Get some guidelines that will help you invest smarter so you can make your money work for you (while avoiding silly mistakes along the way).
“…but in this world nothing can be said to be certain, except death and taxes,” wrote Ben Franklin. He could have added something like “and the fact that inflation will eat away the buying power of your cash over time” and likely still would have had a point.
It’s this fact that makes investing — especially when you’re young and have a long time horizon to when you need to start tapping the nest egg you can begin building today — a critical step to take if you want to walk the path to wealth.
In this episode, we lead an investing 101 conversation and cover some of the most important topics you need to think about before you invest, including:
- How to set up a truly diversified portfolio
- What to think about when it comes to risk
- Ways to set up your asset allocation (and keep it in balance)
- The right mindset to have around your investments
- How to manage your emotions around the markets
…and more. Jump into the episode here, or check out detailed show notes and takeaways below:
Full Show Notes
Although the stock market is complex, we can simplify things down to a few key components. If you just follow these tenants, you’ll be okay — and “okay” in this case is actually a good thing!
A lot of the time we want better than “okay.” But in this conversation, “okay” is the goal because you can easily overreach when you invest. If you don’t understand the relationship between risk and reward, you’re going to get burned.
Remember, we’re talking about your life savings or your nest egg here. Taking on too much risk means risking losing this money… and you need this money. You only have so much capacity for loss before you’re in serious trouble.
The whole point of saving and investing is because you need money down the road! So if you take on far too much risk trying to chase the biggest possible return, you could end up with nothing. We need to balance the reward you want with the risk you take on.
The big question: how much return do I need?
This is where financial planning comes in. The idea is to say “I have these goals/these things I want/priorities. They will cost money to get or achieve. Here’s how much it costs and here’s when I need the money.”
From there you can back into how much you either need to save or invest to have the money you need to live the life you want.
It’s tough to save a million bucks. But if you save a good amount and invest some and compound the balance over time, you’ll hopefully earn a return that will get you to million.
This is why you need to invest. Investing can help you achieve big goals. Remember that sitting on cash comes with a risk just like investing does: it’s purchasing power risk, or risk that inflation will erode the purchasing power of your money.
We fear loss more than we feel a desire for gain. That’s loss aversion; we’d rather avoid loss than put ourselves in a position to get something when it comes with risk of losing that thing.
Human nature makes us want safety and security (which is why many people don’t want to invest). But you need to think about this from the long-term view.
The long-term is the key focal point when it comes to investing. In other words, don’t get caught up in the day to day! If you look at the market on a daily basis your head’s gonna explode.
No one knows WITH CERTAINTY what is going to happen. The news and the media have a vested interest in playing on your emotions (fear) to meet their goals (clicks/views).
Stop thinking day to day; start thinking in terms of 10-20 years when it comes to investing and the markets.
Did you know? Over rolling 20 year periods, the S&P 500 has never provided a negative return! But the chances of the fund being down at the end of every week are about 65-ish percent. Again: all about that long-term view and what your money is likely to do over a period of decades, not weeks or months or even in a single 12-month time period.
Look at the forest (the long-term), not the trees (today, right now, current events, etc).
The temptation to look at your portflio daily is strong, and it’s hard to manage if you don’t have a systematic way to invest. This is where dollar cost averaging comes into play.
Dollar cost averaging is when you have a set amount of money you contribute on a set day, every single month. You consistently put that money in and you don’t decide whether you do or don’t; it just happens.
Over time, that will help you get a better outcome. This is why 401(k)s work so well; if you contribute to a 401(k) you’re already dollar cost averaging with that plan.
This doesn’t mean there are any guarantees. There are not. But probability says over the long term you will earn a return.
If you dollar cost average, you don’t have to look at your portfolio. The more you look, the more you’re going to be tempted to tinker. Check on your investments maybe once or twice a year instead of obsessively looking at them daily, weekly, or even monthly.
…assuming, of course, you’ve set up your portfolio correctly and you can let it ride. Let’s talk for a moment about how to get that set-up portion right.
Only when you set up the right investment allocation can the rest of the system work. If you pick the wrong investments and then set it on automatic mode, that is not going to end well.
You need to understand diversification — actual, global diversification. PS: The S&P500 is not “diversified,” BTW. The index represents large-cap companies in the US (about 504 of them). Those are the companies you invest in when you invest in the S&P500.
500 companies in the US. Meanwhile there’s an entire global market that exists that you’re not taking part of, so you may not be as “diversified” as you think. The entire US stock market is about 55% of the global market.
It’s quite easy to invest in the global market; Vanguard and Fidelity both have offerings that allow you to invest in a single fund to get exposure to the global market. If you do that, your portfolio is much more complex than it looks and much more diversified than a single US index.
Also make sure you’re diversified in terms of what accounts you use to invest. You might not necessarily want to throw everything you have into your 401(k), for example. You might want to contribute to a tax-deferred account like that, but also contribute to something like a brokerage account.
Investing in retirement and non-retirement account also allows you to spread your tax burden a bit, because tax rates in the future are something we can’t control.
We can’t guess or speculate with tremendous accurate, so we want to hedge our bets — again, it goes back to that idea of avoiding unnecessary risks.
Asset allocation and rebalancing are other important concepts to know, understand, and use to manage your portfolio and to get a successful outcome from your investments.
Your asset allocation will depend on not just your risk tolerance but also your capacity for risk. It doesn’t really matter how emotionally comfortable you feel about “risk” if you only have a year to invest — you shouldn’t invest that money because your risk capacity is too low for the market.
One other thing to consider — most people under-perform the market with their investments because they get emotional, and they make emotional, irrational decisions. Most bad decisions come back to one of two things: fear or greed, and usually fear.
Keep calm and carry on, friends.
Further Reading & Resources Mentioned in the Show
- Check out the first section in this article on rolling returns for various indices. The S&P500’s worst return, if you look at 20-year rolling periods, was a little over 6%. Not even a negative number! (via The Balance)
- “Stocks are a LONG-TERM investment. So stop checking them like they are your Twitter feed.” — Ramit Sethi
- For more on some of the investing philosophies we subscribe to, check out Harry Markowitz, the Efficient Market Hypothesis, and the Three Factor Model
- MSCI World Index
- How to Be Rich (Hint: A 401(k) Alone Won’t Get You There), via Kiplinger
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