Over the past year, the ways we live, work, and socialize have changed dramatically. It’s as if the events of 2020 hit “pause” on our hurried lives and forced us to reevaluate our priorities and what’s important to us.
2020 also created the perfect opportunity for us all to examine our financial footing and reaffirm our commitment to achieving those bigger picture long-term goals.
But, as some things change, others stay the same. Markets may have dipped and swiftly rebounded to fly higher than ever, but the fundamental principles of smart investing remain unchanged.
The following time-tested, academically based tenets are the building blocks of a sound investment strategy that can carry you through the best and worst of circumstances—no matter the amount of your investable assets.
As financial advisors, we see evidence of the following in our work every day. The most successful investors have the following habits in common:
1) Don’t Just “Wing It”… Invest with a Purpose and a Plan
Investing without purpose is like taking off in a plane without a flight plan. You’re basically crossing your fingers and hoping you land (not crash) in good spot. The endeavor is fraught with danger, and it's not likely to end well.
Smart investors know exactly where they stand today in relation to where they want to be tomorrow. They then develop a strategy they can follow with conviction to get the most out of the market’s returns.
Time and again, for decades on end, studies have shown that investors who adhere to a long-term strategy outperform investors who don't. Having a well-conceived plan keeps you focused on your objectives rather than the unpredictable turns in the market (all while avoiding costly behavioral mistakes that many solo investors make).
2) Mind Your Fees
Nobel Laureate William Sharp was the first to reveal that active fund managers typically underperform the passive fund managers because of the math. He found that "After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period." The average management fee in actively managed funds is around 2%. Combined with other investment costs, including taxes, active fund managers have to outperform by 4% to 5% percent just to stay even with the performance of passive funds, which charge less than 1%. Few active managers are successful in doing so. The difference in fee costs can mean tens or even hundreds of thousands of dollars over a period of thirty years.
3) Diversify Globally
Diversification is an essential risk reduction investment strategy. Proper diversification takes into account that different asset classes have varying ranges and patterns of volatility and, if you exclude a major asset class from your portfolio, you could be creating more risk exposure.
One significant asset class many investors ignore is global stocks. Global stocks, which tend to behave differently than U.S. stocks, represent almost half of global market capitalization, which means if you invest primarily in U.S. stocks, you may be under-diversified.
4) Remember: Tax Planning = Wealth Planning
The savviest investors know that tax planning is wealth planning and never neglect to consider the tax implications of their investments. Why? Taxes can be one of the biggest obstacles that hinders building wealth. With a lower tax liability, you can compound your earnings much quicker.
Tax planning is especially critical in retirement when you need to make your cash flow last a lifetime. Investments that generate income, such as bonds or dividend stocks, are better suited for tax-qualified accounts such as an IRA or 401(k) plan. Investments that generate long-term capital gains, however, may be better kept in taxable accounts that will allow you to benefit from the more favorable capital gains tax rate. These are just a few examples of many; your personal tax strategy will be dependent on the types of resources you hold.
5) Weigh Risk and Return
On the most basic level, most investors understand the correlation between risk and return in portfolio construction—the higher the risk one assumes, the higher the expected return, and vice-versa. When applied deliberately to a properly diversified portfolio, risk is what drives returns. But, of course, none of us can control returns. We can, however, manage risk.
It is through the management of risk that positive, long-term returns are achieved. For example, investors seeking higher returns with a longer time horizon can combine higher risk, higher return investments such as small-cap stocks with lower risk blue-chip stocks for a higher expected return. Older investors seeking more stability can weight their portfolios towards fixed-income investments rather than equities. Choosing the appropriate allocation for your timeline will manage risk in such a way that maximizes potential return.
6) Keep Calm and Invest On
Hands down, the biggest mistake investors make is shifting their focus away from their long-term objectives to respond to the market's short-term performance. This typically occurs in periods of high volatility. Volatile markets lead to volatile investors. Emotions get the best of solo investors and lead to costly mistakes such as fleeing the market during a steep decline or buying during the exuberance of a big market rally. The outcome is almost invariably negative.
It can be hard to exercise patience and discipline in the face of extreme market moves, but investors who are able to insulate themselves from the hyperbolic media and the panicking herd tend to fare much better than those who don’t. Historically, the stock market has rewarded patient and disciplined investors who have conviction in their long-term investment strategy.
Of course, there are timely investment opportunities to take advantage of when the market swings—such as tax-loss harvesting or buying equities at a discounted price in a down market—but abandoning your fundamental investment principles is never one of them.
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Investing is not rocket science. But it does require a certain amount of knowledge, discipline, and strategy to become a winning investor.
It also requires a steady hand to ensure your emotions don't get the best of you. Some even argue this is the true value of a financial advisor—to keep you from making the same mistakes that cost solo investors their good, green money.
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