A well-defined investing strategy is one of the cornerstones of a successful financial life. While investing techniques vary widely, all good strategies are built on the same foundation. Here are six core principles you should keep in mind as you plan your own strategy.
Principle #1: Success in investing comes not in hoping for the best, but in knowing how you will handle the worst. Always remember: no one really knows what's going to happen next. Some things can be predicted; most things can't. Since no one really knows what is going to happen, your plan must allow for the fact that the investment markets will experience some unexpected downturns every now and then. That's where diversification comes in. The idea is to pick investments that "march to different drummers." This means your strategy involves owning a mix of investments that are affected by different economic events.
Surprisingly, it is possible to assemble lower-risk investment combinations that give pretty much the same returns over time as higher-risk ones. Both of SMI's core strategies explain how to to build portfolios that combine stocks and bonds in various combinations to reduce volatility and risk while still achieving attractive long-term returns.
Principle #2: Your investing plan must have easy-to-understand, clear-cut rules. There must be no room for differing interpretations. You must be able to make your investing decisions quickly and with confidence. This means reducing your decision-making to numerical guidelines as much as possible. A strategy that calls for a "significant investment" in small-company stocks is not as helpful as one that calls for "30% of your portfolio" to be invested in small-company stocks.
As much as possible, your strategy should not only tell you what to invest in, but also how much to invest and when to buy and sell. SMI can help you know exactly where you stand and what you need to do to stay on course via monthly updates in our newsletter and on our website.
Principle #3: Your investing plan must reflect your current financial limitations. Your plan should prevent you from taking risks you can't afford. Every day, people who mistakenly thought "it will never happen to me" find just how wrong they were. Investing in the stock market isn't a game where gains and losses are just the means of keeping score. Money is not an abstract commodity. For most of us, it represents years of work, hopes, and dreams. Unexpected financial losses can be devastating.
That's why the sound mind approach sets getting debt-free and building your emergency reserve as your two top priorities. Only then are you financially strong enough to bear the risk of loss that is an ever-present reality in the stock market. Other than your IRA/401(k) contributions, we encourage you to not invest any discretionary funds in the stock and bond markets until your debt and savings goals are fully met.
Principle #4: Your investing plan must keep you within your emotional "comfort zone." Your plan should prevent you from taking risks that rob you of your peace. You shouldn't adopt a strategy that takes you past your good-night's sleep level! If you do, you will tend to bail out at the worst possible time. A useful investing strategy needs to reflect both your investing personality and current season of life.
Principle #5: Your investing plan must be realistic concerning the level of return you can reasonably expect. We receive letters asking us to recommend safe investments that will guarantee returns of 10% and more. If by "safe" they mean there's no chance of the value of the investment falling, then we don't know of any investments like that! (Investments that are "safe" in that sense pay much less than 10%.)
The reason any investment offers a higher rate of return is that it has to to reward investors for accepting a higher level of risk. SMI's goal is to help you incur the least risk possible that will still get you to your destination safely.
Principle #6: Your investment plan must allow you to begin investing in small amounts so that you can get started right away and take full advantage of the tremendous power of compound interest. Consider the hypothetical story of Jack and Jill: Jack saved $600 in an IRA each year between ages 8-18, then never added to it again; a total of $6,600. Jill waited to start saving until she was out of college at age 26. She put $2,000 per year into an IRA for 40 years; a total of $80,000. We'll say that both earned the same 10% rate of return.
Who would you expect to have the larger retirement fund at age 65? Surprise! Jack is the winner: his fund has grown to more than $1,078,000 — an amount 162 times more than he put in as a child! Jack's earlier start, even with much smaller amounts and for far fewer years, was too much for Jill to overcome, thanks to the tremendous power of compounding.
That's why it's important to start investing as early as possible and to add to your program regularly. Feeding your account regularly via an automatic savings program is a great idea, as even a small regular investment can grow into a substantial sum over many years. Every dollar makes a difference!
Whether you choose to follow one of SMI's investing strategies or create your own, incorporating these six principles will point you toward success. They're a solid foundation on which to build your financial future.
© Sound Mind Investing