A successful investor maximizes gains and minimizes losses. Although there’s never a guarantee that any investment strategy will work perfectly or lack the risks that all trading involves, you can still improve your tactics. Here are six basic principles that may help you invest more successfully over the long run.
1. Long-term compounding can help your nest egg grow
It’s the “rolling snowball” effect. Compounding pays you earnings on your reinvested earnings. The longer you leave your money at work, the more exciting the numbers get. Hypothetically, if you invested $10,000 and never touched it, and your investment earned an annual return of 8%, after 20 years, it would grow to over $46,000. In 25 years, it would grow to over $68,000! The point is that money left alone in an investment, with compounding interest, offers the potential of a significant return over time.
2. Short-term pain for long-term gain
If riding the ups and downs in the market sounds simple, why do so few individual investors do it? Consider: all the money you invested in the stock market dropping like a rock – you’re bound to have an emotional reaction. On paper, you’ve lost a bundle, and it can be tough to stand idle. The question is if you’ll act according to the downturn or stick to your long-term investment strategy?
It’s important to remember two things. First, the longer you stay with a diversified portfolio of investments, the more likely you will reduce your risk and improve your opportunities for gain. While performance doesn’t guarantee future results, the stock market’s long-term direction has historically been up. Second, some asset categories and individual investments have been less volatile during any given period of market or economic turmoil than others. Though diversification alone cannot guarantee profits protected against losses, you can minimize your risk by properly diversifying your investment holdings.
3. Good diversification is asset allocation
Asset allocation refers to how you spread your dollars within several different investment asset class categories. Broadly these asset classes include stocks, bonds, real estate, and cash alternatives. Getting into more detailed asset classes, you’ll find categories such as Large-Cap Value, Small-Cap Growth, High Yield Bond, Municipal Bond, Commodities, and more.
There are two main reasons why asset allocation is essential. First, the mix of asset classes you own is a significant factor in determining your overall investment portfolio performance. Modern Portfolio Theory suggests that 90% of your portfolio’s return is a direct result of the asset allocation. In other words, the immediate decision about how to divide your money between stocks, bonds, and cash is probably more important than your subsequent decisions over exactly which companies to invest in.
Second, by dividing your investment dollars among asset classes that react differently to the same market forces, you can help minimize the effects of market volatility. Ideally, when investments in one asset class perform poorly, money invested in other asset classes may be doing better.
4. Consider liquidity in your investment choices
Liquidity refers to how quickly you can convert an investment into cash. Generally speaking, the sooner you’ll need your money, the wiser it is to keep it in investments that are comparatively less volatile. You want to avoid a situation, for example, where you need to write a tuition check next Tuesday, but the money is tied up in an investment whose price is currently down. Therefore, your liquidity needs should affect your investment choices. If you need the money within the next one to three years, you may want to consider shorter-term investments like limited-term bonds. If you intend to use the money within the next few months, you may want to reconsider investing it in the first place; investing is for the long term.
5. Dollar cost averaging: invest consistently and often
Dollar-cost averaging is a method of accumulating shares of an investment by purchasing a fixed dollar amount regularly over an extended period. When the price is high, your fixed-dollar investment buys less; when prices are low, the same fixed-dollar investment will buy more shares. Over time, a regular, fixed-dollar investment should result in a lower average price per share than you would get buying a fixed number of shares at each investment interval. To maximize the potential effects of dollar-cost averaging, you should assess your ability to continue investing, even when the market is down.
6. Buy and hold, don’t buy and forget
Unless you plan to rely on luck, your portfolio’s long-term success depends on reviewing it periodically. Circumstances do change over time, and so can our goals as well as our overall economic conditions. It’s wise to consider how these changes can impact a particular investment or an entire asset class. Even if nothing terrible happens, our investments will appreciate at different rates over time. Because of this, your asset allocation will be altered without any action on your part.
It’s important to review your portfolio periodically to see if you need to return to your original allocation. Going through this process is referred to as “rebalancing.” To rebalance your portfolio, you would buy more of the lower asset classes than desired, possibly by using some of the proceeds from asset classes that are now larger than you intended. When finished, your investment portfolio should align with your desired asset allocation. Studies suggest that you should rebalance your portfolio at least once per year and possibly more often if you are a conservative investor. Be aware of potential taxes and fees when you make these changes. Contact your financial advisor or accountant to learn more.