10.5 MIN READ
The investing world can be scary. You likely made or know someone who made investment mistakes. This is completely normal! To be honest, everyone has made investment mistakes – myself included. I bought medical marijuana penny stocks in college that weren’t doing that well …
It is extremely It is difficult to give up control of our hard earned money and invest in something we cannot influence. When you invest, you hope that your money will grow over time and give you a higher return than if it were just cash.
Investing boils down to one art and a science. The art relates to the emotional side of investing (also known as behavioral finance) and the science relates to the actual execution of investing. As technology advances, the science part of investing becomes a commodity – you can get a great investment portfolio at a really low cost.
The art It can be very difficult for someone to invest properly, and this blog post describes how to ensure that you are getting the artwork right.
Why are you investing?
Before you can answer how, you need to answer why. A very common mistake in investing is jumping to the how without really knowing the why. “I want to let my money grow!” is no why. It’s like saying, “I want to travel!” Okay … where do you want to go? For how long? How much is it?
This is surprisingly a very difficult question to answer. There is a lot to unzip a very valuable role of a financial planner. A financial planner will help you and your partner articulate why money is important to you, what your dream life would be like if money weren’t an obstacle, and then determine how much it costs.
If you didn’t define how much money you would need, you run the risk of working continuously and sacrificing time in the endless pursuit of money. This uncertainty about not having enough leads you to keep working and building wealth at the expense of your precious time.
Here is a starting point to start asking yourself: imagine that you are completely financially independent. You have the money you ever need and you wouldn’t have to work a day in your life. What would you do? What would you change How would you spend your time?
Start big and then focus on what is really important to you.
Determine your tolerance for risk
Risk tolerance refers to the amount of investment risk you are willing to take with your money. Higher risk = higher expected return, but at the expense of higher volatility.
There are two components to risk tolerance – yours standby Take risk and your capacity To take a risk.
Your willingness to take risks
This aspect of risk is the most difficult for people because it is related to emotions and the way you are hardwired. Most often, couples have very different risk tolerances. One can be very familiar with risk and one can be very risky. This is some financial DNA helps – it makes us aware of how firmly we are attached to risk.
Your ability to take risks
This aspect of risk is more objective. There are two components of risk capacity –the time horizon for your money and yours Career risk.
The time horizon refers to the time your money will be invested before you are ready to use it. If you start investing today and have no plans to touch your money for 10 years, your time horizon is 10 years. The longer Your time horizon, the higher Your ability to take risks because you can easily endure the market downturns on your journey.
On the other hand, career risk relates to your risk of making money. The higher Your career risk, that lower Your ability to take risks.
Take a doctor, for example. Doctors are always in demand and have skills that can easily be transferred to another hospital / private practice if they lose their jobs. They have low Career risk, which means that their risk capacity is higher with investments.
Now let’s say you left the lives of 9-5 W-2 employees and started a business. Well, now your career risk is higher because your income stream is uncertain. Your business will take time to get up and running, which means your risk of not having an income is higher. In this case, your career is at risk higherwhich means that your risk capacity is lower with investments.
How do you determine your risk tolerance?
Carefully weigh both your willingness and your risk tolerance. It is quite common for these two to be opposites.
If you have one high Risk capacity, but a low If you are willing to take risks, you would likely benefit from better education about how markets work so that you can be more comfortable with the risk of investing. Your risk tolerance is the easiest component to change with education.
However, if you have one low Risk capacity, but a high If you are willing to take risks, you need to carefully weigh the downside risk of a market decline and Your income goes down. It can be difficult for people to take less risks when they are hardwired to take more.
Determine your asset allocation
Asset allocation refers to how much money you invest in risky assets (stocks) and safer assets (bonds). Remember, higher risk = higher expected return.
Once you have determined your investment rationale and risk tolerance, you can decide how much risk you actually want to take. Unfortunately, just determining the level of risk is not enough; you also need to make sure you are investing in it right kind of accounts this corresponds to your time horizon for withdrawing money. This graphic shows a good place to start.
