This post was originally published on Beyond Your Hammock
Most people want to know how to make money in the market. They want the secrets to become a better investor.
And too often, they believe the answer is some sort of complex, hard-to-understand, or obscure investment strategy.
The truth is, the path to become a better investor who is capable of growing wealth is a lot less exciting than that. There are no “secrets.” And it’s a lot simpler than you might think, too.
In fact, you don’t even need a formal strategy to start improving your results right now.
While you might think success depends on how smart you are with your stock picks, what really separates poor investors — or even just average investors — from excellent ones is usually one of a few fundamental things:
- Good investors don’t panic (or get greedy).
- Good investors learn about the basics of the market, and don’t try to outsmart it (or anyone else).
- Good investors understand the relationship between risk and reward.
- Good investors can tune out the noise and avoid the temptation to fiddle with their portfolios
- Good investors know that they can be their own worst enemy due to the human tendency we all have to make irrational, emotional decisions.
Investing successfully is insanely simple in theory. In practice, it becomes wildly difficult for a number of reasons.
Managing money is challenging, yes, but managing yourself is exponentially harder for most people.
All this being said, you can become a better investor if you can nail the fundamentals and avoid big mistakes along the way. These 5 guidelines can help keep you on track.
1. Prioritize Your Savings Rate (Instead of Obsessing Over Your Rate of Return)
When you start investing, how much you contribute to your portfolio makes a bigger impact than earning a return — even if that return is really great.
All you need to do is look at the math to know this is true. Say you invest $1,000 every month for 10 months. You contributed $10,000. If you earned a 7% return, then you have $10,700 total.
A 7% return is great and most people wouldn’t sneer at $700 extra bucks, either. But you contributed ten thousand dollars. Relatively speaking, $700 is small fries.
But if you keep saving, keep contributing to your investment account, and keep enjoying compound returns, then eventually a 7% return is going to make a much bigger impact on your wealth. Once you have a $500,000 balance, for example, a 7% return here is $35,000. Much more significant.
The more you contribute, the less you have to rely on big investment returns to reach your goals. And in the beginning, the majority of your investment portfolio will be made up of money you contributed yourself.
2. Compounding Returns Require Time to Work
Let’s talk more about those returns. The reason why keeping your money in cash isn’t a viable long-term strategy is that you face purchasing power risk.
In other words, inflation will erode the value of cash over time. At a rate of about 2–3% per year, a $20 bill in 30 years is not going to buy you $20 worth of goods in the future.
That’s why we invest. Historically, investment returns either keep pace with inflation or return even more than what inflation takes away from us.
“Historically” is a key word there, and points to something smart investors know well: the stock market has never produced a negative return if you look at rolling 20 year periods.
But on any given day, the stock market has about a 50/50 chance of closing up or down. On a day-to-day basis, it’s a coin-flip as to whether that day gave you a positive or negative return.
Time in the market matters. Not timing the market, but time in the market. If you only have this week to invest money, you have a pretty good chance of walking away with a loss.
But if you have 20 years… well, again, history shows that there are no 20-year periods where the market averaged a negative return.
Yes, even for periods of time that include big crashes like 2008! If 2008 is a year on your 20-year timeline, that timeline will still show a positive average return.
This is the power of time.
You might already understand the power of compounding returns and how that can help you build wealth. What you need to make sure you also understand is that compounding gets its power from time.
There are a few lessons to take away from this:
- Invest for the long-term and don’t obsess over daily market movements (or even weekly or monthly movements!)
- Investing provides an amazing opportunity to build wealth because it gives you the chance to earn compounding returns on the money you invest
- Compounding works wonders — but only over time.
It’s much easier to begin the process to create long-term growth now rather than waiting until some point in the future.
By choosing to wait, you’re giving yourself an uphill battle to climb. Don’t wait until it’s too late and you have less time to use to your advantage.
3. Understand the Relationship Between Risk and Reward
The only thing that’s really guaranteed when it comes to investments? The relationship between risk and reward.
