Making smart investment choices is the key to achieving your financial goals. The trick is knowing what a smart investment looks like. There are so many books, magazines and television programs dedicated to the subject, it’s easy to get confused and overwhelmed by the information glut, especially when so called experts provide conflicting advice.
When not kept in check, information overload degenerates into financial info-besity: an unhealthy consumption of financial information that leads to inaction, financial insecurity and in some cases bankruptcy.
Having a basic but well-grounded understanding of a few key investment principles helps filter out the noise and focus on building a flexible framework on which to base financial decisions. It also creates a benchmark to evaluate future investment concepts and strategies.
This piece trims down the sea of advice available on how to invest to five key principles: goals, risk tolerance, balance, cost and discipline. Consider them your five a day portions of fruits and vegetables for healthy finances.
Set clear and appropriate goals. For a goal to be useful, it must be specific, measurable, achievable, realistic and timely. For instance, having the goal of saving $1 million adjusted for inflation by the time you reach retirement age is a useful goal, while just having the objective of becoming rich, isn’t.
How to Set Effective Investment Goals?
Set goals you can describe using numbers, percentages, rates or a set frequency. Like saving 20 percent of your income, contributing $10,000 a year toward your retirement fund or making two mortgage payments a month. Be specific about the beginning and end date of your goal. Deadlines create commitment, urgency and accountability.
Why Do You Need Goals?
Investors without a plan or a goal are like a ship without a rudder who will blindly follow the investment fad of the moment. Without a specific objective to aim for, investors often build their investment portfolios bottom-up, focusing only on investments piecemeal rather than on the big picture. This can move investors to only consider the rate of return of an investment and forget how it fits in their risk profile and whether it is helping them achieve their final objective.
All investments involve some risk. There is no guarantee any particular asset allocation or investment strategy will meet your goals or provide a set level of income. However, not all investments have the same level of volatility or risk. Generally, assets with the highest risk also have the highest potential for profit. How you decide to invest your money will depend on your attitude toward risk, also known as risk tolerance. An investor’s risk tolerance is her ability to endure declines in the prices of investments while waiting for them to eventually increase in value.
How Can You Find Your Risk Tolerance?
Risk tolerance is based on two main factors: your personality and how soon you need to access your investment, also known as investment horizon. Financial advisers estimate the risk tolerance of investors by asking them a set of questions, such as “What would you prefer $50,000 right now or a 50% chance at $200,000?” or “If you owned a stock that lost about 31% in four months, would you sell all the remaining investment, sell a portion, hold on to it, or buy more of the investment.”
Age is often an important variable when setting investment horizons. For instance, if you are 64 and you need to tap into your investment by the time you turn 65, your risk tolerance is very low and you should stick to conservative investments.
A solid investment strategy requires a suitable asset allocation for the portfolio’s goals. Your portfolio’s asset allocation must be in line with your risk profile; based on realistic expectations for rate of return; and should use diversified investments to avoid being exposed to unnecessary risks.
How Do You Design a Balanced Investment Portfolio?
Diversify your investments in stocks, bonds, cash and property according to your objectives and risk tolerance. Historically, stocks are much riskier than cash and bonds, but they also provide much higher returns. Simply avoiding risk is not a smart move with mid to long-term investments. Not including stocks in your portfolio puts you at risk of earning returns that are below inflation, which is tantamount to losing money.
Don’t invest into individual shares unless you’re a trained (and lucky) investor. Attempting to time the market is a fool’s errand for the vast majority of us. Index investing is a cheap and tax-efficient strategy which allows average-Joe passive investors to beat most active professional investors.
What Is an Index Fund?
An index fund is a mutual fund with a portfolio that is designed to track the components of a market index, such as the S&P 500 or the DJ Wilshire. It provides investors with a diversified market exposure, low operating expenses and low portfolio turnover. Do they work? Nothing is certain when it comes to the stock market. However, the S&P 500, an index that tracks 500 large companies with common stock in both the New York Stock Exchange (NYSE) and the NASDAQ stock market, has returned, on average, 9.45% every year 9.45% for the past 20 years. A track record that puts the vast majority of professional investors and active funds to shame.
The uncomfortable truth about markets is that they are unpredictable. However, investment costs are not. They are forever. You can’t control the market, but you can shop around for the lowest investment fees available. The lower your costs, the greater your share of an investment’s return. This may seem obvious, but it is one of the most ignored principles of smart investing.
Believe it or not, the best predictor of a fund’s long term profitability is how much it charges in fees. Lower-cost investments tend to outperform higher-cost investments.
How to Keep Investment Costs Down?
Build your portfolio using low-cost index funds, such as Vanguard 500 Index Fund Admiral Shares (VFIAX), Vanguard Mid-Cap Index Fund Admiral Shares (VIMAX) and Vanguard Short-Term Government Bond ETF (VGSH). Why do I only include Vanguard index funds? Vanguard was the investment company that started the index revolution and it has the lowest costs. Having said that, other outfits, such as Fidelity, iShares and Global X, also provide excellent low-cost index funds.
Investing can trigger strong emotional responses, especially in times of market turmoil. In periods of high volatility investors may find they make impulsive decisions or become paralyzed by fear and fail to make necessary changes to their portfolio. Having discipline and perspective are valuable qualities for investors that can help them remain committed to their goals in times of uncertainty.
As mentioned above, asset allocation is one of the most important decisions an investor can make. However, it only works if the asset allocation is adhered to over the long run through good and bad market environments.
This doesn’t mean you should never re-balance your asset allocations. On the contrary, a disciplined investor will not allow her portfolio to drift aimlessly. It is a good practice to check the performance of your asset allocation every year or even twice a year. If your portfolio has deviated more than 5 percentage points from your objective, it may be time to make some changes.
By its very nature, investing is a risky business. This doesn’t mean you have to be reckless or rely on blind luck. There are countless investment strategies and techniques, but they are all based on just a few principles.
Set clear and realistic goals. Determine your risk tolerance. Create a well-diversified portfolio that is in line with your goals and risk profile. Keep costs as low as possible. Have the discipline to both stick to your investment strategy when it’s on track and the discipline to re-balance your asset allocation when it no longer meeting your goals. Stick to those basic principles and you will probably outperform most active professional investors and keep you financial fitness in tip-top shape.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.