This table assumes that you prefer flexibility over Tax efficiency. This type of savings plan would allow you to withdraw money and experience your money for your entire life, not just age 60, which is what IRS rules are by. In other words, you Don’t buy into the work-till-65 mentality.
One of the most common mistakes I see is people saving on the wrong type of accounts. This is a big reason why I recommend them diversify how you save So you don’t pay high taxes and fines if you use your money before the age of 60.
Choose your investment philosophy
There are two main philosophies in the investment world: active and passive Administration. Active management refers to trying to beat the market. If the S&P 500 index were to return 10% in a year, you would hope that your stock portfolio is producing a return more than 10% this year. Sounds great, doesn’t it? Who wouldn’t want to do better than the market?
The reality is that active managers really stink while trying to beat the index. Here are some highlights from a SPIVA study from 2018:
- 24% of active managers have beaten the S&P 500 in 2018. Okay – so it is possible!
- 13% of active managers beat the S&P 500 over a 3 years. Oh … maybe not.
- 8% of active managers beat the S&P 500 by a 5 years. Uh … so why should I try to find that 8%?
Enter passive management. Rather than trying to find the 8% of managers who outperformed the S&P over a 5 year period, buy really affordable index funds that track the S&P 500 or some other index. Yes, it might not be as exciting as finding the 8% that do better, but framed differently, you do better than 92% of the people trying to outperform the market.
I spent nearly 1,000 hours studying and passing three brutal investment exams to learn all about investing when I received the Chartered Financial Analyst (CFA) award. It taught you all of these complex ways of finding undervalued companies, implementing complex investment strategies, and trying to beat the market. Guess what? Most of the 92% of active managers have the CFA designation and still do not outperform the index.
Instead of paying higher fees and taxes to try to beat the 8%, keep it simple, inexpensive, and be happy to keep track of the index.
Stick to your investment plan
The best, most thought out investment plan in the world won’t work if you can’t stick to it. I’m referring to the emotional side of investing.
We are hardwired to buy more things that bring us joy and fewer things that cause us pain. Why do you think all of the Patriot’s coaches are hired by other NFL teams? The other NFL teams want more of what worked.
But … this is the opposite of buying low and selling high. When the market is fueling we are hardwired to want to sell and to ease the pain when our money goes down. And as soon as the market rises, we feel better and want to buy more!
Welcome to the roller coaster of investing. The most important investment decisions are made in the most painful of situations. When the news tells you the market is recovering, you start to doubt how your investments are distributed, but it does so important Do not leave the ship.
Check out this table from JP Morgan:
If you missed that TEN BEST DAYS or 0.27% of the days from 1999 to 2018 was your annual return 64% lower than if you had stayed invested all along. How crazy is that?
When the market is in free fall, ask yourself, “Have my core values, goals, and reasons for investing changed?” If not, you shouldn’t change your investment strategy
The central theses
- Before you can answer Howyou have to answer Why. If you don’t, then try the dark when it comes to investing.
- Discuss your risk tolerance with your partner. That likelihood is that you have different levels of risk tolerance and it is so important to have an investment plan for you both can stay.
- To keep. It. Easy. There is a common myth that as your money grows, your investments should get more complex. This couldn’t be further from the truth.
- If you want to try to outperform the market, limit exposure to a small part of your portfolio. This is also known as the core-satellite approach. Let your core investments be low-cost index funds and take some small calculated risks elsewhere for better performance. The likelihood is that it won’t succeed, but at least if you are wrong you will limit the harm.
About the author
Jake is the founder of Experience Your Wealth, LLC, a fixed fee virtual financial planning firm that helps young families with student debt strike the responsible balance between paying off debt, investing in the future, and living life now.
Did you know that XYPN consultants offer virtual services? You can work with clients in any state! View Jake’s Find a Advisor profile.