Before you can sit down and decide how to invest your money, you first need to set your long-term investment objectives. What will the money be used for? Retirement? A new home? Child’s education? Once this is determined and you have assessed your time horizon and risk tolerance, it is time build a portfolio. Overall, there are three determinants to successful investing: when you invest, what you invest in, and how those investments relate to one another.
How Your Investments Relate
Research has shown that asset allocation is the main determinate in how well your portfolio performs. As you can see from the chart below, 94% of the variability in returns is due to asset allocation, while 4% is due to individual security selection and 2% to market timing. What is interesting is the 6% from the latter two actually contributed to a negative return of 1% annually! You may be thinking that 1% isn’t that great of a deal. Well it actually is.
If you have $100,000 invested and earn 6% per year for 20 years, you would end up with just shy of $320,000. Take the same investment but earn 5% instead and your investment grew to $265,000. That is a difference of $55,000 or a year’s worth of living expenses!
When to Invest
Realize that you cannot control time the market. To overcome this, you need to learn to take the emotion out of investing. The reason why the average investor only earns 2% per year is because they let their emotions get the best of them and jump in and out of the stock market, aka they try to time the market. By taking your emotions out of the equation, you increase the likelihood of your success.
The lesson you should take away from this is to invest early and often. This doesn’t mean you should jump in an out of investments all of the time. You should pick a good staple of low-cost mutual funds and invest in them over the long-term. They will have ups and downs, but over the long-term, the trend will be positive. Simply keep putting more money into these funds every year.
What to Invest In
The first decision you need to make is what to invest in to start. Look at the historical returns and pros/cons of shares vs property vs cash. When it comes to individual security selection, accept the fact that you cannot pick the stocks that will outperform every year. No one can, not even the professionals. If their job is to beat the market and they cannot do this on a consistent basis, why do you think you can when you devote a weekend to stock picking?
Don’t go for the long ball, play small ball. Save yourself many headaches of chasing returns and instead invest in index funds. These are designed to track the market. These funds have low expenses and low turnover, which are two of the things you need to look for when investing in mutual funds.
That leads us back to asset allocation. This is also something that you have full control over and therefore is the way to increase your odds of successful investing. You need to make sure you invest in a fully diverse array of investments, from domestic to international stocks and include short and intermediate term bonds as well in the mix.
Everyone’s asset allocation will vary depending on their long-term objective, time horizon and risk tolerance. As has been shown above, make sure to take the time needed to structure your portfolio correctly since it has such a great impact of your success. Then at the end of the day, use a return on investment calculator to see how successful of an investor you are.
If you are ready to be a successful investor, I highly suggest you try out Personal Capital. It’s a free website I use that aggregates all of my investment accounts into one place. I track my net worth and can review portfolio and 401(k) fees so that I can make sure I’m not getting overcharged and keeping my hard earned money.
If you don’t have an investment account, take a look at Betterment. They will put you in a portfolio that has the right asset allocation for you from the start. All you have to do is answer a few quick questions and set up a transfer to fund the account. Their fee for doing this is reasonable and I’ve had a great experience with them. If Betterment doesn’t sound like an option to you, check out my online broker comparison chart to find a broker that meets your needs best.
Finally, another option is to look into peer to peer lending. With peer to peer lending, you cut out the middle man and act as the lender for individual borrowers. In many cases, you can earn a higher return than you would get in the stock market for around the same amount of risk, or in some cases less.