The following is a guest post from Mark Biller, the Executive Editor at Sound Mind Investing. I'm a big fan of SMI and have written about the company several times (see Review: Sound Mind Investing and Review: Sound Mind Investing Website). I asked them to cover this topic because I think it's especially appropriate for what many investors are dealing with in today's rollercoaster stock market.
SMI added to this post by creating an offer for those of you who may want to check out their service (for free). Be sure to read all the way to the bottom for details.
When it comes to investing, there’s a lot that you can’t control – the economy, the price of oil, your cousin Bobby’s constant flow of “can’t-miss” investment advice.
However, there’s also a lot that you can control, and that’s where to focus when navigating the often-wild world of investing.
Before you start investing, you should be using a budget (which helps you find the money to invest), be completely out of debt except a reasonable mortgage, and have an adequate emergency fund (typically six months’ worth of essential living expenses). Assuming those steps have been taken, here are three core controllable factors for successful investing.
1. Develop a Written Long-Term Plan
Many people think they have an investing plan. And they do. Sort of. At least until the market drops 10% in two weeks. Then they realize what they really have is a collection of investing tips and vague ideas, all of which tend to ebb and flow based on what’s happening in the stock market.
In contrast, we encourage you to create a personalized, long-term investing plan and put it in writing.
A good place to start is with some of your most important financial goals. When do you want to retire and how much income are you likely to need? Would you like to help your kids pay for college? How much would you like to be able to provide and when?
2. Make Your Most Important Investing Decision
Of all the factors that impact the performance of your investment portfolio, there is one that is far more important than all the rest: how much of your portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. This is known as asset allocation.
The allocation of a portfolio is the primary driver of its expected returns and volatility. Knowing that you have the right allocation should give you confidence that you can keep growing your money at a reasonable rate and with a reasonable amount of risk given your age and investing time frame.
3. Choose the Right Investment Strategy
It’s important that you believe in whatever strategy you choose enough to stick with it during the inevitable downturns. Every strategy will falter occasionally. Bailing out at those times in search of a better-performing approach is the equivalent of buying high and selling low — not a good formula for building long-term wealth.
Whether your strategy involves choosing your own investments or relying on professional advice, here are some important points to keep in mind:
- Instead of hoping for the best, know how you will handle the worst. Nobody really knows what is going to happen next year, next month, or even next week. Your plan must allow for the fact that the markets will experience rough sledding every now and then. That's where diversification comes in. The idea is to pick investments that are affected differently by economic events.
- Your investing plan must be clear and easy-to-understand. This means reducing your decision-making to numerical guidelines as much as possible. A strategy that calls for a "significant investment" in small company stock funds is not as helpful as one that calls for 30% of your portfolio to be invested that way.
- Your investing plan should reflect a balance between your emotional comfort zone and your need for capital growth. You shouldn't embrace a strategy that keeps you from sleeping at night. If you do, you will tend to bail out at the worst possible time. On the other hand, you can't set your risk level so low that you have no chance of meeting your long-term goals.
The primary obstacle for most people as they pursue financial freedom is not the lack of a "perfect" plan; it’s inertia. By moving forward with these principles in practice, you'll be headed in the right direction.
Offer from SMI: The core investment strategy offered by Sound Mind Investing, Fund Upgrading, has beaten the market in 11 of the past 13 years, growing nearly 170% in that time vs. about 42% for U.S. stocks. An SMI web membership usually costs $9.95 per month, but for a limited time Free Money Finance readers can access all that SMI has to offer with a 30-Day free-trial membership (simply click the link to sign up). You’ll be able to use SMI’s tools to help you determine the optimal stock/bond allocation given your risk tolerance and current season of life. And you’ll see what funds SMI currently recommends. Find out for yourself why Sound Mind Investing is the best-selling investment newsletter written from a biblical perspective.
A written plan sounds like a good idea. I have a plan, but it's not written down and I probably should do that. Along with asset allocation, people should figure out their risk tolerance. It's important to know what you can handle.
Posted by: retirebyforty | July 12, 2012 at 10:04 AM
You definitely need to know the risk tolerance that you can handle before buying anything.
My son's 401K has 26 funds available. For the last 3 months, this is what the best and the worst did.
Worst - Janus Worldwide fund --- ANN= -27.43% - Volatility 8.11
Best - Pimco Total Return fund - ANN= +11.96% - Volatility 0.23
To obtain a good performance while keeping volatility within your comfort level it is essential that you have the tools and data to be able to rank the funds available to you and make changes when deemed necessary.
Notice there is 35 times greater volatility in the worst performer as well as the fact that it lost money rather than making money. You would have to be ignorant to have held the worst fund for the last 3 months.
I have never believed in over diversification. The most I have ever had in his 401K is two funds, for the last few months he has only owned the top performer.
Posted by: Old Limey | July 12, 2012 at 12:20 PM