Third Chapter: 5 Ways to Proof Your Investment Recipe

Today's article is a guest submission from Janine Guenther CFA, CMT, a Portfolio Manager and Senior Wealth Family Advisor with over 30 years of industry experience. The views presented here do not necessarily represent those of Bellwether Investment Management.

I love to bake. The way butter, flour, sugar, and eggs come together to create something that's greater than the sum of its parts never fails to fascinate me. As far as hobbies go, you'd assume kneading and proofing dough couldn't be more different from my day job, where the financial markets, valuations, diversification, and prices command unwavering attention.

That said, there is a similarity between the two—the recipe.

I promised in my last post to discuss common mistakes made when building wealth through practical money management. I have made plenty of mistakes in my career, and I've come to acknowledge that they occur when I deviate from the recipe! The positive news is that, unlike dough, you don't need to throw your hard-earned money out and start over if you make a miscalculation—you can make adjustments, remember to practice discipline, and carry on.

Here are a few errors that, once you learn to recognize them, will allow you to pivot and get back on track. I've categorized them below, both for your convenience and to mimic my favourite recipe's formatting.

Behavioural and Emotional Mistakes

1. Falling in love with an investment: Times change, leadership transitions occur, and market dynamics evolve. The company you fell in love with five years ago may not be the same one today. Examples include technology stocks like BlackBerry and Nokia, which have not maintained their position at the forefront of the industry. The pursuit of profits, much like trying to perfect a lemon meringue, requires you to break a few eggs along the way.

2. Letting emotions drive your decisions: When you are fearful or greedy, it can cause you to panic sell or be reluctant to realize gains. For all we've accomplished as a species, the evolution of our cerebral cortex is insufficient to overcome our fight-or-flight response. Having a checklist, advisor, or trusted confidante to guide you through emotionally charged moments can provide an objective opinion on how to improve your dish.

Portfolio Management Mistakes

1. Ignoring diversification: History has shown time and time again that diversifying your holdings across asset classes, geographies, and even fund managers can help build all-weather portfolios. The adage of "don't put all of your eggs in one basket” is especially true in our industry, as spreading out your capital can help mitigate market volatility and better manage risk. Without diversification, we'd be stuck with a few favourites, rather than enjoying the thousands of desserts available to us through a global lens of food.

2. Failing to rebalance: The performance of asset classes and countries can vary significantly. It makes sense to review your portfolios semiannually, or even quarterly, to take profits in areas that have outperformed and to redirect capital towards underperforming sectors with sound fundamentals and an appealing outlook. Although there's something to be said about a warm apple crisp, it's typically best enjoyed on frigid winter nights—come summertime, a colder dish may be more popular and well-suited to the conditions.

Research and Knowledge Mistakes

Chasing trends: Thorough research into emerging trends and products can save you from losses. For instance, certain "meme" stocks seem to have been short-lived sprints rather than long-term marathons. If a recipe calls for baking at 350°F for one hour, trying to achieve the same result in 30 minutes at 500°F may turn into an invitation from the fire department. Remain patient and keep in mind that well-informed, confident decisions are often the best ones.

Buying cheap stocks: “Cheap for a reason” is one of the most accurate statements in financial markets. Investments sometimes drop in value because of listless leadership, poor financial strength, rising competition, or an entire industry falling out of favour. There is a distinction between being costly and being expensive. The former suggests that the underlying value validates the price, while the latter suggests a product may not meet expectations despite its high cost. Applying a similar logic can help you identify undervalued and avoid cheap fodder. There's a reason professional chefs buy the best equipment when it goes on sale, take care of it, and have it last for decades rather than buying cheaper, less durable substitutes.

Risk Management Mistakes

1. Taking on too much or too little risk: In good times, people become overconfident and tend to take on more risk than they typically would. The inverse is equally true. It makes sense to have a trusted advisor who can help put short- and long-term objectives related to individual wealth goals in perspective. Instead of measuring your success with a volatile index, you can build a portfolio that aligns with your personal goals, such as "To fund my retirement plans, I'll need to generate 5% returns to meet my income needs." Saffron is an expensive ingredient—a novice baker would be wise to avoid using—and potentially wasting—their entire supply in one recipe, even if it appears to be an effortless one.

2. Holding losers too long: When you make an error with an investment, it is best to cut your losses and move on. Many might succumb to investment paralysis, convincing themselves they'll get out once they break even. In the meantime, they could have put that money to work in a new investment while avoiding the psychological punishment of checking daily, waiting for it to turn around. Hope, in the investment world, is not a strategy. I've spent more time than I'd like to admit trying to fix a broken buttercream frosting. Thankfully, it's taught me that the true mistake with the sunk cost fallacy is not knowing when to pivot.

Planning, Trading, and Cost-related Errors

1. Investing without a plan: We all appreciate the value of savings, and everyone has a different goal in mind depending on their family, retirement, or education needs. A good friend of mine once said, "A good financial plan knows your goals, but a great one understands the motivations behind them." In other words, it's wise to invest time in understanding the purpose of your money in order to guide your decisions. French cuisine is often heralded as the greatest school of kitchen technique, and at its core is a system called mise en place—every ingredient is prepped and placed perfectly, so when it's time to execute, there aren't any hiccups getting in the way of the plan.

2. Timing the market: It's crucial to stay invested, as no one can accurately predict the market's ups or downs. Trading too much can erode profits, and moving completely in and out of the market can mean that you miss the best upside days. It’s crucial to pay attention to the time, look, and internal temperature of baked goods. For example, underproofing a dough will result in a subpar outcome that's tough, flat, and may not even bake properly.

3. Forgetting taxes: Almost every jurisdiction offers tax-smart ways to keep more of what you earn. For example, in Canada, the tax-free savings account allows you to have an investment portfolio that can grow without any taxes. Strangely enough, not everyone takes advantage of it. Have a discussion with your tax accountant or your financial advisor to make sure you are doing everything you can to help your portfolio grow in the most tax-efficient manner. Admittedly—and I'm shocked to say this—I don't have a baking analogy when it comes to taxes.

With this shopping list of potential errors in hand, I hope you can identify a few areas that can help you steer your investment portfolio in the right direction. The financial markets offer boundless opportunities for those who know how to interact with them strategically, but they also carry their own set of risks. While you cannot control every pitfall, you can influence a surprising amount of them if you take a measured, calculated approach to investing in your future.

In the next blog post, I will tackle the importance of estate planning regardless of your age and stage of life.