Creating financial wealth requires understanding five essentials; investing concepts that really work if you apply them to all your investment decisions.
It would be nice if we could all make investments like a machine, and “set it and forget it,” but because we are human, it is near impossible to do. We are emotional creatures, not Mr. Spock. Even so, knowledge is power. Consider these five basic concepts to help you make and keep your investment plans on track.
- Markets are efficient, but they are not always rational – Think of the stock market like one big machine, one that collects real time data on every company’s goings-on, and that there is someone always there to arbitrage every cent of price discrepancy to build wealth. A multitude of financial corporations funding armies of analysts, along with hedge fund managers, mutual fund and private portfolio managers, are all working 8-14 hours a day studying the companies making up the stock market. All are trying to find and exploit stocks with prices that are undervalued even by tiny amounts. The combined decisions of these experts determine current stock market prices. Understanding the efficient market hypothesis is the first step in intelligent investing. Periods of speculation are marked by emotional reactions to trends of interest, such as the internet mania of the late 1990s and the Dutch tulip-mania of the 1630s. While there may have been a fundamental basis for investment interest, the sheer volume of emotion-based interest by the public overcame rational pricing. It is all but impossible to discern the difference between normal and speculative periods, until after the fact. For example, a number of experts, including “bond king” Bill Gross have been predicting a “bond bubble” at various times over a period of years, and yet there has not yet been a bond “crash.” Sure, it is possible we are in a bond bubble which could eventually crash. After all, bond prices are still at very high valuations when compared with the yields investors earned in past decades. You know what? I have no clue what will happen, nor do I care, because my plans account for all bond market outcomes.
- Risks you cannot control – It is no help with building wealth by trying to predict what global stock and bond returns will be. It is realistic to have faith investors collectively put their hard-earned money at risk only if the value of an investment will provide a reasonable return on that investment. As an example, John Bogle emphasizes that the long term performance of the US stock market is highly correlated to GDP growth and corresponding corporate profits. By investing in the total US stock market, you are asserting faith that this relationship will continue. Some do not believe that it will necessarily continue. So, long term, we want to own everything, not any single market or investment type. In the short run, the market is a voting machine, but in the long run, it is a weighing machine. From this point of view, valuations really do not matter much when it comes to building long-term wealth. Nevertheless, as mortal beings, we have to manage risk over a defined lifetime, and so the weighing machine may not have enough time to provide results that meet our expected returns. This is why my byline is “there is no free lunch.” There is no real return with taking on real risk.
- Risks you can control – After building an emergency fund and having a reasonable amount of insurance coverage, which are key to protecting your wealth, the most important investment risk decision you will make is choosing what percentage of your portfolio is allocated to stocks. In addition, while there is no free lunch, you can at least maximize diversification of that risk. That means owning not only stock index funds, but also including small cap, value, international, and emerging markets within your index choices. Yes, these are all very risky. Even if you have a low risk tolerance, and have 20% allocated to stocks, the idea is to make that 20% as diversified as possible.
- Your Risk Tolerance – The process of determining what amount of risk is appropriate for you is far more important than the actual selection of investments. This is a personal decision. Disregard any advice when you hear what risk you should be able to tolerate based on age or other general variables. You cannot build wealth if you do not have an allocation tailored to your risk tolerance. If you have too much in stocks, it is not going to be real fun when there is a bear market. There will be one in your investment lifetime. It is a question of when, not if. Your ability to stay the course will determine your wealth outcome. If you have too much in stocks, you will bail at the worst possible time, when stocks are down.
- Learn, Be Confident, and Go It Alone – Investing may not be easy, but it is simple. It does not take very much time and effort to learn investment basics. Despite what the retail investment industry would have you believe, investing is not complicated. Great sites for basic and unbiased investing help are FINRA Key Investing Concepts and Bogleheads.org’s Getting Started. Write an Investment Policy Statement and follow the rest of my Seven Simple Steps for investing.