns show if this year we are expecting any amount of the principal invested back. Next, we have C. – Appreciation which is also reflected as a percentage and dollar amount. Appreciation shows how much our investment is anticipated to grow that year. Column D -Total Return also shown as a percentage and dollar amount, shows the full amount we expect to receive from each investment. It is calculated by adding Income and Appreciation. Next is E – Total Cash Flow – also shown as a percentage and dollar amount. This shows expected payments, and we get this figure by adding anticipated Income with anticipated return of Principal.

CAPITAL CALLS

Capital Calls are the final two columns. There are some investments where you do not invest all the money upfront – but a smaller amount initially, and more later. The Capital Call Remaining column therefore shows the total balance of any capital still to be paid out. The Projected Capital Calls column reflects the cash calls we project for the current year. 

You then compare your cash calls with your liquidity standpoint to determine how much of your liquidity is already planned for. Most people make the mistake of only looking at what they have in the bank without fully understanding the total cash commitment. In other words, what’s committed in cash calls and what’s committed in overheads. Knowing this is important because when you get to the stage where you’re not earning a salary, you need to include overhead as part of what your liquidity is committed to.

FORECAST SUMMARY

The second page on the handout titled Forecast Summary 2021 provides us with a complete portfolio outlook for the coming year. This review breaks down all my investments by asset class – cash, fixed income, real estate, equities, hedge funds and oil & gas. Once we input all the information, we are able to look at various aspects. For example, I can see how my portfolio has appreciated year over year, get a clear overview on the liquidity of my portfolio, or even view my risk assessment as a percentage in dollars and by number of investments. Ideally, under your risk profile, you want more of your investments to fall under acceptable and less under watch list. In essence, through this detailed summary, we’re able to determine how my whole portfolio might perform this year. 

This information is fed from a detailed analysis that we create for each specific real estate, oil & gas, and alternatives investments. This is where we show in detail cash being invested, funds being returned, profits, etc. You will need something similar to track the details of each investment. I’ve included in the handouts section a copy of the format we use showing an Alternative investment, Oil and Gas investment and Real Estate investment that feed into the Asset Return Report titled Asset Return Report Investment Calculations. 

This practice of reviewing, analyzing and forecasting is done on an annual basis at the beginning of each new year. Before doing this exercise however, I strongly recommend you review last year’s projections, compare them to last year’s actuals and then move to this new year. As you do this, you will get better at making projections. It’s impossible to accurately project what will happen each year, but with practice, you will get closer to your estimations. 

This is also very helpful as we gather rich insights from this comparison. We always look back before looking forward; because we’ve proven the more you look at and learn from history, the better you become at planning for the future. But remember, past performance does not always predict future performance.

As I get older, I have been moving towards less investments (which means dollar amounts for each investment) and a simpler portfolio to manage. More investments generally mean more work and is more complicated to manage. By the time I’m in my 70’s, my goal is to have a less complicated portfolio. 

ACTIONS STEPS

When it comes to developing your investment strategy, remember, all the business disciplines and acumens that you used to build your business and/or career are highly valuable and should be applied to your investing strategy. So often, people think these skills are not useful – that they require a different set for investing. They are however transferable and applicable to setting up your plan. 

If you haven’t already, begin to put together your investment strategy using the tools discussed above. If you already have one, use the following questions to review how you are faring: 

1. What stage are you in in life and what are you after? Are you trying to make money or are you investing for the future?
2. What is your risk tolerance? Are you more principal preservation minded or more return minded?

I know I’ve shared a lot of information and detail in this blog. I encourage you to revisit it as often as you need it and if any questions may arise, please do email me at paul@paulslifelessons.com or share your thoughts in the comments section. Your feedback is helpful to me and other readers.

Building a sound investment portfolio requires hard work, discipline and patience; but when done consistently you will reap rewards over time.