You cannot get the reward — a return on investment — unless you take some degree of risk.
The more risk you take on, the higher potential return you may earn. It works the other way, too. The less risk you take, the smaller the reward you should expect to return.
To become a better investor, you need to strike a balance between taking on just enough risk to earn just enough return to meet your goals. In other words, smart investors don’t try to go for home runs every. single. time.
Brian Portnoy’s book, The Geometry of Wealth, does a really good job explaining this — and suggesting that, as an investor, you don’t need to try to make the absolute most money possible.
You need to define your goals, understand how much money it will take you to reach those goals, and then invest appropriately. “Appropriately” means taking on an amount of risk that is correlated to the return you need — and not a bit more risk than that.
This is some of what makes “investing” different than “gambling” or “speculating.” And by all means, you certainly are free to gamble or speculate.
But you need to know there’s a difference — and you should never gamble with money that you can’t afford to lose.
4. Don’t Let Your Emotions Take Over
Along with risk, you face market volatility. Volatility is a measure of how much markets go up and down.
These market movements tend to freak people out in one way or another. When markets are up, people get greedy and start buying more. When markets drop, people panic and start selling.
Lots of other things can make people react emotionally, too. Current events, politics, global news — the list goes on and on.
And then of course there are the countless cognitive biases and irrational behaviors that we’re all susceptible to, because we’re all human.
Here’s just a sampling of the common thinking errors investors make that lead to dumb money decisions:
- Over-confidence bias
- Recency bias
- Confirmation bias
- Survivorship bias
- Gambler’s fallacy
- Loss aversion and sunk-cost fallacy
- Misunderstanding the role of randomness, luck, and chance
The problem is not that we get emotional, or have brains that aren’t necessarily compatible with easily understanding the stock market.
The problem is failing to acknowledge this. The problem is in choosing to ignore potential blind spots and cognitive errors that we all make.
The problem is feeling highly emotional and then acting on your emotions rather than sticking to a strategic investment plan.
5. Know the Basics
So far, these guidelines have covered things that you might consider intangible — emotions, mindsets, and basic knowledge.
But part of what it takes to become a better investor is in the tangible and tactical actions you take.
Let’s take a quick look at the basics you need to understand:
Proper Asset Allocation
The right asset allocation for you depends on a huge number of variables — but if you want to boil it down to a very simple rule of thumb, take 125 and subtract your age.
If you’re 40 years old, for example, then 125–40 = 77. That suggests that a good starting point for your asset allocation, or how much of your portfolio is dedicated to a particular asset class, should be about 77% allocated to equities (or stocks) and 23% to bonds.
Again, this is a very simple rule of thumb and the results you get from subtracting your age from 125 does not necessarily mean that’s how you should construct your whole portfolio (and, for that matter, none of this is meant to be investment advice.
If you do want advice tailored to your specific situation, needs, goals, challenges, and opportunities, then consider becoming a BYH client by booking a free 30 minute Exploratory Session.)
Know Your Time Horizon & Comfort/Capacity with Risk
Part of what determines your asset allocation is your time horizon, or the amount of time between when you invest and when you need to use the money you invested.
If you need to use the money in 5 years or less, any investment in the market is likely not a good option. You take on too much risk of losing money, since that amount of time may not be enough to ride out a downturn in the market, or volatility that can cause the value of your portfolio to drop at an inopportune moment.
If your time horizon is 10 years, investing might make sense — but a conservative portfolio that reduces volatility could be a good choice. That way you give yourself a chance to participate in market upside, without putting too much of your portfolio at risk of losses that don’t have time to recover.
If, however, you’re investing to reach a goal like financial independence and you have 15, 20, or more years to get there, investing in the market makes sense — and your asset allocation can be more aggressive since you have time available to ride out a normal market cycle.
In addition to knowing how much time you have, you also need to know your risk tolerance and your risk capacity.
Your tolerance for risk is how well you can “stay in your seat” when you start seeing losses in your portfolio. Can you stomach seeing things lose value and can you be patient enough to sit still and wait for the market to change directions again?
