10 Basic Investment Principles
Having an understanding of fundamental investment concepts is important for a number of reasons. Knowledgeable investors are more likely to follow their investment plan, are better able to evaluate investment choices, and stay rational in up and down market cycles.
Here are the basic principles everyone should know:
- Invest to Create Wealth
Saving is different from investing. Putting cash in a bank account is saving. Investing involves buying an asset in order to give you the opportunity to earn higher returns while assuming a certain level of risk. History has shown that overtime, investing in stocks can be beneficial because the average return has been 12%.[1]
- The Longer the Better
Investing on a regular basis over a long period of time is the best way to accomplish your long-term financial goals because of compounding interest. Compounding occurs as you reinvest your returns, those returns generate their own returns and increasing your wealth. If you invest $1,000 every year for 30 years (a total of $30,000), earning 8% every year, you will accumulate $330,240.
- Diversify
Dividing your money among various asset classes such as stocks, bonds, commodities, and cash allows you to limit losses in any given period of time. Each asset class has different risk characteristics and the amount you put in each will influence your gains or losses over time. Include as many broad asset classes as possible to help make your returns more predictable.
- Pay attention to Fees and Taxes
Investment costs reduce your returns. The average annual cost of an actively managed mutual fund is 1.5%. Add on the 1% fee to pay your financial advisor and you are in the hole 2.5% every year. Problem is the mutual fund is not outperforming the index and all the buying and selling they do creates taxes that you have to pay.
A better alternative are exchange traded funds (ETF’s) which offer low costs (Vanguard’s averages 0.16%) and little to no capital gains (Vanguard ETF’s had zero distributions in 2008).
- Rebalance Often
When your asset allocation moves from its original plan the risk you could be more or less. In order to keep your investments aligned with your goals, your investments should be rebalanced at least annually. Either use new money to buy the asset that is low or sell some of the winners and use the proceeds to buy the laggards.
- Frequent Buying and Selling Hurts
A 2004 Dalbar Study found that over the last 20 years the average investor earned only 3.51% per year while the S&P 500 averaged 12.98%.[2] This doesn’t account for the commissions for doing all the trades. The same rule applies to using actively managed stock mutual fund managers, 75% underperformed their benchmark in 2008 and 80% of bond fund managers underperformed their benchmark.[3]
- Create a Plan and Follow It
Your plan will give you confidence when times are bad and when times are good. It will be comprehensive in addressing all your financial matters, spell out all the things you want to accomplish, risk profile, asset allocation, and specify dates/milestones.
- Be a Contrarian
When things are up slow down your purchases. When things are down buy more.
- You Decide if You Are a Long Term Investor
Be honest with what you want to accomplish and how the amount of money you are willing to lose. Nothing is worse than buying stocks, losing half of your money and then deciding you can’t handle that much risk. You worked hard for your money and you want to invest it wisely and in a way that makes you comfortable. Instead of making your decisions based on percentages, convert it into dollar figures. Losing $10,000 has a different feeling than losing 10%.
- Work Only With a Registered Investment Advisor
Stockbrokers are not financial advisors. The SEC says so. Stockbrokers are salespeople, not advisors, says the Securities and Exchange Commission. If you want genuine financial advice that is in your best interests, work only with a Registered Investment Advisor.