Follow Three Steps to Financial Health

Just like you, your portfolio needs regular checkups, too.
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If the first three months of this year have reminded investors of one thing, it's this old adage: "The only thing constant is change."

A big rally was followed by a selloff that spooked many investors, especially less-experienced ones who have never watched the market plummet literally over the course of minutes. Although the recent swoon, in percentage terms, was relatively minor, its shock value was powerful.

Significant market moves -- in either direction -- often prompt people to evaluate their investments: what they own, what they don't own and even what they should own.

While such a reaction is healthy, periodic portfolio reviews should be a regular part of your investment process. Just like a routine doctor's appointment, a portfolio physical will increase your odds of avoiding the emergency room. The good news is that the portfolio review process isn't brain surgery.

Very simply, there are three basic tenets of portfolio-building and management:

  • Know yourself.
  • Know your portfolio.
  • Know your investments.

Let's take a look at each.

The Personal Review

While knowing yourself may seem like the simplest step of portfolio development, it is also the most important. Your goals and objectives and your personal style and demeanor will set the tone for your portfolio.

Think back to the first time you filled out a brokerage application. You most likely completely a rudimentary set of questions about your investment history, age, income and the like. It wasn't a very compelling profile, but it was a broker's attempt to get to know you a little better. Fortunately, if you run your own portfolio, you have a wealth of information about yourself that you can use to develop a much more complete profile.

Ask yourself some questions. What is your primary investment objective: long-term growth, stability or income? What is your investment time horizon? What is your tolerance for volatility and risk? How much of your investment portfolio might you need to access quickly? Are there major events pending in your life, such as marriage, a child, a college education or a new house? Is tax efficiency important in your portfolio? Are there other issues that could impact your investment decision-making process?

Those may seem obvious, but investors don't often think about their investments from a holistic perspective. Rather, they buy and sell individual securities in a vacuum. And far too often, investors look at their portfolios in retrospect and wonder why they own what they do.

Your primary objective, time horizon and risk tolerance are the three key elements of your personal investment profile. Moreover, objective/investment mismatch is the top reason why individual investors become disenchanted with their portfolios and don't reach their longer-term investment goals. Your personal investment objectives can and will change over time.

Countless worksheets and other gimmicks can help you work through the "know yourself" process. Yet, at the end of the day, what it really requires is looking in the mirror, being honest with yourself and candidly assessing what you really want from your investment portfolio.

Believe it or not, this is the hardest part of the process. Once it's done, the rest is relatively objective.

The Portfolio Review

There are two parts of the know-your-portfolio review: the "big picture" and "objective support."

The big picture review is another way of playing one of Jim Cramer's

Mad Money

games, "Are You Diversified?" It's crucial to review your portfolio regularly to make sure it hasn't become too concentrated in any one sector and isn't overexposed to investments that are too closely related in other ways.

Examine all the securities in your portfolio and list the sectors in which they operate. Make sure you have exposure to various business sectors and diverse economic segments. While there's nothing wrong with making an occasional "bet" by being more weighted to a specific sector, individual investors often become far too concentrated because they fall in love with ideas from time to time. Remember, these are stocks, not people.

However, you can be

too

diversified. Simply put, you can own too many stocks. A highly diversified portfolio can contain only five stocks. My good friend Robert Hagstrom, a longtime Buffettologist and portfolio manager of the Legg Mason Growth Trust (formerly the Legg Mason Focus Trust), has had huge success running a mutual fund with roughly 20 stocks. Although the positions were concentrated, the portfolio was also diversified. In this case, numbers are less important than strategy.

The "objective support" portion of the review is even simpler. At regular intervals, you should compare a list of all the stocks in your portfolio with a list of your portfolio objectives. Check to ensure that each investment supports your primary investment objective.

For example, let's say you want income and stability, and you own utility

American Electric Power

(AEP) - Get Report

, REIT

Boston Properties

(BXP) - Get Report

,

Bank of America

(BAC) - Get Report

and

Dell

(DELL) - Get Report

. You'd have an "objective support" issue. Three of the four stocks fit nicely, but Dell is an outlier, so you'd need to ask yourself why you own Dell and whether it fits in your portfolio.

The Investment Review

The final step of the process is the most involved but is in many ways the easiest because it's the most objective. It is driven by easily determined metrics, such as earnings, cash flow, debt, dividends and payout ratios.

It's also simple because it's an ongoing process. Another Cramer-ism fits nicely here: Be prepared to spend an hour a week on each investment you own. You'll need to spend this time reviewing your stocks, fundamental changes and news on both companies and their industries.

If you don't have that much time, you probably own too many companies. Staying on top of your individual investments is key to investment success.

Finally, part of portfolio management is discipline. Know what makes a particular investment attractive and why a particular security is appropriate for your portfolio. Your criteria may include value indicators such as a low price-to-earnings ratio, growth indicators such as an attractive PEG ratio or income parameters, such as a consistently growing dividend. The potential variables are nearly endless, but your process must be consistent.

You also need to cultivate your sell discipline. It's much harder to sell a stock than it is to buy one. As a result, developing a methodology for taking profits and limiting losses may be the most important part of your investment review process.

Market volatility like we've seen in the past two weeks can cause investor indigestion. However, if you're consistently thinking about your portfolio holistically, you'll be better positioned to see opportunity amid chaos. A regular portfolio review will almost always lead to better decision-making and, as a result, better profits along the way.

Eat right, get regular checkups and live longer. Think about your investments, give your portfolio a regular review and live richer. Consider it financial health insurance.

At time of publication, Edmonds had no positions in the stocks mentioned, although holdings can change at any time.

Christopher Edmonds is managing principal at Energy Research & Capital Partners, an energy investment firm and an affiliate of FIG Partners. He is based in Atlanta. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he appreciates your feedback;

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