1. Einstein and the power of compounding. Use it.
Albert Einstein said “The most powerful force in the universe is compound interest” and he just might be right! Over longer time periods, the math behind compounded returns is astonishing because the money you earn from your returns in turn earns more returns. It’s a bit of a tongue twister, but it’s true. A common analogy is a snowball rolling down a hill, getting bigger and bigger, at a faster and faster rate. But…harnessing the power of compounding requires patience because it takes time (typically many years) for the snowball effect to take effect. So start investing early, and be patient!
2. Diversification, the only “free lunch”.
Investment diversification is one of the most important and time-tested investment principles. Most investors do not put all their money in one stock, or even many stocks all in the same industry. Diversifying generally reduces risk because owning more stocks, and different types of stocks, bonds and ETFs, the less the effects of any one investment doing poorly will be. Some people suggest that owning too few stocks is a bit like buying lottery tickets, hoping the ones you buy are the winners, and that owning a diversified selection is the way to build wealth while taking much less risk.
3. Invest for the long-term.
Looking for “fast buck” performance is risky business, often involving guessing and hoping for luck. Investments usually take time to grow, just as companies take time to grow. Focus on investments you are comfortable owning for a time period that fits your wealth building plan, over the long-term. That means avoiding investments where short-term price fluctuations may be a distraction and price declines will make you uncomfortable. When choosing your investments focus on expected long-term returns – think up to 5 or 10 years out. The direction of financial markets can be uncertain in the short-term, by building your portfolio for the long-term you’ll be less likely to make foolish decisions at the first sign of market volatility.
4. Keep it as simple as ABC.
Choose the portfolio mix that’s best for you, which usually means a mix of stocks, bonds and some cash. The best mix of stocks and bonds (which can be bought individually or through ETFs) for you depends on your investment time horizon and risk tolerance. A common rule of thumb is the longer your time horizon and the higher your risk tolerance, the greater your allocation to equities and the lower your allocation to bonds and cash. Investors can be sorted in categories “A, B or C”: “A” for All Stocks, “B” for Blend or Balance of stocks and bonds, and “C” for Conservative investors, who own mostly bonds. “All stocks” may be appropriate for younger investors with very long-term goals or more aggressive investment targets and the time to reach them. A “Blend or Balance” of stocks and bonds is a more moderate approach to investing, adding bonds to a stock portfolio, to take a smoother ride on the journey to financial freedom. “Conservative” investors, mostly in bonds, are generally those who prefer or need to avoid risk, put a high priority on preserving value, and forgo the potential returns that come with owning more stocks, perhaps because they have less time to achieve their investment goals.
5. Consistently put money to work over time.
Investing your money over time can be a good idea because it may result in a smoother ride. It is also a good discipline that will help build wealth gradually. If you invest the majority of your money at any one time, the effects of a market decline shortly thereafter will be increased. However, if you’re investing a small portion of your money every week, month, or quarter, the effects of a big changes in market prices will be reduced.
6. Avoid mistakes.
This may sound like telling a fisherman to fish where the fish are, but it’s important. Investing foolishly or hastily may result in significant price declines, which can seriously affect your approach to investing going forward. Investing is very psychological, and humans are highly prone to becoming overly emotional and subsequently making decisions that aren’t in their best interest. Making foolish investments with high volatility will only increase your susceptibility to these traps.
7. Market volatility is fact of life, don’t let it affect you.
Markets will inevitably experience periods of elevated volatility and it will affect even the best portfolios designed for long-term investing. Whether markets roar higher or drop on geopolitical risk, stick to your well thought-out, long-term plan.
8. Set stepping stone goals and big goals.
This strategy helps with motivation, as you see the benefit of your savings plan, and the growth of your wealth, gradually approaching the goals you want to achieve. If your goal is to have $1 million saved by the time you’re 55, figure out how much you’ll need at 50, 40 and 30 to stay on target, by having ‘stepping stone’ goals. Using stepping stone goals, will make bigger goals seem more attainable and you’ll be more likely to stick to your plan.
9. Take advantage of ETFs.
ETFs can be a great tool for individual investors. ETFs are generally less expensive and significantly increase diversification relative to a basket of hand-picked stocks and bonds. These benefits and others are why many experts say individual investors should focus on using ETFs for the core of their portfolio. On the fixed income side, buying individual bonds is widely considered to be expensive and problematic for individual investors. For these reasons and others, building your fixed income allocation entirely out of bond ETFs is generally viewed as a good idea.
10. Choosing your own stocks.
Before you start choosing your own stocks, keep in mind, picking companies requires lots of work including hours of research and reading. Moreover, it can be very difficult to outperform the market – so much so that even full-time professional investors can have difficulty doing it. For these reason and others, many experts recommend that individual investors use funds, like ETFs, for the bulk of their portfolio. That being said combining your ETF portfolio with some individual stocks can be a good idea, provided you’ve done your homework. Make sure you understand your companies fully and ensure they are likely to be attractive long-term investments with metrics including strong profitability, good products and sound management. When building your basket of stocks, make sure to diversify across multiple industries, while keeping position sizes relatively small, generally within a 1% to 3% range.
11. Some cash can be King.
Keeping a moderate amount of cash in your account is widely viewed as a good idea. A cash allocation can help reduce volatility and if the markets declines significantly or you spot opportunities, you’ll have cash on hand ready to take advantage. There are different views on exactly how much of your portfolio should be held in cash, and the exact amount is often determined by your circumstance, but the numbers typically range from a low as 2% to as high as 10%.
12. Be a learning machine.
Personal finance and investing is a fulfilling, lucrative and fun lifelong project, which you should aim to get better and better at over time. The web is a fantastic resource to help you, filled with useful and interesting tips to help you along the way. Whether it be investing blogs, books, fundamental research or newspapers, you have to be eager to read and learn!