The Main Investing Principles That Are Critical For Every Market Participant to Know:
Investing can be an extremely confusing undertaking for most people. It’s safe to say that the average individual doesn’t even know where to begin when it comes to properly building a long-term portfolio. In fact, most people are so afraid of investing that they completely avoid and ignore the reality of it. And the harsh reality is that in most cases we can’t simply earn our way to financial freedom through our own efforts. We have to find ways to make money work for us in order to ultimately make it where we want to go. In direct contrast to this concept, however, only about half of millennials own stocks. So it begs the question – do we understand the core principles of investing? Or are we letting uncertainty and fear hold us back from attaining our financial goals?
Millennials have personally witnessed and lived through the 2008 financial crisis deemed The Great Recession, so that’s probably a major factor in their reluctance to invest. But their fear and hesitancy is most likely only doing them a disservice. In fact, the year following the financial crisis after the S&P 500 hit rock bottom on March 9, 2009, the index surged 70% within those next twelve months. Unfortunately, those who were too scared of the volatility were caught sitting on the sidelines instead of benefiting from this massive upswing. Overall, the financial markets are so vast and “scary” that it can be overwhelming trying to figure where to even start. But with a complete understanding of the main principles, we can move past our worries and fears through understanding, and realize that what we should actually fear is our own inaction. Based on history, sitting on the sidelines just isn’t a winning approach.
1. Take Full Advantage of the Power of Compounding
If there was only one concept that could be committed to memory and marked as critical, it would be the power of compounding. Some of the best-known investors of all time, including Warren Buffet, consider it to be the the most powerful force in investing. Albert Einstein even designated compound interest as the “8th Wonder of the World“. The main function behind the power of compounding is the time value of money, meaning a dollar is worth more right now than at any time in the future due to its earning capacity, or ability to accrue interest. So over time, exponential growth can be achieved by earning interest on both the principal and interest accrued from previous periods. It’s essentially the ability to earn interest on interest or gains on gains.
To give a solidifying example of the power of compounding, let’s consider two investors, John and Bill. John has $25,000 invested right now and Bill has $50,000. For simplicity, let’s say neither of them invest any more money over the course of 50 years and they both earn a 10% annual return. At the end of the 50-year span, John will have $2,934,772 and Bill will have $5,869,543. So over the course of 50 years, the initial $25,000 difference in what John and Bill initially invested ballooned to a massive $2,934,771 difference due to compounding. Utilize this compounding calculator to run more examples, if necessary, but it goes without saying that this is a force that everybody should be trying to take advantage of. When we hear the old adage that “the best time to invest is now”, the power of compounding is the reason why. So start as early as possible in order to give those investments as much time to grow as possible.
2. Diversify Your Investments in Order to Reduce Risk (Asset Allocation)
We’ve all heard the advice “don’t put all of your eggs in one basket” before, and that’s exactly what diversification means. What we want to do is split up our investments across various asset classes, times, sectors, markets, countries, and currencies in order to reduce the risk and volatility involved with any particular one. The various asset classes are stocks, bonds, real estate, precious metals, etc. And some sectors are industrials, financials, communication services, and energy, among many more. The idea of dollar-cost averaging also allows diversification across time instead of trying to guess market tops and bottoms, and throwing all of our resources in at once. This technique is actually used by most individuals with employer-based retirement accounts (401K or 403B) – whether they realize it or not, in which a percentage of every paycheck is deposited into their investment account on a consistent basis (weekly, bi-weekly, monthly, etc.) and is automatically allocated into pre-determined investment funds of their choosing.
Having to diversify across all of these asset classes, sectors, markets, countries, and currencies might seem extremely complicated, but it can actually be quite easy with the utilization of index funds. These funds are essentially built to mirror the performance of a specific index, market, or group of assets. The ticker VTI, for example, is a Vanguard Total Stock Market Index Fund that is a blend of the entire US stock market. It contains stocks within various sectors, ranging from small to large capitalization, with a solid expense ratio of just .03%. So instead of having to buy hundreds of different stocks across various sectors on our own, we can simply invest in index funds that inherently diversify for us. In addition to these types of index funds that are available, it’s also worth noting that many 401K and 403B plans offer target-date funds, which are typically well-diversified with asset allocations based on estimated retirement year. These are common choices in retirement accounts for their simplicity, but as with any investment, always consider the fees and expenses.
3. Avoid High Fees and Consider Tax Implications
This should be a no-brainer, but it’s crucial to consider any sort of fees and expenses associated with your investments. Excessive fees can have an absolutely devastating impact on your portfolio. They’re like termites that may seem small and insignificant on their own, but can add up to cause significant damage to any wooden structure. Just think about the power of compounding and how much of a force it can be over time – well, the concept of compounding also applies to fees, just in the opposite direction of the way we want it to. So it’s important to try to keep them as low as possible in order to reduce the damage. As those who fully understand the impact of fees and taxes say: “it’s not about how much you make, but how much of it you keep”.
Let’s take a look at a few investment fund options for comparison. As previously discussed, index funds are typically some of the best options for diversification while also maintaining low fees. Mutual funds are similar to index funds in terms of diversification, but they’re more actively managed and tend to have higher fees as a result. Hedge funds are exclusively for high net worth individuals and typically require a large initial minimum deposit, in addition to charging hefty asset management and performance fees. It’s definitely worth noting that over 80% of actively managed funds (mutual and hedge funds) fail to beat the market over a ten year span, and that percentage jumps well over 90% over a twenty year span. So investing in them almost always equates to overpaying for underperformance. The results over time have proven again-and-again that these “professional” mutual fund and hedge fund managers aren’t typically able to outperform the market with their “expertise”, yet they’re charging excessive fees for it! So the end result seems clear: index funds offer the passive, diversified, and low-fee attributes that most investors are searching for.
