Markets are full of traps and without a good plan you can very quickly get into trouble. But, by understanding a few basic concepts and following a handful of principles you can easily avoid most of the common pitfalls. The following is a guide to help you on the road to better investing.
1. Costs Matter
The costs associated with investing can eat away at a significant portion of your returns. The following example illustrate just how much fees can impact the portfolio you end up with.
If you invest $1,000 for 20 years and earn 15% per year:
- If you pay no fees you’ll end up with $16,367
- If you pay a 1% fee every year, you end up with $13,743
- If you pay a 3% fee every year, you will end up with $9,646
A 3% fee might not seem like a massive amount, but it results in you ending up with $6,721 less. That’s 41% of your potential nest egg.
The returns your portfolio generates do have an impact on how much you end up with – but returns are something you have very little control over. The inputs you have the most control over are the amount you save and the fees you pay.
Costs come in many forms – some explicit and some hidden. There are annual management fees, commissions to buy and sell stocks or ETFs, fees paid to an advisor and subscription fees for newsletters, and other services.
You should make sure you know all of these costs and make sure the total amount you are paying is below 1%. And you should also ask yourself if everything you are paying for is worth it.
2. Develop a process
Many novice investors try to time the market. They want to be invested when stocks are going up and then get out before the market falls. The reality is that timing the market is very difficult, and most investors who try to time the market end up under performing.
The better investing approach is to remain invested and make very small changes to a portfolio over time. Changes can include moving some capital to sectors that have better than average fundamentals, rotating part of a portfolio into sectors that are performing well, or buying some individual stocks that present exceptional opportunities. It is also acceptable to move some capital to cash during severe bear markets, but this should be done in a systematic way.
Following a process and making incremental changes over time will stop you from making impulsive decisions. Investments grow by compounding returns over time, but if you don’t give them time to compound, they won’t.
3. Understanding the relationship between Value and Momentum
Broadly speaking there are two approaches to investing. The first involves buying assets that are priced below some sort of measure of their value. The logic behind this is that a share that is ‘cheap’, shouldn’t fall very much, and that when the share becomes over valued the investor will be able to sell it at a profit. This is value investing.
The second approach is to buy shares that have strong upward momentum. The logic behind this is that trends tend to be persistent and that shares that are performing well tend to continue to perform well in the medium term. This is momentum investing.
Both approaches have their place, and both will perform well during certain periods and badly during other periods. Momentum investing works well during strong bull trends, when expensive shares often rise the most. Just because a share or an entire market is expensive, it doesn’t mean it will crash. However, when markets do decline, its often the most expensive shares that fall the most.
Occasionally when cheap shares come back into favor, momentum and value coincide. This doesn’t happen often, but when it does some of the best opportunities can be found.
4. Understand the Behavior Gap
Very often individual investors in a top performing mutual fund, ETF or share, have far worse returns than the fund or share. The reason is that they tend to invest when the fund or share has done well, and take money out when it does badly. This means they end up buying high and selling low. This is known as the behavior gap, and the majority of investors make this mistake.
The first step in avoiding this mistake, is being aware of it. Every time you make a decision, ask yourself if you are really acting in your own best interest, or if you are responding to an emotional impulse. Bad investing decisions often come down fear – either of losing money or of missing out. Better investing decisions form part of a process and have deliberate long term goals.
5. Benchmark Yourself
All funds have a benchmark against which they are measured, and individual investors should benchmark themselves too. If you have no benchmark, you can’t possibly know how well your investments are doing, or whether they would be better off in an index tracker fund.
You can use a local headline index such as the S&P 500 or the FTSE 100 or a global index like the MSCI World index. Or you can average the two, and use that as a benchmark. When accounting for fees, find out what the lowest cost ETF for each index costs too. That way you will know whether you are getting your money’s worth for the fees you are paying.
There’s no such thing as the perfect investment, the perfect portfolio or the perfect investment method. But there are principles and approaches, which when followed will result in better investing results over time. Following the principles listed above will create a framework for your investing process so that you are in fact investing and not gambling or making impulsive decisions and hoping for the best.