I spend a great deal of my time explaining things to my clients as well as many other individuals that do not necessarily revolve directly around specific 'investments'. Over time I have learned that there are a number of issues that individuals should know and understand PRIOR to making investing decisions.
Let's study each one in detail:
Investing in a vacuum is never a good idea.
This sounds ultra simplistic but I cannot count the number of times I have helped someone through these issues. Set and establish goals for your future and determine how those goals are influenced by the results of your investing. It is never wise to invest solely for the sake of 'doing well' or 'I want to retire comfortably'. Goals such as these leave too much ambiguity and room for error. Your portfolio should reflect your goals (to retire at 55 with a specific income), risk tolerance (I feel comfortable with a 8% annual loss exposure) and time horizon (the kids start college in 10 years, I have 18 years until retirement). Think of it this way, you are on a journey. How do you know if you have arrived if you do not know where you are going?
You have an advantage over the pros.
Professional money managers are usually always tied to beating 'the market' month to month and quarter to quarter. They are judged solely by their performance and are therefore influenced to take more inherent risk in order to beat indexes and peers. The professionals also do not have the luxury of holding on (or buying more of) when a specific security starts to tank. You should have no such worries over performance measurement but can simply sit back, focused on the long-term, and wait it out.
Asset allocation is THE most important part of investing*.
Much more so than choosing the right security or being lucky enough to own the next Microsoft, asset allocation determines over 91% of the total portfolio performance according to an Ibbotson study. A good, sound selection of asset classes mixed together will establish the framework of your portfolio performance over the long run.
Investing is risky!
No matter what you invest in there is an inherent level of risk associated with ALL investments. If you choose to be ultra conservative and invest in CD's then you are assuming inflationary and income generating risk. Investing in bonds can contain as much risk as stocks at times.
The level of return you seek is tied to a level of risk, or in other words the higher the rate of return the higher the risk you assume.
Earning a high level of return requires taking more risk, but taking more risk does not always equate to a higher return. It is a well-known fact that in order to achieve higher return rates you must assume a higher level of risk which can and typically does equate to losses within a portfolio greater than many investors are comfortable with accepting. However, just because a holding or portfolio is high risk it is not necessarily capable of generating high returns. In some cases something is considered 'high risk' because it is unlikely to generate a moderate or high return. In fact as Mark Twain once remarked, 'I am more concerned about the return of my money than the return on my money'.
* Asset Allocation cannot assure a profit nor protect against loss. Investments are subject to market risks including the potential loss of principal invested.
The Rule of 72.
Many investors I have spoken with over time wonder about how long it takes to double their money. This is typically presented in a statement that they desire their money to double every 3 or 4 years. The rule of 72 is one of those rules of thumb for quick and basic calculation. Take the rate of return and divide it into 72. This will be the approximate amount of time it takes for the money to double at the specified rate of return. For example, if you assume a 12% rate of return and divide 72 by 12 then your money would double in 6 years. For those of you who wish your money to double every 3 or 4 years this should give you an idea of the level of return (and subsequent level of risk) you must achieve.
Never allow the tax dog to wag the tail of a portfolio or holding.
Tax decisions absolutely have an impact on the overall return of a portfolio but allowing the tax issue to drive portfolio decisions can have detrimental results. I have seen investors hold onto an asset much too long because of not wanting to pay capital gains on the sale of the asset. Instead they realized a much larger loss from movements within the particular asset when the price falls. Make sound investment decisions on logic and do not let the emotion of taxes drive you.
Watch what you watch and read.
Turn off the talking heads on TV and put down the latest investment periodical. These formats are informative if taken lightly and in the proper amount but they are more interested in selling subscriptions and driving ratings than they are about giving quality advice. The movements generated by the advice of those in the television and print media are not always the best for the investor. News only sells when it gets our attention and unfortunately that hardly ever equates to good news.
Good (even great) well-established companies do not always make great stocks.
It seems counterintuitive that a well-established, well-known company would not automatically make a great stock to hold. Good, even great companies can and do falter as well as the lesser-known companies. In fact many of the well established companies get stale and have a hard time growing beyond the boundaries in which they have typically always existed. Too much exposure to too many of these giants can have a less than stellar effect upon your portfolio.
This one could really be 2 in 1.
Do not put more than 10% of your money in your companies stock or within any 1 individual stock. The first part deals with most investors who utilize their 401(k) and have company stock within the plan. If the plan allows it and does not require you to hold a set minimum in stock make sure you have allocated your 401(k) holdings to limit your exposure to your company's stock. In addition, within any portfolio (look at the holdings in the aggregate and not strictly by account) make sure that you have any individual stock position limited to no more than 10% of your holdings. We all think that the stock we have loaded up on is a high flyer and because of their business model or sales or new product coming on the market it is bound to double in price. Every stock you purchase was from someone else who wanted out. Do not expose yourself to excessive risk with excessive positions. Remember some of the big stock blunders of recent years, Enron, WorldCom, K-Mart'the list is long and everyone had a reason to have 30, 50 even 70 or 80% of their holdings within stocks like these.
As I have stated on a very frequent basis, and will continue to do so at every opportunity, investing is risking and should be approached with care. One should never avoid investing but should approach it with diligence and understanding. The lack of knowledge of basics is one of the biggest hurdles I see most investors struggle with in regards to what they are looking for and what they expect. Balance out expectations with reality and see how well they fit. Get a good understanding of investing basics, especially including the emotional side to investing and utilize sound logic and reasoning. Chasing returns on the up side or running away from them on the down side never accomplishes either race. Utilizing logic and emotional balance as well as good asset class selection and you should find a much better fit. You and your portfolio will be much better served and more comfortable as a result.
Securities and investment advice offered through FSC Securities Corporation, A registered broker/dealer, Member NASD/SIPC and a registered investment advisor.
Get registered and learn more