The world of investments can seem complicated. There are many different assets to invest in, many different risk factors, and many different theories about which strategy is best. Yet, while there are many different investing styles, certain principles are universal. Investing can be much more lucrative than simply saving money in a bank—but there are also extra risks. Whether you are a beginner or a certified pro, it is vital to keep these four maxims in mind.
Respect the Market
Investing money wisely is as much about understanding what you don’t know as what you do know. The amount of potentially investable assets is truly huge, from postage stamps to collateralized debt obligations. It is vital to remember that the market is made up of millions of other investors, many of whom are specialists in their respective fields.
Let’s say you think a particular asset is undervalued. If we are dealing with a liquid market, the market price represents the fair value of an asset as determined by thousands or even millions of market participants. While it is certainly possible to beat the market, you should always ask yourself “Why is the market wrong? Why am I right?”
This is important whether your assets are going up or down in value—but it is often most important when you are having a winning streak. Although you might feel like you’re on the top of the world, winning blinds you to potential mistakes. It is very easy to get overconfident about your prowess, when you might have just been lucky.
For years, academics argued for the “random walk” theory of investing, and some still believe in it today. Essentially, this school of thought argues that market prices cannot be predicted, thus making it impossible to consistently outperform the market. Regardless whether it is true, the fact that most hedge funds fail—the average lasts only five years—shows us that even investors who are paid handsomely to be the very best often fail to predict market trends.
Although historical performance does not guarantee future returns, in the long run the stock market has generally outperformed most other asset classes. The best way to get exposure to the stock market for someone without specialized knowledge is to invest in an index fund—a low cost fund that tracks the performance of the market as a whole.
Diversification reduces risk. This is probably the single most important aspect of portfolio management, and is something you should never forget. Even more importantly, diversification between assets that are not correlated further reduces risk.
Think about a $100,000 portfolio that only includes gold. This $100,000 is completely subject to the risk that the price of gold changes. If gold falls 50%, the portfolio is suddenly worth $50,000. This investment is not diversified, and exposes you to ruin if gold falls dramatically.
Now consider a portfolio that is half gold and half technology stocks. For this same portfolio to fall to $50,000, either gold and tech stocks must both drop by 50%, or an even larger fall in one asset must take place. This is a better, but still not ideal.
Now consider a $100,000 portfolio that is equally weighted between 10 different assets. For this portfolio to lose half its value, we would need 10 different assets to lose an average of half their value—or five assets to lose all of their value. While it is easy to imagine a single asset losing 50% of its value, it is rare for 10 different assets to do it all at the same time. It is easy to see why this portfolio is much more protected from a large swing in value.
True diversification means investing in uncorrelated asset classes. Similar assets often rise and fall together. Thus, a portfolio of gold and silver is only weakly diversified, while a mix of technology stocks, commodities, emerging market assets, and real estate is more strongly diversified.
If a financial crisis hits, most finance stocks will fall. If there is a tech bubble that bursts, valuations in the sector will generally fall across the board. Thus, ensuring you have different assets in different sectors is key to achieving true diversification.
Diversification is important because the value of assets can rapidly change in unpredictable ways. Speaking of precious metals, aluminum was once more expensive than gold, and Napoleon III’s most honored guests used aluminum cutlery, while those lower on the totem pole had to settle for silver. Technological changes that began in the late 1880s eventually made aluminum so cheap that we now use it to wrap sandwiches and burritos.
While the 19th century price of aluminum may seem irrelevant to us today, there are plenty of modern examples. Copper lost around 50% of its value in 2008. Lehman Brothers went bankrupt the same year. Big changes can and will happen. Diversification helps protects you from big changes.
Diversification works because it spreads risk among different assets, making it far less likely that any one event will wipe out your portfolio. Although academics disagree about the optimal number of assets needed to achieve diversification, it is generally understood that most of the benefits from diversification can be achieved with 10 or so different assets.
Understand Compound Interest
Compound interest is your friend. It is a simple mathematical fact that underlies nearly every investment strategy. So what is compound interest and why is it so important?
Compound interest is simply interest that is reinvested towards your investment principal. It is simple and powerful. Let’s look at an example.
Let’s say you have a $1,000 savings account with a 10% interest rate compounded annually. At the end of that first year, you earned $100 (10%) of your initial $1,000 investment, and now you have $1,100. Here’s where the compounding comes in. Assuming you leave the $100 of interest in your account, that money works just as hard as your original investment. It earns 10% too. So, at the end of your second year, you now earn $110, bringing your total to $1,210. These changes might seem small, but in the long run, these small changes have big results.
JP Morgan Asset Management made a chart illustrating the power of compound interest through three different savers. Susan, the dashed line, invests $5,000 per year between 25-35, saving a total of $50,000. Bill, the green line, invests $5,000 per year, but does so for 30 years, saving a total of $150,000. Surely Bill has more money than Susan—right?
Wrong. Even though Bill saved three times as much as Susan, at 65, he ends up with less money than her. That’s the magic of compound interest. Even though Susan saved far less than Bill, she did so 10 years earlier. Those extra 10 years allowed her money to grow and grow.
Chris, the final saver, also began investing $5,000 per year at 25, and continued until 65. He saved a total of $200,000, only 50,000 more than Chris, but ends up with more than twice as much money at 65.
The lesson? Save early and save often, but if you have to choose between the two, save early. As we can clearly see on the chart, saving early allows the power of compound interest to deliver amazing results.
Although it may seem like a rounding error, losing one or two percent on unnecessary fees can be very costly. For example, $1,000 invested for 30 years at 6% would eventually grow to $5744, while the same sum invested at 8% would grow to $10,063. That is a huge difference, and is a testament not only to the power of compound interest, but more importantly to just how crucial it is to keep fees low.
Fees can come in many forms. Those trading stocks or options often need to pay transaction fees to their broker. Those who have retirement money invested in a mutual fund may not realize that their hard-earned money is being whittled away by management fees. Even worse, a retirement account is precisely the place that minimizing fees is crucial. As we have already learned, small differences can result in huge changes over time.
Most analysts agree that you should avoid putting your money in a fund that charges more than 1% per year. But there are ways to do much, much better than that. The average expense ratio at Vanguard is a mere .18%, much lower than the industry average of 1.02%.
Investing money wisely isn’t easy—but it doesn’t have to be hard either. If you respect the market, diversify, understand compound interest and minimize fees, you’ll be well on your way towards investment success.