This is an investment strategy that works, all it takes is a good plan and discipline.
Saving is the process of reserving a portion of current income for future use. Investing is putting those savings to work to increase wealth. Diversifying and rebalancing are investment strategies meant to increase the likelihood of success.
Not So Simply Done:
Most people understand saving. Investing is a much more complicated process which tends to produce feelings of fear and inadequacy in many people. With good reason – over the last 10 years we experienced two market meltdowns and in result, a negative return on U.S. stock market indices. In volatile markets, investors tend to experience see-sawing emotions of fear and greed causing counter-productive behaviors like selling at market bottoms and buying at market tops – a recipe for financial failure.
Some Simple Steps That Lead to Financial Success:
Believe it or not, some investors were able to achieve positive returns over the last 10 years. How did they do it? By being diversified. These successful investors didn’t have all their money invested in U.S. stocks. Sure they had some, but they also owned different types of bond and alternative investments, international and emerging markets investments. These investors also rebalanced periodically – selling assets that gained enough to cause their original asset allocation to get out- of- whack and buying assets that didn’t do so well. The end goal: staying properly diversified so the portfolio doesn’t became too conservative (by having too large a position in fixed income) or too risky (by owning too many stock investments). Over time, this type of portfolio should be less volatile (decreasing the chance of emotional buying and selling), therefore boosting returns.
How to Do it:
1. The first step to building an investment portfolio is deciding which asset classes will be included and determining the target percentage for each asset class. Here is a non-exhaustive list of assets classes to start with: larger-cap U.S. stocks, smaller-cap U.S. stocks, international stocks, emerging markets stocks, investment-grade bonds, inflation-protected bonds, international and emerging markets bonds, real estate, and alternative assets (precious metals, commodities). Basically the more risk you can take, the more stocks you want to own as they have higher return expectations. In addition, large-cap stocks are less risky than small cap and U.S. stocks tend to be less risky than international. Before deciding on an asset allocation, do some research or hire an investment advisor to help you.
2. The next step is choosing the securities within each of the asset classes. Choosing individual stocks isn’t the safest or easiest way to build a portfolio. Most people are better off choosing mutual funds or exchange-traded funds that invest in the particular asset class. For example, there are large cap stock mutual funds and international stock (or bond) mutual funds. Another distinction: there are actively-managed mutual funds and passively-managed mutual funds (better known as index funds). With actively managed funds a manager(s) picks the stocks that go into the fund, with index funds the stocks in the fund are determined by a pre-established index such as the S&P 500. As in everything, there are pros and cons to both – do your research.
3. Once your target asset allocation is set (you’ve decided what percentage of your money will go into each chosen asset class), you’ve invested the money in chosen securities (mutual funds or exchange-traded funds) – you’re set until you decide to rebalance the portfolio. Once a year is realistic and doable. This is how it’s done: Let’s say your U.S. large cap stock allocation was 40% when you started. At the end of the first year it is 50%. At that same time you note that your investment in international stocks went from 20% to 10%. What you want to do is sell 10% of your U.S. large cap security and buy 10% more of your international security thereby rebalancing back to your target allocation. Note you are also selling something that has gone up and buying something that has gone down increasing your chances of making money over your investment horizon.
As you get older and reach retirement, you will want to review your target allocation and add more fixed income. This is only prudent as you transition from earning a paycheck to withdrawing from your investments. However, as we live longer the need to maintain a balance between growth and income is important, so stocks should be a part of most portfolios at any age.