How to Avoid Making Irresponsible Investments
When it comes to investing, even the most astute individuals may make a mistake. My view is that most individuals don’t have enough time to study what they should do in order to make wise selections.
In addition, it’s not uncommon for someone else—an investment salesman, for example—to profit from your mistakes. Fortunately, avoiding poor financial choices may save you a lot of money and aggravation.
Take the Time to Diversify Your Portfolio
The average return on the stock market is 10% or so, but if you want to make 10%, you’ll need to own a wide variety of companies. Diversification is essential.
Anyone who takes the time to reflect on this for more than a few seconds will come to the same conclusion, but it’s remarkable how few people do.
For instance, some employees own a large percentage of their company’s shares, but they own very little else. Or they have a small stake in a few companies in the same sector.
It takes 15 to 20 stocks from various businesses to earn money on the stock market. In many upper-division and graduate finance textbooks, the 15 to 20 number is used to describe a statistical computation.
Your portfolio’s returns will almost certainly be better or lower than the market average if you own fewer than 10 to 20 stocks.
Even while you don’t care whether your portfolio returns more than the stock market average, you do worry if it returns less than the stock market average.
To be fair, I should point out that a number of intelligent individuals disagree with my decision to own 15 to 20 stocks.
For example, it is recommended by former Fidelity Magellan fund manager Peter Lynch, for example, that individual investors keep four to six securities they know well.
In his publications, he believes that an individual investor may outperform the stock market average by adopting this technique.
Despite the fact that Mr. Lynch is much more experienced than me when it comes to stock selection, I must respectfully disagree with him for two reasons.
It’s hard to overstate how much Peter Lynch has accomplished in the world of finance. I’m not sure whether he realizes just how strong of an analyst he is when it comes to stock picking.
As a second point, I believe that most ordinary investors lack the accounting skills to properly use the quarterly and yearly financial statements that publicly-owned firms offer in the manner that Mr. Lynch proposes.
Patience is Key!
Every day, week, and year, the stock market and other financial markets fluctuate, but the long-term trend has always been upward.
A year’s return of 26.5 percent has been the worst since World War II. The worst ten-year return in recent history averaged only 1.2 percent per year.
If you take a long-term view, things appear a lot better than they do in the short term. Each year, the worst 25-year rate of return was 7.9 percent.
Patience is essential for investors. There will be more unpleasant years ahead. A terrible year is often followed by another one.
Good years outweigh poor ones, though, over time. They make up for the years when things aren’t going well.
Investors who stick with the market through good and poor years are nearly always better off than those who attempt to ride the latest trend or purchase last year’s hottest company.
Dollar-average investing may be familiar to you. Instead of buying a certain number of shares on a monthly basis, you may buy a predetermined cash amount, such as $100, all at once.
You buy ten shares if the stock price is $10. A $20 share purchase gets you five shares. If the stock price is $5, then you would need to buy 20 shares.
Two benefits of a dollar-average investment are available. You frequently invest in both good and poor markets, which is the most important thing. Because everyone is trying to put out the flames of fear in finance, you keep buying shares even though the stock market is falling.
If you’re looking for a way to diversify your portfolio, dollar-average investing is an excellent option. When the stock market or a specific stock rises, you don’t get carried away by the wave of optimism and acquire a large percentage of the shares.
Even if the market or the price of a stock has gone down, you don’t hesitate to buy a stock.
Participating in an employer-sponsored 401(k) plan or deferred compensation plan is an easy way to adopt a dollar-average investment program.
These programs make it so that every time money is taken out of your paycheck, you are investing.
Dollar-average investing only works if you average each stock separately. There is a specific dollar amount of IBM stock that you must purchase each month, each quarter, or whatever.
Investing Costs Must Not Be Ignored
Investing costs might soon go up. If you’re investing for a long time, even the smallest variances in expense ratio, investment newsletter subscription costs, online financial services (like Quicken Quotes!), and income taxes may wipe out hundreds of thousands of dollars in wealth.
The following are some instances to help illustrate my point. Let’s imagine you invest $7,000 a year from your 401(k) in two mutual funds that mirror the Standard & Poor’s 500 indexes.
Yearly expenses for one fund are 0.25 percent, whereas the annual expenses for the other fund are 1.25 percent. With a 0.25 percent cost ratio, you’ll have around $900,000 in the fund and $750,000 with a 1 percent expense ratio after 35 years.
Another case in point: For example, instead of investing $500 a year in a specialized financial newsletter, you put the money in an IRA, which is tax-deductible.
A tax-deductible investment is a good place to put your tax savings if you can afford it. You’ll have accumulated around $200, 000 over the course of 35 years.
When you consider that you might have invested the money and collected interest and dividends for years, investment fees may quickly mount up.
Don’t Let Yourself Get Angry
Ideally, I’d want a risk-free method of making 15% to 20% a year. I really care about this. There is, however, no such thing.
Depending on how far back in time you want to go, the stock market has historically returned between 9 and 10 percent. Smaller, more volatile equities have performed marginally better than their larger counterparts.
On average, they earn between 12 and 13 percent per year. While 9 percent returns may not seem like much, it’s really very lucrative.
You just have to take your time. This is not true for risk-free investments. In the long run, no risk-free investment has ever made yearly gains that were higher than those of the stock market over the long term.
The reason I bring this up is that when investors become greedy and aim for returns that are far higher than the stock market’s average yearly returns, they tend to make a lot of bad investing selections.
Do not trust anybody who claims to have an investment or investing plan that returns 15%. Under no circumstances should you trust that individual with your money or your financial advice.
The world’s wealthiest individual would soon be someone who had a sure-fire means of generating yearly returns of, say, 18%.
The individual could operate a $20 billion investment fund and make $500 million a year with year-in, year-out returns like that. The takeaway here is that investment does not have any guarantees.
Don’t Try to Be Too Exotic
The bulk of my income has come from evaluating difficult assets over the last many years. But I believe that investors should stick to straightforward investments like mutual funds, individual equities, government, corporate bonds, etc.
Complex assets like real estate partnership units, derivatives, and cash-value life insurance are very difficult for those who have not been schooled in financial analysis to understand and evaluate.
Accurate cash flow estimates are a must-have skill. Internal rates of return and net present values can only be calculated with data from cash flow predictions.
In comparison to rocket science, financial analysis is not nearly as difficult. For this job, you need to have a college degree in accounting or finance, as well as computer and spreadsheet software (like Microsoft Excel or Lotus 1-3-2).