Although investing may seem like a guessing game, there are consistent principles that promote reliable long-term outcomes. As you consider investing to save for your personal financial goals, understanding these principles can enable you to meet your long-term financial goals with your investments.
DIVERSIFICATION IS THE ONLY FREE LUNCH
Do you know anyone who owned a large amount of General Electric stock to begin 2018? If so, do something nice for them, because their investments likely have had a rough 2018. Once considered a bona fide blue-chip stock, GE has suffered unprecedented drops in valuation over the past few months. This example shouts the lesson: whenever a portfolio is concentrated in a small number of assets, it becomes much more volatile and subject to a host of avoidable risks. These risks can include negative government regulation, industry disruption, or the corporate mismanagement that has plagued GE.
Diversifying your investments means your portfolio owns a broad spectrum of assets. For example, instead of trading a limited amount of individual stocks at your brokerage, you could buy an S&P 500 index fund. From there you could diversify further across international equities, emerging market equities, small cap US stocks, bonds, or real estate. The more diversified your portfolio, the less your portfolio will be vulnerable to the volatility of the individual assets within it. Once you add in consistent rebalancing and a long time horizon, you have a portfolio that has a higher total return than the average return of your individual holdings, and a lower total volatility than the average volatility of your individual holdings. That’s a free lunch if I’ve ever heard one.
UNDERSTAND RISK VS. RETURN
At their core, the best investing strategies seek to maximize return based off a given level of risk. Even within the realms of proper portfolio diversification, there is a wide range of possible volatility. This means that every portfolio needs to be adjusted to the owner’s individual risk tolerance and time horizon. A diversified portfolio for a couple in their 30s is likely not appropriate for a retired couple in their 60s.
Investors need to understand the inverse relationship between risk and return. In general, the more risk you assume with your investments, the higher the potential return. However, not all investment assets are created equal, and not all assets with similar volatility have the same expected long-term return. This implies that each investor should pick the level of risk that they are able to bear and then maximize their return within that risk profile. This helps prevent suboptimal choices stemming from the emotions caused by market volatility. There are plenty of resources to help you determine an appropriate portfolio allocation for your risk tolerance. Try starting with this calculator at Vanguard’s website. Even better, meet with a fee-only financial fiduciary, such as TrueNorth Wealth, to help you construct an optimal portfolio for your needs and help you implement it throughout your life.
FOCUS ON THE LONG-TERM
Markets are unpredictable and cyclical. Since 1949, the S&P 500 has experienced nine different periods of decline, averaging about 33% each time. There is no doubt that these decline periods can be painful; however, these bear markets only last about 14 months on average. Over a longer period of time, the overall market’s return remains consistent. Over the last 6 years the bull market has experienced a 268% increase.
So, when the market looks scary, do not run for the exit. While seeing the short-term erosion of one’s life savings can be traumatizing, one of the worst financial decisions possible can be to sell during a market downturn and then miss the accompanying upturn. Owning a diverse, risk-appropriate portfolio will limit your downside and allow you to thrive through market gyrations, but many people focus too much on short term movements when they won’t use the money for many years. Once emotions enter your investing equation, you are much more likely to make suboptimal decisions. Long-term focus and discipline gives compound interest the freedom to do its mighty work with your nest egg.
Working with an experienced fee-only financial fiduciary can be key to keeping the right perspective towards your investments. A huge part of their role is to be a teacher and behavioral coach to help you keep emotions out of your investment decisions. For many clients of our firm whose emotions screamed to get out of the market during the throes of the Great Recession but didn’t (because of our counsel), their resulting gains in 2009 would pay our fee for many decades.
Keeping a long-term perspective with your investment portfolio works hand-in-hand with diversification and maintaining appropriate risk to safeguard your investment outcomes and help you meet your long-term financial goals. These principles should be the foundation of any investment portfolio and are key to building and securing wealth.