The 5 Stages of Investing Enlightenment

The following is a guest post from Retirement Savior. I found this piece especially insightful since these are the exact stages I went through (many, many years ago.)

Have you experienced the stages to becoming an ideal investor? It is not difficult to learn the tricks of the trade if you put forth diligent effort. For many people, it follows a common pattern of 5 stages:

1. Seeing Successful Investors, and Trying to get Rich Quick

No doubt you have had friends of family tell you how much they made on a certain stock pick. It's so easy! Maybe they have a new advisor, or they heard it on Cramer or Fast Money. You just KNEW you should have paid more attention when you watched those shows. The next time you see Cramer back up the truck on another stock, you will have to check it out.

After you heard that last tip from your friend or from Cramer, you just had to buy that stock. And what do you know, you bought at the top. The stock price fell 10%, and you thought "It will surely come back, this is just a pullback and other people are taking profits. Once they are done, this stock will jump right back up." Only it didn't, and sunk further.

So you tried another stock, and then another. Every once in a while you could console yourself with a winning stock, but overall, this investing wasn't what you imagined. How could it be so different for other people who got rich, and not for you? You must be the unlucky one. This brings you to the next stage...

2. Realizing You Will Not Get Rich Quick

Did you know that your friends aren't telling you about both their winning picks AND their losers? They generally only tell you the profitable ones. They aren't telling you about the 30% loss in that small tech company that they are sitting on, waiting for the price to get back to breakeven.

If only you knew that you aren't the only unlucky one losing money on hot tips! Everyone who chases these returns, the pot of gold at the end of the stock market rainbow, fails to get rich easily. Only when you realize this can you reach enlightenment stage #3.

3. Educating Yourself about Investments

Why in the world of investing not as easy as you pictured? When you see dozens of stocks that have doubled or tripled in just a few short years, you believe that there must be some way to buy when the stock is low and to know when to sell.

Not at all. Warren Buffett and George Soros can't even buy at the bottom and sell at the top. There is no reason why you should be able to either.

Slowly, you learn that a diversified portfolio is the only free lunch that the market gives you. You learn about ETFs and index funds, and maybe a little about finding stocks of solid companies that are selling cheaply. You learn that the way to better returns is to control your costs, by holding for the long term and only picking funds and ETFs with low expenses.

4. Coming Up with a Plan

So you decide to set up a plan. You calculate how much you should need for retirement. Then you come up with a plan for how much you should save each pay period, month or year. You put that savings in a qualified, tax-sheltered retirement plan, and if your employer offers a match in the retirement plan, you put in the maximum matched amount up to your ability. If you can fund an IRA, you open one of those as well.

You decide your risk tolerance based on your time horizon until retirement, and adjust your asset allocation accordingly. You know that there will be bear markets and drawdowns in your portfolio, but you also know that your strategy will lead to solid returns that will hold up over the long term.

If you want to invest funds on your own outside of retirement plans, then you have a written plan of your risk tolerance, what types of asset classes or securities you will buy, and what your criteria are for taking profits and losses. You also acknowledge that you will not buy based on stock tips, nor from what talking heads spout on TV shows. You do not mind if other people bought a hot stock and you didn't. In fact, you are more concerned about protecting your capital from losses than having high returns.

5. Implementing a Disciplined Plan

Congratulations! You have reached the last stage. Here is where you execute your plan. You contribute your planned amounts to your retirement plans, while investing according to your asset allocation strategy. You will not deviate from your plan, because you know in the end it will get you where you need to go. You continue learning and applying your knowledge to your investing, and realize that you have beaten all of the pitfalls and traps that the investing world lays in your path.

Now if you aren't yet at stage 5, go and make it happen!

Comments

[kenyantykoon]

this is basically my game plan. at the moment i am in the education part- i am reading everything that i can get on my favored investments. its amazing the kind of things that you will find out about any investment when you go out looking. something that i find amusing is the way people that have absolutely no interest in investment seem to know more than you and even choose to advice you on the preferred strategies!!

[Eugene Krabs]

Hehe, not to be a pain, but enlightenment tend to be circular. The master becomes the student once again, except is guided by wide-eyed understanding rather than wide-eyed ignorance.

I suppose then, the sixth step would be to become that successful guy that the people in step #1 are attempting to become. Except they don't yet realize that, in reality, the successful guy didn't actually pick that magic stock or hit it out the field with his first business to become who he is today.

[Retirement Savior]

@KenyanTykoon - Sounds like you're on the right track, and you're right, it seems like everyone has their own strategy or tip that they would like to sell you on.

@Eugene - You hit the mark, no matter how much you learn, and no matter how successful you are as an investor, there is always plenty more to learn.

[Old Limey]

One topic that seems to be taboo with individuals that make their living advising others how to invest their money is "Market Timing".

I have kept daily records of my investment performance since 12/28/1992, the first market day, shortly after I retired, and had moved my 401K and taxable account to Fidelity Investments.

From 12/28/1992 to 10/12/2009 my compounded annual rate of return was 19.24%.
During this same period the Vanguard S&P500 fund VFINX (incl. income distributions) was 7.46%.

In order to be fair I account for money removed from my portfolio for taxes, home improvements, vacations, etc. as if it was still there but has earned nothing. If I had withdrawn nothing at all, my annual rate of return would have been 20.67% rather than the 19.24% shown above.

I achieved this by being a market timer - not the short term type like a day trader but as a "Momentum" investor that rides a rising fund upwards until it stalls out and starts to head down at which time I switched into either a better fund or into the money market fund if nothing better was available.

When I retired I educated myself in the technical analysis of stock trends and with the help of a subscription to a proprietary database of mutual funds and market indexes, and using my engineering and computer expertise I starting writing my own software to perform technical analysis. I also collaborated with a large group of fairly experienced investors that exchanged imformation on a bulletin board frequented by users of the same mutual fund database. I gave these users free use of my software and they beta tested it for me and gave me a lot of good ideas gained from their greater experience as I developed it.

There is no "magic bullet" for market timing, different methods work better for different classes of investments. Losing money is the best teacher of all, and in the beginning I would perform a post mortem on each trade to see what I did right or what I did wrong, and how I should improve the next time.
While market timing is far from being perfect, as you can see from my track record, it greatly outperforms "Buy & Hold" and eliminates disastrous losses. I found that timing signals behaved poorly in real time, but that a combination of diligence, hard work, experience, interpretation of technical indicators and superior fund selection were definitely superior to Buy & Hold. This all required keeping a close eye on one's investments and the market every single market day.

In late 2007 my indicators showed me the deterioration that had taken place in many parameters of market health, plus my portfolio had reached the size where it made good sense to shift gears and become very conservative, and that's what I did. I am now wholly in income investments such as CDs, municipal bonds, and funds that invest in instruments backed by the US government and its agencies. Now I am quite happy with a tax exempt and tax deferred return of about 5%/annum and don't have to worry about anything.

Maybe I have answered my opening statement - market timing takes tools, lots of knowledge, lots of experience and is not practical for everyone.

[Zorak Blomg1]

I am in stage 5, but I still have a lot to learn. Using technical analysis of stock trends and almost can beat the market now.

[FB @ FabulouslyBroke.com]

I'm fairly sure I skipped over #1 because I had no money to invest in individual stocks the first place, but I had already started my retirement accounts with my first company.

But other than that, I went through most of those stages!