If you can’t stand the thought of losing any money, your risk tolerance might be lower than someone who is comfortable with the idea. On the other hand, your risk capacity is an entirely different thing.
You might be perfectly “tolerant” of risk… but your capacity to sustain actual losses might be limited.
Just because you feel you can handle a potential 100% loss of your investment if the potential for a big reward is on the table does not mean you can actually afford such a loss. That’s where risk capacity comes in.
Once you set your asset allocation, you can’t simply forget it. As markets move up and down, your assets will gain or lose value. Rebalancing means selling positions you now have too much of and buying more of those that you don’t.
For example, say you originally had an asset allocation of 80% stocks and 20% bonds. But due to market movements, you now have 70% stocks and 30% bonds.
You need to rebalance to get back to the appropriate asset allocation for you… which means buying more stocks to get back to 80% of your portfolio being represented by that asset class, and selling bonds to drop back down to 20%.
Rebalancing is something you can do once or twice a year. Just like checking your portfolio, it’s best not to get carried away with high frequency.
A lot of people get tripped up here, because they believe that a total-market Vanguard fund = diversified portfolio. Or that the S&P500 is offering lots of diversification.
Sure, it’s better than a holding a handful of stocks. But the S&P500 represents a tiny fraction of the global stock market. A Vanguard US markets fund is just that: the US market, which is a little over 50% of the total global market.
If you’re failing to pay attention to any investment outside the US, you can add another bias/cognitive error to that list above: home country bias.
Reinvesting Earnings & Dividends
With your investment accounts, you have the option to receive any dividends as checks written to you — or, you can reinvest those dividends into your portfolio.
Make sure you’re reinvesting the dividends so they can add to the impact of compounding returns (especially if you’re in your 20s, 30s, or 40s! Things might change as you get older and closer to your retirement/financial freedom goal.)
Use Dollar Cost Averaging
Dollar cost averaging is a straightforward strategy that can help you avoid market timing and lower the overall, long-term cost of investing in the market.
Dollar cost averaging is as simple as choosing a monthly contribution amount to put into your portfolio, then making that contribution at the same time every month.
For example, you could decide to contribute $1,000 per month to a brokerage account. You can then set up an automatic contribution for $1,000 to hit on the 15th every month.
Then, you let that automatic transfer go to work. You don’t change it or tweak it, no matter what the market is doing.
You contribute through ups and downs — which means your average purchase price will most likely be lower than if you tried to time the market and selectively invested instead.
Enjoy Discounts When They Happen
The one exception to the suggestion above? If you’re a long-term investor (meaning you have a 20–30 year time horizon) then you might want to take advantage of sales on stock when they happen.
The problem is, a “sale” or “discount” on stock happens during downturns. As in, when prices are falling and you might be seeing a lot of red in your portfolio. When people are panicking and the talking heads on TV are predicting doom and gloom.
It’s HARD to see a crash, a correction, or a dip in the market as an opportunity but that is exactly what it is if you have a long time horizon and can use this chance to buy low — and then hang onto those positions as the market rises again at some point in the future.
Leveraging Indices and Mutual Funds
Active stock-picking is a losing game for countless reasons. Instead, consider a passive investment approach by using index funds, index ETFs, or other mutual funds that allow you to quickly, cheaply, and easily invest into the diversified global market.
At Beyond Your Hammock, our portfolios use DFA funds. Individual investors can’t access these unless they use a qualified financial advisor, but if you’re DIYing your investments you can still make use of other low-cost index funds to invest for long-term growth.
Again, these are just the basics to get you started — and if this is all you ever do, it will serve you well enough to be okay.
If, however, you want to be more than just okay, you need to add onto this knowledge and dig into the nuances to build out a more complex investing strategy.
The basics can get you a long way — but if you want to reach your fullest potential for building wealth, let this be just the start of your investing education.
Not sure of where to start? Check out this page for a 2 minute video and a PDF you can download that shows you how to have a better investing experience.