What sets apart a successful investor from an unsuccessful one? Is it deeper knowledge, extensive experience, or an Ivy League education? Could it simply be luck? Or is it something else entirely? To understand this better, let’s flip the perspective. A successful investor might be defined as someone who avoids investment mistakes that lead to failure. Rather than trying to embody every characteristic of success, perhaps it’s easier to simply avoid financial missteps – such as market timing, concentration risk, and failing to balance your portfolio – especially in times of increased market volatility.
Easier said than done, right?
In this article, we won’t examine the technical aspects of stocks and bonds that only financial professionals have time for, but rather time-honored investing principles that you don’t need to go to Yale or Harvard to master.
Time, Patience, & Discipline
There’s an interesting cognitive bias known as ‘hyperbolic discounting.’ The idea goes that, given two choices of rewards, people will most likely choose a smaller reward that is closer to the present time, even if the more delayed reward is significantly greater. The more significant the gap, the greater the bias is. So, an investor is likelier to lock in a small gain rather than be patient and lock in compound gains.
Complicating matters is the fact that no investment is guaranteed. If you have a 20% gain in Stock XYZ and no guarantee that that particular stock will even exist in thirty years, why not simply lock in the gain? The psychological pressure is too immense for some investors.
The only kind of investing that will reap the rewards of compound gains is not something we achieve overnight, and a 20% one-time, short-term gain won’t cut it. It takes time—decades even—and the longer you give it, the greater the rewards will be.
Let’s look at how an initial $20,000 investment will grow with enough time and consistent contributions of $12,000 a year (lump-sum invested at the beginning of the year), assuming a 10% rate of return.
After the fourth decade, you’ll notice how the ending balance line transforms into a rapid ascent. After fifty years of investing, you’ve earned over $17,000,000 on $600,000 worth of contributions.
That kind of growth isn’t possible by locking in every small gain you ever achieve.
But just to show you the true power of compound interest, let’s look at the next decades if you were to stay invested:
That’s right, in 100 years, your modest contributions could balloon to over two billion dollars. You likely won’t be around to see it, but this is how you set your children and grandchildren up for generational wealth.
It can’t be that easy, right?
Unfortunately, it’s not – because of those aforementioned pitfalls. We can’t guarantee a 10% consistent rate of return, but we can implement a system that will increase our chances of obtaining one.
Diversify Across Asset Classes And Sectors
If you’d purchased a significant amount of Microsoft shares in 1986, you’d likely be a multi-millionaire today. But how many start-ups seem poised for success only to ultimately flop? Okay, so Microsoft has proven its staying power—why not invest a significant portion of your savings into Microsoft and a few other large players, like Apple and Nvidia?
Corporations don’t last forever. Polaroid, Lehman Brothers, PanAm Airlines, and Bethlehem Steel all seemed like permanent mainstays in their respective sectors, and they all eventually went away—some in spectacular fashion, others in long, slow descents. But few would have predicted their demise.
Concentrating your funds on individual corporations is a recipe for disaster. However, you have to be careful of entire sectors as well, not just single corporations. In the late 90s, the tech industry was on fire. Many investors couldn’t resist the urge to throw their savings into the industry, further driving up stock prices well beyond what they deserved, forming a bubble poised to pop, though few could see it at the time. In March 2001, things came crashing down, leaving investors with pennies to the dollar, if anything at all.
Instead, we should focus on purchasing a wide range of stocks and bonds so that your assets in other sectors are safe even if one sector crashes. This also means purchasing international assets. While the American stock market is by far the largest and most stable, the rest of the world still has much to offer and can provide enhanced stability in volatile times.
This doesn’t mean you have to purchase individual shares of a thousand different corporations. To facilitate diversification, we have mutual funds and ETFs to utilize. These funds do the legwork of purchasing multiple stocks and then bundling them together for you to purchase as a package deal. For example, SPY is a popular ETF that replicates the composition (and thereby the performance) of the S&P 500 benchmark. With one ETF, you can diversify your funds across 500 different major companies.
Avoid Timing the Market
When stocks plunge, amateur investors bail. The process works like this: an investor purchases shares as a company’s stock price climbs. Then, as prices fall, they sell, either making a paltry gain that trading fees cut into or locking in losses.
On the upswing, the investor purchases the shares again, hoping the price will skyrocket this time. Instead, it goes up, then down, then up, then down. Along the way, the investor misses out on those crucial dividends, further weakening their position. To make things worse, fees eat away at any profits with every transaction they make.
Besides missing incremental gains, being out of the market also means missing potential significant gains. The stock market can be flat for months, even years, and when volatility kicks in, the biggest losses and the biggest gains can rapidly occur. Missing those vital market gains will lead to subpar long-term investment performance, and the only way to guarantee you won’t miss them is to remain invested.
The difference is crystal clear. Missing those days leads to minimal gains, while staying invested leads to impressive compound gains. You have to take some hits to win the match.
Rebalancing Your Portfolio
When you design your portfolio, you’ll assign certain proportions to your asset classes and sectors. As those classes and sectors grow and shrink, your portfolio will drift away from its original allocation. You have two general options to realign your asset allocation with your intended risk profile.
Firstly, you can sell assets from the sector that has overgrown its proportions. Say your tech sector allocation has grown from about 17% of your portfolio to 30%. You can sell off tech assets and use those funds to purchase assets in your other sectors as needed until you reach alignment. Be aware, though, that depending on the kind of account, you may face a tax burden with this method.
Alternatively, you can use your liquid funds to purchase assets within your ‘losing’ sectors, which is particularly easy to do if you have a dollar-cost averaging strategy in place.
As the second pie chart shows, the tech industry has ballooned in value, creating an uneven allocation within the portfolio. A crash in the tech sector would disproportionately harm the portfolio.
By continuously selling sectors that have overgrown their allocation and using those funds to purchase assets within underrepresented sectors, we are essentially buying low and selling high—something that is exceedingly difficult to accomplish regularly by trying to predict the market’s moves.
Dollar-Cost Averaging
Lump-sum investing can have the potential for greater gains. Imagine a scenario where you purchase $20,000 of a stock when it’s at its lowest point, and then it steadily grows over the years. You’d earn more than if you had purchased $1,000 worth of shares twenty different times from that low point.
However, as we’ve shown throughout this article, we can’t time the market and have no way of knowing the future direction of any particular asset.
Dollar-cost averaging helps us stabilize the average cost of an asset and instill investing discipline by investing a fixed amount of funds into your portfolio at set times, for example, the last day of the month when you get your salary. Yes, that means possibly buying high, but it also means possibly buying low. More importantly, it helps prevent you from making irrational decisions.
In Conclusion
Will the stock market make you rich overnight? For a few, yes – especially those who receive stock options as part of an equity package or are particularly risky and incredibly lucky. Most of us, though, who value consistent, long-term gains to achieve our financial goals need a systematic, disciplined approach that keeps us on a safe track that, with enough time, could generate enormous compound returns.
If you’re like me, you don’t want to take chances on luck. Instead, you want a system much more likely to achieve what you seek – generational wealth building, a secure retirement, and a break from the nerve-wracking ups and downs of volatile markets.
If that sounds like you, and you’d like assistance establishing a portfolio that stands the test of time, I’d be happy to help. You can schedule a consultation by clicking the button below.
