Nobody can consistently predict when the stock market will go up or down. Even the so-called experts are really just going on hunches. If that’s the case, then why would anyone invest in the stock market if they don’t know whether they are going to make more money or lose it? We usually have some expected outcome based on previous experiences. Or at the very least we have some control in how we earn and spend money. If we can’t predict or control when the stock market will go up or down, then what can you control with investing? Well, lots of things, really. Here’s a look at the top five factors that you have control of and their impact as you build up your investment portfolio.
1) You Are Your Own Worst Enemy
Investing is simple, in theory. All you have to do is buy low and sell high. Sounds easy, right? Unfortunately, most individual investors are doing almost the exact opposite. Research data shows that most of us are horrible at deciding when to buy and sell investments. Investors tend to buy near the high-end of the price cycle after companies have been in the headlines for a while and the price has been steadily climbing. Then the stock is seen as overvalued and the price starts falling to well below the price you paid for the stock. After a couple of months of the stock price being so low you start to panic and decide to cut your losses and sell just to hold onto some of the money you have left. Well, that point is typically near the bottom of the cycle and the stock starts to rise again a short time later.
Don’t get too discouraged, this happens to almost everybody at one time or another. This is the result of our irrational mind making decisions based on the feeling of missing out and the fear or losing money. Check out the chart below from Business Insider showing just how horrible the average person is at investing.
The average investor not only underperformed in every major asset class, but didn’t even keep up with inflation!
Fidelity Investments conducted a study a couple of years ago looking for trends in their clients that had the highest returns in their accounts. What they found was unexpected and pretty funny. Fidelity reached out to the owners of the accounts that were performing the best. The catch was that almost all of them had forgotten that they even had an account at Fidelity! These forgotten accounts were outperforming all the other active accounts just because there wasn’t someone making poor emotionally charged decisions on when to buy or sell investments. So stop reacting to how much the stock market goes up and down and let your investments work for you.
One approach I take to make more mindful and deliberate investing decisions is by taking notes. When I buy a stock or mutual fund I write a list of a couple of reasons of why I decided to buy an investment and some conditions when I think I should consider selling. This helps keep me from buying or selling based on emotions or reactions to short-term events.
One critical point to understand is that our financial markets and global economy are far more resilient than we give them credit for. Over the past century, we’ve experienced world wars, recessions, depressions, financial crises and more recent international upsets, such as Brexit and the largely unexpected Trump victory. Although there’s been a bit of volatility and seemingly reasons to panic, financial markets are now close to all-time highs.
2) Stop Paying So Many Fees!
The less you spend, the more you will be able to save. This principle is true for every aspect of finance, not just investing. The two most common fees you are likely to encounter in the investing world are transaction fees and fees charged when you own shares in a mutual fund.
You pay transaction fees when you buy and sell a stock market investment. These fees are usually anywhere from $4 to $12 each time you buy or sell. There are some scenarios where you don’t pay any transaction fees. For example, if you have an account at Vanguard and you buy Vanguard mutual funds, they do not charge any transaction fees. These fees may not seem like very much money if you are investing $1,000 or more but if you make multiple transactions they will start to add up quickly.
The second most common fee is commonly called the expense ratio associated with mutual funds and ETFs. This fee is for the daily operating costs of the company who manages the fund. The fee covers the compensation for the fund manager, administration fees, printing and distributing periodic reports, etc. A small fraction of the annual expense ratio is deducted every day. It is such a small amount daily that I doubt you will ever notice the fee is being deducted from your account each day.
As with anything, with a fee, the lower the better. It is counterintuitive. Usually if you pay more for a service you expect a better outcome or more quality service. In the investing world that is definitely not the case. Vanguard is the widely known as the low-cost leader for investing in mutual funds and ETFs. Fees for mutual funds typically average about 1% a year. But Vanguard funds are typically 0.2% or sometimes even lower. A fraction of a percent might not sound like a big deal or worth worrying about. But due to the power of compound interest it will make a huge difference over the long run. Look at the figures on the graph below.
