Many people think investing is a complex code to be cracked or an activity that requires advanced degrees to achieve success. It isn’t. At a basic level, there are only a handful of things you must understand to be a successful investor. However, as with many things in life, implementation is the key. Knowledge is useless if not applied, and just because investing is simple, doesn’t mean it’s easy.
So let’s step back and discuss why it is important to be a good investor in the first place. It’s not so you can outperform your neighbor (unless you still really have it out for that 3rd grade bully). Rather, it is to ensure you are better off in the future for having made the decision today to save your money instead of spending it. In fact, the difference between successful and unsuccessful investing could mean achieving financial independence years earlier (or later), whether or not your children graduate college with student loans, or the number of charities you are able to support financially. Embracing, and applying, the following principles will put you on the path to becoming a successful investor.
1. Markets Are Efficient
The prices you see reflected each day in the stock and bond markets are the byproduct of millions of investors globally competing to determine the value of these securities. The number of investors in the market, coupled with the amount of information and computing power available to these investors, creates a scenario where current security prices reflect all available information and future expectations. Against this backdrop, it is extremely unlikely that the average investor (or financial advisor) will consistently generate better returns than those available in the market. Your goal as an investor should be not to outperform the market, but to efficiently capture the returns available in the market.
2. Do Not Try to Time the Market
Similarly, it is nearly impossible for anyone to consistently time the market. Doing so requires making two correct decisions, when to get out and when to get back in. Yes, you may get the timing “right” occasionally, but the timing of such market movements is nothing more than a speculative guess. There will always be periodic corrections and declines in the market. These are healthy elements of global markets and are a reason why stocks produce higher returns than bonds over time. Market declines are temporary pauses within a longer-term advance, and while no one can predict what the market will do in the short-run, there is little doubt what it will do in the long-run.
3. Diversification is Important
Diversification is more than simply the idea of not putting all your eggs in one basket (although this is certainly a key element). It is the idea that, by combining multiple assets globally that don’t move together, you can generate more consistent, less volatile investment returns since the prices of some holdings zig while others zag. While there is no free lunch in investing, diversification comes closest.
4. Risk and Return Tend to be Correlated
Risk is generally defined as volatility, or the amount by which a security’s price fluctuates over time. We like to remind clients that a bad day for stocks is like a bad month for bonds, which is another way of saying stock prices tend to jump around more than bond prices. This makes stocks more challenging to hold, and thus requires a higher return as compensation for doing so. Generally speaking, it is necessary to take on more risk to achieve a higher return, and if something seems too good to be true (such as an investment product that promises the same return but lower volatility or the same volatility but higher return), it probably is.
5. Investing Should be Goals-Based
Investing without a plan is like sailing in the dark without a compass. Without an understanding of where you want to be and when, you can’t know what decisions to make along the way that will get you there. Having a financial plan in place provides an anchor for when market conditions become challenging, and your plan should incorporate the inevitable ups and downs of the market. Therefore, if stock prices become volatile and your long-term goals have not changed, your investment strategy should not change. Also keep in mind that your performance benchmark should not be the S&P 500, or some other arbitrary market index, but rather the returns required to achieve your financial goals.
6. Managing Behavior is the Most Challenging Aspect of Investing
Humans, by nature, are not wired to be good investors. We are emotional beings who tend to swing between states of fear and greed and make the wrong decisions at the wrong time, inevitably buying high and selling low. This is the reason the average investor tends to underperform his or her own investments, often by a substantial margin. In other words, if you invested $100, fell asleep, and woke up ten years later, you would have more money than the average person who made the same investment, simply because you stayed out of your own way. The implications are profound, since selling out at the bottom of a bear market and failing to get back in over a reasonable amount of time can do significant damage to an otherwise sound financial plan. It’s perfectly normal to feel the roller coaster of emotions with investing – the key is to avoid making poor decisions as a result. Investor management is often more challenging than investment management, especially when the investor is yourself.
In some ways, investing can be viewed along the same lines as losing weight. The information about how to do it is widely available and the concepts required for success (consume fewer calories and exercise more) are simple, but implementation can be challenging and people frequently turn to professionals for help because they are unable to do it by themselves. While investment success ultimately comes down to execution, embracing the six concepts described here should provide you with a strong foundation and set you on the path to becoming a better investor.
About MD Wealth Management: We are an Ann Arbor financial planner that specializes in providing financial planning for physicians and retirees. We are CERTIFIED FINANCIAL PLANNER™ professionals and fiduciary financial advisors who operate on a fee-only basis, which means we do not sell financial products or collect commissions. As an Ann Arbor financial advisor, we enjoy working with clients both locally and remotely.