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When Investing, Are You Asking These Three Questions?

Robert Steven Kaplan |Author, "What to Ask the Person in the Mirror"

GUEST AUTHOR BLOG: What to Ask the Individual Investor in the Mirror by Robert Steven Kaplan on his new book "What to Ask the Person in the Mirror: Critical Questions for Becoming a More Effective Leader and Reaching Your Potential."

This has been a tumultuous last four years for individual investors. Some have managed well during this period while others have lost a substantial portion of their wealth. Many individual investors are looking for answers regarding where to go from here and wonder what they could do to be more successful.

In my experience, every investor goes through difficult and confusing periods. A key difference between those who ultimately succeed and those who experience weaker performance is, very often, their ability to ask the right questions.

In that spirit, let me focus on three key questions that I believe individuals should spend more time considering. These questions should help you to better understand yourself and your portfolio in order to enhance your ability to become a more successful investor.

Do You Focus Sufficiently on Asset Allocation?

Do you consciously make an asset allocation plan for your overall portfolio? Potential asset classes include US equity, European equity, emerging market equities, government debt, emerging market debt, high yield debt, other types of debt, hedge funds (of various types), private equity, real estate, commodities for starters. This sounds like a long list and each category has different performance characteristics. However long, this list is worth studying.

Why? In my experience, the great bulk of your investment returns will derive from your decisions (implicit or explicit) regarding asset allocation. There is no “right” answer for everyone and the allocation needs to be tailored to consider your age, total wealth, profession (industry correlation), family situation, risk tolerance and other factors.

Most individual investors spend an overwhelming portion of their time on security selection and timing as opposed to asset allocation. Newspapers, television, and magazines focus heavily on security selection and market timing. A substantial portion of fees paid to securities firms are based on selling “products” — mutual funds, hedge funds, complex products/strategies and the like.

Individuals, as a result, tend to construct portfolios that are skewed to single stocks (of their own company), geographic regions (usually their home region) or particular asset classes. As a result, they often overweight domestic stocks and underweight emerging market equities, cash, bonds and alternatives. They tend to spend 80% of their time picking products or securities versus thinking about their overall asset allocation.

What can you do to address this? First, organize your current portfolio into asset class and regional categories. Spend time studying the performance dynamics and key elements of broad asset classes. Ask your advisor to give you his or her firm’s advice regarding an appropriate asset allocation for you. Your advisor can also run historical analyses for you regarding how various asset allocation models might perform in various market scenarios.

It may take several years to develop a better feel for each asset class. My advice is to start now and be more explicitly conscious of your current asset allocation. It is likely to be the most critical determinant of your overall performance.

Do You Manage Your Portfolio to Survive a Severe Downside Scenario (“Tail” Event)?

Have you thought through potential downside scenarios that could confront you and your family — a severe economic downturn, family health issues, loss of job or other events that could have severe negative economic implications for you and your family? In each of these scenarios, will you have sufficient cash and financial flexibility to sustain your family and wealth? These seem like simple questions yet many individual investors choose not to ask them and/or prepare for them.

I was always taught that institutional investors have an enormous advantage over individuals based on their superior information, insight, focus, contacts etc. In recent years, I have begun to question the extent to which this is still true.
Author, What to Ask the Person in the Mirror
Robert S. Kaplan

One piece of strategic advice I regularly give to CEO’s and investors is to assume this economic recovery is going to take far longer than people are expecting. The US household sector is highly leveraged, the US government is highly leveraged (by historical standards) and municipal government challenges are well documented. While the corporate sector is in good shape, western economies have a multi-year de-leveraging process to get through.

While there are likely to be excellent opportunities, you will only be able to take advantage of them if you’re financially prepared on the downside. To do this, it may make sense for you to keep a higher level of cash in your asset allocation (even though it earns very little) and to reduce/eliminate leverage whenever possible. It might also make sense to forego some amount of upside in order to keep “dry powder” in case of a downside scenario. Monitor your asset allocation and ask, “Do I keep sufficient liquidity and downside protection? If not, why not?”

By asking these questions, I believe you will be far better positioned to weather a financial/personal storm as well as take advantage of compelling opportunities when they arise.

Have You Consciously Determined Your Investment Time Horizon?

I was always taught that institutional investors have an enormous advantage over individuals based on their superior information, insight, focus, contacts etc. In recent years, I have begun to question the extent to which this is still true. Institutions must mark their investments to market every day and are evaluated regularly based on their performance. If they have a weak quarter, these mutual funds and hedge funds may face withdrawals. As a result, their time frames have become much shorter and they often can’t afford to wait for an investment thesis to play out.

As an individual, I believe you can take advantage of this phenomenon if you have structured your portfolio appropriately and are emotionally prepared to be patient. You don’t face redemptions or pressure to sell unless you are over-leveraged or do not keep sufficient liquidity to manage for a longer term investment horizon. As a result, you can focus on the longer term fundamentals of an investment or asset class. With this approach, you can also wait for “bargains” even while understanding that those bargains may get cheaper after you buy them.

This approach requires you to focus explicitly on determining your investing time horizon. If it is very short term and you trade frequently, you may often get “whipsawed” and fritter away one of your critical strengths as an investor. If you have the temperament and structure your portfolio so that you have staying power, you can put money to work with a longer time horizon and, I believe, be a more effective investor.

There are numerous other questions and sub-questions you could be asking yourself.

This article is intended to outline three of the basics. I would recommend that you spend more of your “investing” time reflecting on these questions. Choose advisors who are willing to discuss these issues with you and help you learn more.

To be a competent individual investor, you don’t need to have all the answers. I would argue that you do need to ask the right questions. The process of framing and discussing the answers to these questions should help you to become a better investor.  

Robert Steven Kaplan

About the author:

Robert S. Kaplan is a Professor of Management Practice at Harvard Business School and co-chairman of Draper Richards Kaplan Foundation, a global venture philanthropy firm.

Prior to joining Harvard Business School in September 2005, Rob served as Vice Chairman of The Goldman Sachs Group, Inc. with oversight responsibility for the Investment Banking and Investment Management Divisions.

You can learn more about him and is new book "What to Ask the Person in the Mirror: Critical Questions for Becoming a More Effective Leader and Reaching Your Potential."on his YouTube channel.

Email me at bullishonbooks@cnbc.comAnd follow me on Twitter @BullishonBooks