Investing Basics

When it comes to investing, people don’t agree on anything. Investors disagree on what to buy, when to buy it, and how long to hold it. Some trade individual stocks or bonds, others only invest in mutual funds. There are disciples of real estate, commodity traders . . . you name it. Some investors believe in using a pure asset allocation strategy. They maintain specific target percentages of their portfolio in specific asset classes (X% stock, Y% bond, Z% real estate,. . .) regardless of what the markets do. Other investors try to time the market (buy low, sell high). Regardless of what method they use, most investors believe that their method is best and every other investment style is inferior.

But here’s the truth. The "best" method to use is one that you understand and can live with. Trying to emulate the success of someone else probably won't work for you unless you have the exact same knowledge and temperament that they have. Here’s another fact: Most investors who think they have the best method are fooling themselves and are almost certainly underperforming the markets.

For the vast majority of successful investors, the key to asset accumulation is to 1) Live Below Your Means (LBYM), 2) Invest regularly, and 3) Let time in the markets work its magic. Obsession about trying to beat the market is more likely to hurt your chances of success than to help you. If you avoid throwing your money at get-rich-quick schemes, invest regularly, and follow a few simple guidelines, the choices of what specifically to invest in are less important than many investors fear.

The simple guidelines:
1) Diversify. Don’t put all your investments in a handful of stocks, for example. Index funds are a great way to do this. They diversify investments across an entire market index.
2) Minimize Fees. If you buy mutual funds you should be looking at the expense ratio (expenses/assets expressed as a percentage). Different mutual funds will have expense ratios that vary from as low as 0.15% to over 4%. Countless studies have shown that over periods of a few decades or longer, fees are the single best predictor of which funds will do best. Higher fees mean poorer performance. It’s that simple. If you buy stocks or bonds directly, look for discount brokers. Fees matter.
3) You don’t have to beat the market to get rich. Timing the market is hard. Despite what your neighbors, colleagues or broker may tell you, the vast majority of people do not beat the market. And the longer the period of time you consider, the fewer the number who actually do. The truth is that your neighbors, colleagues and broker probably spend too much money, have too much debt, and don’t have a clue how their portfolio really did against the market. If you invest in index funds, you will (by definition) match the markets (minus fees). If you put your money in low fee index funds and let time do its magic, you can achieve the nest egg you need to retire. You have better things to do than read corporate 10K forms, study charts and call your broker. If you do choose to try to time the market, you will need to understand your greed/fear levels and control them well as your investments rise and fall. Invest in a good program that will keep track of your returns and be honest with yourself. Studies show that most people who invest this way dramatically overestimate the actual performance of their portfolios.
4) Understand your risk tolerance. Your investments are at risk. Regardless of how you have chosen to save (stocks, bonds, commodities, annuities, houses, or buried in a jar in the back yard) there is a chance you could lose all or part of your investment. The underlying principle that drives investment results is that there is a direct relationship between risk and return. Greater investment risk brings greater potential returns (long term). The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. It is hard to understand risk and its effect on comfort until an investor actually experiences significant declines in their portfolio. Risk tolerance before a market decline is like courage before a battle. Until it is tested, it is difficult to distinguish someone who is brave from someone merely showing bravado. Establishing your appetite for risk involves gauging the potential impact of a major loss on both your portfolio and psyche. You need to make sure you have balanced your high flying investments with enough less volatile investments to let you sleep at night in the event of a catastrophic market crash.

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