News Flash: Shock and Awe in the Stock Market!
Read my blog entry here on the extraordinary day we experienced in the stock market today (5/6/10) with a nearly 1000 point intraday decline!
Investment 101 - 5 Cardinal Rules
There are clearly many rules one could apply to investing, and I certainly don't mean to imply that these are the only ones that are important, but to keep it simple for beginner investors or even experienced investors who need a refresher, here are 5 basic guidelines that can help you get started:
1. Understand your time horizon. This may seem obvious, but it has many far ranging implications. For one, having the luxury of time affords you the ability to take risks and withstand inevitable market volatility. Is the objective of your portfolio to fund a retirement in 10-20 years, or are you simply seeking to make short term gains to help pay for a home purchase? By understanding your objective and time frame, you can best determine the types of assets that you are willing to invest in to get the desired returns. For instance, If you are an investor in your 20s with many more years to retirement, you can cast a wider net and consider deep value stocks or even investments/assets with illiquidity premiums (essentially a discount for the fact that the asset is more or less locked up, e.g. debt in bankrupt companies that have yet to emerge with a reorganization plan). On the other hand, if you are soon to be retired or are in retirement, your investment choices should reflect the fact that you will need to access the funds and require more stable returns with lower risk (since any losses will have an immediate impact on your lifestyle!).
2. Know your own tolerance for risk and commit to it. Does the potential joy from a $100 profit outweigh the potential disappointment of a $100 loss for you? Or is it the other way around? Investing can be an emotional experience, both in the positive and negative, and knowing your own limitations and preferences can allow you to be more effective in sticking to your strategies, especially when things are not looking good in the short-term. A lot of wealth can and has been destroyed by people who act out of emotion simply because they overestimated their tolerance for risk. This is why small investors often buy high and sell low even though everyone knows the "buy low, sell high" mantra! I personally know folks who have sold at significant losses at the bottom of the market because they realized that they "were not comfortable with the risk of stock investing after all." While I am not questioning that rationale, all I'm proposing is that the time to figure this out is at the beginning, not in the midst of executing your investment strategy!
3. Diversify your portfolio. Many empirical studies have proven that asset allocation is the #1 driver for investment returns and having a diversified portfolio is key to a good asset allocation strategy. For many folks, diversification may simply mean having a mix of asset types, e.g. stocks, bonds, and cash, or even something as simple as picking a few different funds so that "all your eggs are not in one basket". While that's a good starting point, true diversification requires a much broader perspective.
For instance, many people, including professional investors, often make the mistake of not being sufficiently globally diversified. That's particularly important with the continued rise of emerging economies like China and India (see my China article in this section). By many estimates, those two economies will certainly eclipse the size of the US and European economies in our lifetime, but I would hazard to guess that most Americans have portfolios that are still overwhelmingly focused on the US with little allocation to those important markets.
A related point here is that most people don't take into account their home as an asset in their portfolio. But the fact of the matter is that it is not only an asset but is often the largest single investment in most people's "portfolio" - and by definition it is in the US, so it should certainly be factored into any global allocation decisions.
It's also important to diversify across industries. What I've often observed in people (and have been guilty of myself) is the tendency to gravitate to what they know, which are the industries in which they work. This creates a "double whammy" effect given that they are already dependent on that industry for their primary source of income so it's even worse to compound that with over dependence on that same industry for their investments as well. Just ask the folks at Enron or employees of recently deceased wall street firms - I'm sure that's a lesson many of them have taken to heart.
The last aspect of diversification is temporal which relates to my first point first rule on time horizons, meaning that you should have a short, medium, and long term component to your portfolio and the assets you select and type of vehicle (e.g. IRAs, 401ks) used to invest for each of those time frames need to be optimized accordingly.
4. Be realistic - don't overestimate yourself. The reality is that all of us, myself included, are small investors. The market is hard enough for sophisticated institutions with their armies of MBAs and extensive resources to be successful, let alone a small investor. Most investors will have no material advantage on information or insight in particular companies, sectors, or markets from which to gain unusual returns. I often hear people talk about tips from gurus on the radio, their knowledgeable co-worker, or neighbor. The reality is, those folks likely have no more knowledge that will guarantee your success than you (and if they did have some "inside" knowledge, it's most likely illegal!). They may be a source of potential ideas, but it will still require you to do your homework before investing and more likely than not, you will only get out-sized returns if you are willing to take out-sized risks! Another related point here is time. To be a good investor takes time to research, track the performance of different stocks, and to stay connected with the market. There are no short cuts here, so if you don't have the time, you will need to calibrate your return expectations accordingly.
5. Watch your costs. There's a whole topic around whether to engage the services of "helpers" as Warren Buffett would call investment advisors/brokers. That's a great topic for another time. But this last point is about managing investment costs within your control, whether it is investment fees, trading costs, or picking funds with lower fees. At the end of the day, while you won't have any assurances on your market returns other than the fact that they are generally correlated with the amount of risk you are willing to take, you can and should always know your costs. After all, an extra percentage compounded over 30 years can reduce your returns by 30% or more depending on your average annual returns (based on the difference between 5% vs. 6% return for a $100 investment over 30 years)!