The Importance of Investing via Rules and Formulas

These days, investors are often swamped with information and sales pitches. Between the news pundits; family, friends, and acquaintances; constant market news; and places like Reddit, home of the meme stocks, it’s easy to get overwhelmed and lose sight of what’s right for you.

While it can be fun to have a small portion of your investable assets set aside to take big swings on the latest hot tip, most investors have a long-term goal for their portfolios. Whether it’s funding retirement, paying for kids’ college, or taking that once-in-a-lifetime vacation, there’s a purpose that—in many cases—can’t be put off until later if that sure thing turns out to be... well... not so sure.

For every investor who made a mint off of Game Stop, after all, hundreds or even thousands lost a lot of money.

The antidote to the overwhelm and to chasing big (but unlikely returns) is investing via a set of rules and formulas. These aren’t generic; it’s important that you define them in light of your goals, your timeline, and your capacity to absorb potential losses. Having these rules and formulas gives you a way to evaluate potential investments without getting caught up in the hype.

Let’s look at why this is useful, and what kinds of rules and formulas you might consider.

Why rules and formulas?

When we talk about rules and formulas, we’re usually talking about things like how much new money you’ll invest and how often, or how much of your portfolio you want in different asset classes or sectors.

These guardrails are geared to your unique situation and can help you avoid common investing mistakes.

Many behavioral finance experts have theorized that conceptual biases like anchoring, loss aversion, confirmation bias, familiarity bias, and recency bias, among many others, can interfere with our ability to make sound, rational choices when it comes to investing. We believe having and sticking to your personal rules and formulas can help reduce the potential effects of these biases on your investing.

As we like to say, it’s not timing the market that matters, it’s time in the market. Having a clear and actionable plan for when and how you’ll add new money—and when and how you’ll review your existing investments—could help you avoid selling low and buying high because of market movements, or focusing on what other investors are doing.

Investing impulsively, based on the latest news or a strong pitch, can be costly. More trading can mean more trading costs, making it harder to manage the taxes one owes. A set of rules and formulas can be aligned with tax strategies to help minimize the tax burden.

In other words, using a set of appropriate investing rules and formulas can keep your investing efforts aligned with your overall financial planning strategy.

They aren’t set in stone

Just as your financial plan will change over the years as your needs and time horizon change, so should your rules and formulas. 

For example, your target asset allocation might need to be revised over time simply due to the fact that you’re getting older and may want to shift a portion from stocks (which tend to be more volatile) to bonds (which tend to be less volatile).

Like your financial plan, we believe your rules and formulas should be reviewed regularly, but not too frequently. The whole idea is to give you something stable to work from, after all. Annually is a good cadence for many people, and you may choose to do so less often, especially when you’re further away from retirement.

Rules and formulas to consider

As you’re building your individual plan, there are some common categories of rules and formulas you may want to incorporate.

Timing

How much new money will you add to your portfolio, and how often? Dollar-cost averaging is a time-tested strategy that involves investing the same amount of money on a regular basis, which means you’re investing in bear markets and bull. Planning for how much you can afford to set aside (and how often) can help avoid the temptation to invest more than you can afford right now, because of the fear missing out.

Employer-sponsored retirement accounts like 401(k)s or 403(b)s often work this way, and you can also set up something similar and automatic in your IRA, Roth IRA, or brokerage account.

Asset allocation

Asset allocation describes how much of a given portfolio is invested in basic asset classes like stocks, bonds, and cash. The allocation often gets a bit more refined to include a number of sub-asset classes, like market cap or geography.

Asset allocation should reflect the level of risk that you’re comfortable taking as an investor, as well as the potential upside in your portfolio. An asset allocation that’s weighted more towards stocks may have more potential upside, but also more potential downside. An allocation weighted more towards bonds may have less potential downside, but also less potential upside.

The allocation you’re comfortable with, and the allocation will help you reach your goals, may change as you get near to or into retirement.

Rebalancing

How often will you address the reality that, as investments gain and lose value, your asset allocation will get skewed and will need to be adjusted back in line with your plan? Generally, asset allocation will include acceptable levels of variation from the target allocations, and when the percentage allocation of one or more asset classes falls outside of these ranges, it’s time to rebalance.

That being said, markets can be volatile, and you may not want to rebalance too often, lest you rack up trading costs and complications that the market might have corrected on its own. Many financial professionals recommend reviewing and rebalancing on a quarterly, semi-annual or annual basis. 

Investment types

You can invest in asset classes using different investing vehicles. For example, you may want to use managed investment vehicles like ETFs, which can include equities and bonds, among other things. You may want to focus on individual stocks and bonds.

What you choose will affect and be affected by other parts of your plan, including asset allocation and diversification. For example, you might choose to use ETFs to diversify your investments across and within asset classes, but choose to invest in a few equities directly because you believe strongly in them.

Diversification

How many stocks are you interested in holding? Diversification is important for managing risk by not concentrating too heavily in only a few investments, but it’s important not to diversify so much you dilute the power of your investments.

This won’t be a single number, but it’s likely to be a range that allows you to mitigate the downside risk of concentration—without diluting your investments. That way, your winners can still potentially move the needle in a positive way.

Conclusion

Creating a set of rules and formulas that reflect your goals and your financial plan can help you stick to that plan, avoid taking on investments you don’t understand, and avoid investments that might entail more risk than you’re actually comfortable with.

All investing involves risk and may lose money. The best investing plan is the one that lets you sleep at night—the one you can commit to and use consistently. Using rules and formulas can help you take the anxiety out of investing and feel confident that your choices are aligned with your goals.