Albert Einstein called compound interest “the most powerful force in the universe.” Of course, this is only true if your interest has time to compound. Starting to save early is one of the most critical steps you can take towards accumulating a portfolio that can carry you through retirement, or whatever your savings goal may be. For each decade you delay your savings program, you will need to roughly double your savings rate to meet the same financial goal.
Saving enough is another critical step toward achieving financial independence. How much you can save is directly related to how much you spend, and in order to have anything left over you must learn to live below your means. Investing provides rewards, but not without risks. Future projections are never certain, and having a cushion is never a bad idea. Millions of investors will have to make difficult decisions as they realize they have saved too little. Not many people would be upset if they find they have saved more than enough.
Risk and reward cannot be separated. Taking on more risk brings the likelihood of higher reward, but also the possibility that the reward might not materialize. Avoiding investment risk introduces another type of a risk- the risk that meager returns will prevent you from accumulating enough assets to achieve financial independence. Determining the appropriate level of investment risk for each individual investor and their specific goals can be difficult. If you have never experienced a bear market, it is best to start out with more moderate levels of risk to see how you react to loss. And loss will certainly occur at some point. You might consider taking on as much risk as you can stomach, or as much risk as is necessary to meet your goals, whichever is less. Your level of investment risk is typically controlled with your overall allocation between stocks and bonds.
STAY THE COURSE
A disciplined investor is a good investor. The best investment decisions are determined with a well thought plan, not made in times of crises or excitement. Come up with your plan and stick to it, through thick and thin. The more you can leave your emotions behind the better.
DON’T TRY TO BEAT THE MARKET
Professional fund managers cannot consistently beat the market by picking winning stocks, and neither can you. Consider the fact that each time you make a trade you are probably buying from or selling to a large, well staffed financial services company, or even an executive at the very company you are trading. To put it bluntly, they know a lot more than you do. Would you consider betting money on a game of golf if you didn’t know who you were playing against? And in all likelihood, you are playing against Tiger Woods or Phil Mickelson. As Charles Ellis would say, it’s a loser’s game.
DON’T TRY TO TIME THE MARKET
Just as professional investors cannot outsmart the market when it comes to choosing individual securities, neither can they outsmart even the broad market direction in the coming weeks, months, or years. It is only over the truly long-term that we may have some certainty with direction the markets are heading (hopefully up). If the market’s next move was so obvious, then hoards of professional investors would have already bid the prices up or down. The only appropriate type of “market timing” is portfolio rebalancing, or resetting your portfolio back to its desired asset allocation and risk level based on a predetermined plan.
Any type of fee is a drag on performance, and it is less money for you. Some level of fees are necessary, but higher fees degrade a portfolio and are rarely worth it. A single percentage point may not seem like much, but as it compounds over time, the portfolio suffers significant losses. Lower fees are what gives passive index funds a clear edge over active management. Advisor fees should also be considered, as they are often excessive as well. Consider what you are getting from your advisor, and if it is really worth what you are paying them. However, studies show that most investors make emotional mistakes, specifically regarding market timing and performance chasing. These types of mistakes lead to a 2-3% annual drag on performance, which over time is extremely damaging. If a good advisor with reasonable fees can help a client stay the course, they are probably worth it indeed.
LEARN TO IGNORE
The financial media exists to sell advertisements in their periodicals and television shows. Your friends exist to brag about their latest great stock pick while failing to mention their big loss. Your monthly statements exist to claw at your emotions. Once you have a solid investment plan you don’t need any of these things, and they will more likely cause you harm. Check up on your progress about once per year, and tune out the noise.
LEARN WHO TO TRUST
Is there anybody you can trust? Yes, but those people are few and far between. The business models of most financial services companies puts their interests at odds with the very clients they hope to serve. This includes most advisors, most fund companies, nearly every broker, most financial journalists, and almost anybody who understands that the money you wish to invest is money they could be slowly transferring into their own pockets. If you need help investing, as most people do, your best bet is to find a good advisor who you trust, who charges a reasonable fee, and who follows a passive or index based investment strategy. As author Paul Merriman says, you can either trust Wall Street (who is trying to take money from you), Main Street (your friends who are trying to impress you), or Academic Street. University researches have little incentive other than to come up with the best ideas and publish them. What do the academics tell us? Buy low cost index funds.
DON’T PAY MORE TAXES THAN YOU HAVE TO
Be sure to take full advantage of tax efficient savings vehicles such as IRA’s and 401(k)’s. Just like fees, taxes are a drag on performance that compounds over time. Avoiding, minimizing, and deferring your taxes on investments is almost always the best option.
LEARN MARKET HISTORY
With a solid understanding of what has come before, it is much easier to prepare for and understand the roller coaster ride of the markets. Risk is real, and crushing bear markets are inevitable, but they usually don’t last forever. They also provide excellent but stomach churning opportunities to cash in on the “rebalancing bonus.”
UNDERSTAND INVESTOR PSYCHOLOGY
Most investors fall prey to a variety of mistakes such as overconfidence, chasing performance, following the crowd, and market timing. We must understand the mistakes that can degrade our performance and learn to avoid them.