4. Change Your Perspective on Corrections and Bear Markets
Corrections and bear markets are natural realities of the market that we must learn to navigate appropriately. Sometimes the market goes up and sometimes it goes down. It never stays the same. In fact, change is the only constant in the market, so we better figure out how to deal with the impermanence and uncertainty associated with it. The uncomplicated reality is that corrections happen about once every year, and bear markets happen once every three to five years, on average. So if we have a long-term, buy & hold approach, we can expect quite a few short-term setbacks along the way. But we also need to keep in mind that the economic tide (population growth, new technology/innovation, and increased production/efficiency) will generally rise over time, bolstering the value of the companies that make up the economy. Over any ten year period of time, the market almost always rises.
So if we understand that the market generally rises over long periods of time, then why don’t we view corrections and bear markets as amazing opportunities to add assets to our portfolios at bargain prices, especially if we’re far from retirement age? It’s basically a time when stocks and other assets go on sale. In what other scenario besides the financial market would we be complaining about discounts? When we understand the true nature of the market, we realize that pessimism always turns back to optimism, and bear markets always turn into bull markets. In fact, every bear market in US history up to this point in time has been directly followed by a bull market. Oddly enough, even the best days in the market tend to occur within just a few weeks of the worst days. Research has shown that if you miss the best 10 trading days in a year, you can pretty much expect your returns to be cut in half, and if you miss the best 40 trading days, you can essentially say goodbye to any hope of a positive return at all. So if we panic sell and wait for the market to feel “safe” again, or choose to sit on the sidelines the entire time, we’ll most likely miss out on major opportunities by trying to time or avoid the market. Our perspective needs to change from bear market= BAD to bear market = OPPORTUNITY.
5. Only Focus on What You Can Control
The market environment tends to be stress-inducing for most people because of the uncertainty and seemingly chaotic nature of it. But as traders and long-term investors, we have to realize that we can only control what we can control. If we try to control external forces, it will only leave us feeling overwhelmed and disappointed. What we do have control over, however, are our thoughts and behaviors within the market, and this is where the consistently successful investors like Warren Buffett and Jack Bogle separate themselves from the masses. When everyone else is pessimistic, panicking, and acting impulsively, they’re confident amidst the storm. They think and behave in a way that sets them up for true success over time, using corrections and bear markets to their advantage. While everyone else is too caught up in their own emotions, being sabotaged by their minds, these legends are mentally prepared for anything the market throws at them. The masses, however, are not.
One of the general concepts of making money in the market is to “buy low and sell high”. Unfortunately, most people do the opposite. They buy at highs when everyone is feeling optimistic and cheerful, and then sell at lows when everyone is feeling worried and fearful. Seems obvious, but this type of behavior will only lead to losses, yet the majority of people take this same losing approach again-and-again. One solid idea to help investors do the opposite is to rebalance their portfolios every year. To give a simple example, let’s say Bob has a portfolio with 70% stocks and 30% bonds. Over the course of the year, the stock market falls making his new asset allocation 60% stocks and 40% bonds. What he could do is sell some bonds and use the proceeds to invest in more stocks, returning his allocation back to 70% stocks and 30% bonds. This is a tactic that can help investors buy certain assets when they’re out of favor and undervalued and sell them when they’re in favor and overvalued. Overall, focusing only on what we can control is honestly just a fundamental principle of life. It’s common sense and applies to everything. Unfortunately, common sense isn’t always common practice.
Long-Term Investing is 80% Psychological and 20% Methodological, So Focus on Your Mindset:
If we choose not to take advantage of the financial markets, we’ll most likely never hit our goals of “financial freedom”. The meaning of that term can vary drastically from person-to-person, but we’re all striving for that goal. It’s not so much a particular number as it is a feeling. A feeling of freedom to be able to do whatever we want and not have to worry so much about our future. But if we succumb to the fears we have about investing in the first place, and we want the certainty of never seeing losses in the market during corrections and crashes, then we can just keep our savings in cash – earning essentially nothing in interest and not even keeping up with inflation. That route might seem “safe”, but it could actually be viewed as “risky” seeing as it stands virtually no chance of getting us where we want to go. Presently, we have the ultimate choice as individuals. We have the power to decide on whichever path we choose to take.
When it comes to trading and long-term investing, the principles that guide us and even the methods we choose are often fairly easy to understand intellectually, but it’s our minds that we need to monitor like hawks. We need to understand that we all have biases and defense mechanisms that essentially distort our own individual versions of reality. But our own made-up realities often don’t align with the realities of the market itself. We have brains that naturally treat any negative movements in our investment accounts as mortal threats. And the massive internal pain that can cause often results in irrational, erratic, and impulsive behaviors. But those behaviors simply aren’t producing the financial results we want in the market. The good news, however, is that once we become self-aware of the thoughts and behaviors that are leading us down the wrong path, it is possible to re-program ourselves to think and behave in more consistent and empowering ways. So maybe it’s time to make a paradigm shift in order to think and act without fear in the market.
Written by Matt Thomas (@MattThomasTP)
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