Yes, an almost $100,000 dollar difference in the value of your investment after 30 years!
3) Invest Based On How Much Risk You Are Willing to Take
Adjusting your investment approach based on how much risk you are willing to take on will keep you out of trouble and very likely make you more money in the end. The goal of diversification is to mitigate risks and huge drops in your portfolio value.
One of the simplest examples of diversification is provided by the old saying “Don’t put all your eggs in one basket”. Dropping the basket will break all of your eggs. Instead, to reduce the risk, place each egg in a different basket and you will be more diversified.
In finance, an example of a portfolio that is not diversified would to have only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. But it is much less common for a portfolio of 25 stocks to go down that much in a single, especially if they are not in the same industry. And if you held hundreds or thousands of stocks, the expected return would still be the same, but you would be exposed to even less risk. The point is that as long as there is no (or very minimal) cost to achieve this type of diversification then you are effectively reducing your risk with no downside.
Another perk of having well diversified investments is when your investments do go down (and they will) that it won’t be all of your investments. One of the easiest ways to maximize returns and minimize risk is by investing in index funds. An index fund is a large group of stocks with the goal of replicating a specific index or benchmark. Keep it simple and stick with index funds and you will be diversified. My favorite index fund is VTSAX, which is Vanguard’s Total U.S. Stock Market Index fund and holds every single stock in the U.S stock market.
4) Use Specific Types of Accounts to Reduce Your Taxes
There are several options available to reduce taxes with your investments. Here are three of the most popular tax-advantaged accounts:
The most common type of account is the 401(k) – an employer sponsored retirement plan. With a traditional 401(k) you don’t pay any tax on the money you contribute. But come retirement age and you go to withdraw money from the account, you will have to pay taxes on the money you initially contributed as well as any capital gains.
An individual retirement account (IRA) is the second most common type of account you can invest through. The tax-advantages of an IRA are practically the same as a 401(k). But there are a few key differences, like the choice to invest in any stock or mutual fund you want instead of being restricted to a dozen or so funds in a 401(k). But the annual contribution limits are a bit lower than a 401(k) at $5,500 a year.
Related: All About IRAs
If you participate in a high-deductible health insurance plan, you are probably eligible to contribute to a Health Savings Account (HSA). A HSA is a tax-advantaged medical savings account. Money you contribute to a HSA is not subject to federal income tax. Also, any money left in the account rolls over and accumulates year to year. Plus, many times you can grow your money within HSA account by investing in mutual funds.
5) Savings Can Make Up for Mistakes
We have all made poor financial decisions in the past and will likely make a few more in the future. Just learn from your mistakes and adjust your financial plan accordingly. The good thing is that you can almost always recover from a few poor financial decisions. Especially if you have at least a few years before you need to use the money. This is one of the reasons why it is encouraged to just get started with savings and investing as early as you can no matter how little you are able to put away.
Savings will be the most important factor in growing your nest egg. When you are just starting out, saving extra money will grow your account much quicker than investment returns will. This is because investing is all about percentages. Let’s say the stock market goes up 10%. Well if you only have $100 invested then a 10% a gain will only get you $10. You could easily have saved another $20 bucks and grow your account much quicker than the $10 gain. But if your account is much larger a 10% gain will have a huge impact. For example a $100,000 investment that experiences a 10% gain you will result in an extra $10,000!
Here’s What To Do About It
So what does all of this mean? Here’s a recap: invest early and often. Have a diversified investing plan that is primarily made up of low-cost index funds. Maximize tax-advantaged accounts like 401(k)s, IRAs, and HSAs when possible. Put your plan on auto-pilot with automatic paycheck deductions and scheduled checking account transfers. Then sit back, relax, and watch your account grow. Remember not to react to adjustments in your investments’ values based on emotion – have a plan for when you want to enter and exit different investments and stick to it. Just remember that past performance of any stock, mutual fund is no indication of future returns so monitor your plan and adjust accordingly.
What is the first thing you are going to do to get better control if your finances and investments?