Four Steps to Successful Long-term Investing
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Investing Fundamentals
Investing can be counterintuitive. With the efficiency of markets, no individual investor has an edge. The more effort you put in, the more likely you are to underperform. When it comes to your investments, it pays to be passive.
You spend money over your entire life, but earn over only a portion of it. This means investing is not about getting rich, but rather about transferring purchasing power from years in which you earn to years in which you don’t.
A committed saver can add more to their portfolio’s growth than a savvy investor. Diligent savers require less time to accumulate assets and less money to retire.
One of the biggest impediments to successful investing may be yourself. Behavioral biases frequently get in the way of making rational investment decisions.
Successful long-term investing is about creating a plan and sticking to it, not trying to outsmart the market.
(1) Select an asset allocation in-line with your capacity and tolerance For Risk
Your asset allocation is the percentage of stocks and bonds in your portfolio. More stock means greater expected (i.e., hoped for) return and greater risk (i.e., fluctuations in return). More bonds mean lesser expected return and lesser risk.
The appropriate mix of stocks and bonds will depend on your capacity and tolerance for risk, which can adjust over time and as your financial situation changes. Your risk capacity is the amount of stock you can afford to hold in your portfolio without putting undue stress on your living standard if future returns are poorer than expected. Your risk tolerance is the amount of stock you can tolerate to hold in your portfolio without panicking when returns are poor.
Choosing an asset allocation is all about finding a balance. Having too much stock may lead you to panic and sell in a downturn or force you to cut your living standard if returns are poorer than expected. Having too little stock may lead you to panic and buy in an upturn or leave you with a lower living standard than you had hoped for.
(2) Select index funds that capture broad market returns at lowest cost
Next, you’ll need to identify which securities to buy. Active investors select specific securities they believe will outperform a comparative benchmark, while passive investors simply buy an index that tracks the benchmark.
Simple arithmetic reminds us that not everyone can have a winning edge in the market. For every buyer there is a seller. Year after year the data shows that actively managed funds consistently underperform their respective index benchmarks, after fees. The best bet you can make as an individual investor is therefore to buy the entire market at lowest cost, assuring yourself a fair share of market returns.
In practice, this means selecting index funds that provide the greatest level of market diversification at lowest cost. For example, consider the Vanguard Total World Stock Fund and the Vanguard Total US Bond Fund. By combining these two funds, investors can own a globally diversified portfolio of nearly 20,000 stocks and bonds at an annual expense of less than 0.08%—that’s just $80 a year for every $100,000 invested.
(3) Automate Your Investment Plan and Tune Out Market Noise
Next, you’ll want to automate your savings and investment plan. This may involve automating contributions to your employer retirement plan, IRAs and brokerage account. It may also involve automating extra debt payments, including prepaying your mortgage or student loans.
Automation makes it more likely that you’ll meet your goals by helping you separate your emotions from your investment decisions, tune out market noise and stick to your plan. Paying yourself first can make it more difficult to overspend, and thus under save.
(4) Revisit and Rebalance Your Investments When Your Situation Changes
Next, you’ll want to revisit your asset allocation when your financial situation changes. This step allows you to maintain an appropriate amount of risk with your investments. For example, if you get a new job, have a child, sell a business, or receive an inheritance, your capacity or tolerance for risk may change. Even if your financial situation hasn’t changed, it’s prudent to revisit your investments every few years to rebalance your asset allocation.
Conclusion
With the efficiency of markets, no individual investor has an edge. The sooner you embrace this fact, the better off you’ll be. Rather than trying to outsmart the market you can focus on what you can control. This involves selecting an appropriate asset allocation, buying the market at lowest cost, automating your savings plan, and revisiting your investments when things change.