A Young Professional’s Guide to Successful Investing
Your career is off to a great start, and you’ve started to build a solid financial foundation for the future.
You’re participating in your company’s 401(k) plan, and while you picked a few funds off the plan’s investment menu that looked like they were good performers, you’re not one hundred percent sure it they were the right ones. And you’re not sure if the funds you picked make your account too risky or too conservative.
These are valid questions and concerns, and to be able to answer them, you’ll need to understand what you need to do to be a successful long-term investor. And that’s what you’ll learn in this guide.
You know why saving is important – at some point, you’ll retire, your income from work will stop, and you’ll need to have resources that you can live off. For most people, their Social Security benefit alone won’t be enough – in fact, for high-income earners, Social Security benefits only replace a small percentage of their pre-retirement income.
You probably know that there are lots of different ways to save – there are checking and savings accounts for cash, certificates of deposit (CDs), money market funds, individual stocks and bonds, mutual funds and exchange-traded funds (ETFs), real estate investment trusts (REITs), and more. With all these choices, and without a solid understanding of investment theory, it’s easy to get lost in jargon, marketing hype and misinformation.
The starting point is understanding why – unless you’ve already earned or inherited more money than you’ll ever possibly need – parking your savings in the perceived safety of cash is a terrible idea. Why? Well, it’s true that keeping all of your savings and investments in cash ensures that they won’t decline in value. But, at the same time, inflation is eroding the purchasing power of your savings. For example, if prices are going up 3% per year, today’s $5 latte will cost over $12 in 30 years. So, your savings need to keep pace with, or ideally grow faster than, the rate of inflation.
So, let’s start by reviewing the keys to successful investing.
Chapter 1: Keys to Successful Investing
Chapter 2: Investing Mistakes to Avoid
Chapter 3: Investing in a Volatile Market
Chapter 4: Getting Investment Advice
Understand Your Risk Tolerance
Even if you’ve only recently started saving and investing, you probably know that the stock market fluctuates – often dramatically – from day to day. These fluctuations impact the value of your investments – your savings. This can cause some investors to become very anxious, and to question their decision-making and commitment to an investment strategy.Risk tolerance is a measure of how emotionally comfortable you are with taking financial risk. For example, how much you’re willing to see your portfolio’s value decline for a chance to see it earn larger returns. Risk tolerance is psychological.
Risk profiling is a process for finding your optimal level of investment risk by balancing the amount of investment risk required, your risk capacity and your individual risk tolerance.
By knowing how comfortable you are with the variability of investment returns, you (and your advisor, if you’re working with one) can make sure don’t panic when the markets take one of their periodic tumbles. Bear markets – defined as when stock prices fall 20% or more from their most recent high – generally occur every 7 to 10 years. So, depending on your age, you’re likely to experience five, six or even seven of these gut-wrenching episodes in your investing life.
Get Your Asset Allocation Right
Asset allocation is one of the most important investing concepts. It’s the strategy of dividing your investments across different asset classes – such as stocks, bonds, real estate, cash, and cash alternatives.
It may seem counter-intuitive, but it’s important to own investments that don’t move in lock-step with each other, but instead perform differently over time. Why is that? Well, over time we do expect the stock market to go up, notwithstanding the inevitable periodic bear markets and smaller, less severe corrections. But if your portfolio includes investments that increase in value when your stocks decline, the variability of your portfolio’s returns will be lower and your returns smoother.
Looking back over many decades of investment history, there have been many asset classes – or categories of investments – that have demonstrated this “zig zag” relationship, including stocks and bonds, stocks and real estate, US stocks and international stocks, large company stocks and small company stocks, developed markets stocks and emerging markets stocks, etc.
Your asset allocation is the primary determinant of how risky your portfolio is. To the extent you include a higher percentage of risky asset classes – like stocks – in your portfolio, your returns will vary more from day to day, month to month, and year to year. But – over time – you can expect higher returns.
Perhaps you remember your grandmother or one of your other, older relatives telling you, “Don’t put all of your eggs in one basket”. This adage warning against putting all your resources or efforts into one thing or place applies to investing, too.
A suitable asset allocation isn’t enough to ensure that you’re appropriately diversified. If you and your advisor have decided that you should invest 60% of your portfolio in stocks, you shouldn’t concentrate the full 60% in one or even a few stocks. Within each asset class, you should own as many securities as possible. This eliminates the risk that one underperforming investment can damage your portfolio. This broad diversification is best done with mutual funds or exchange-traded funds (“ETFs”).
When done properly, a suitable asset allocation will ensure that your portfolio is correctly positioned on the risk-return spectrum, while proper diversification across and within the asset classes you’ve selected will insulate your portfolio against suffering large losses all at once.
It’s important to note that some company-sponsored retirement plans, offer access to only a limited number of mutual funds that represent distinct asset classes, together with a collection of so-called lifestyle or “target date funds”. There are some potential pitfalls to be aware of if your plan offers these investment options.
What’s Your True Investment Horizon?
You know that inflation can erode the value of your savings, but also that investing can be risky, and that the fluctuations of the stock market can make for a stressful experience.
As a young professional, you may well be comfortable with a relatively high allocation to stocks in your portfolio, understanding that retirement is (or at least seems) a long way off, and you won’t need to tap those retirement account resources for a couple of decades.
As you get closer to retirement, you may be tempted to reduce the riskiness of your portfolio, reasoning that you should focus more on preserving what you’ve already accumulated rather than on continuing to grow it.
It’s true that “the magic of compounding” is more powerful when you’re younger and your investment horizon is longer. But even when you’ve retired in your sixties or seventies, there’s a real possibility that you could live several decades more, and may still need your portfolio’s growth to keep up with inflation.
That’s why at Springwater we remind our clients that when saving for retirement, your investment horizon isn’t “to retirement”, but “through retirement”.
If your portfolio is properly diversified, the investments you own will perform differently over time. After a while, your actual allocation to stocks, bonds, and other important asset classes will look different than your target, or ideal, allocation. When that time comes, your portfolio will need to be rebalanced.
At its core, rebalancing is nothing more than the systematic process of selling some of those asset classes you own too much of, and buying more of those asset classes you own too little of, in order to bring your portfolio’s mix back in line with the target allocation.
Why rebalance? Well, a portfolio that has drifted too much from its target allocation will take on risk and return characteristics that are also (potentially very) different from your intended mix. If stocks do very well for several years in a row, and you never rebalance in the interim, your target 50% stock allocation could turn into a 75% stock allocation. And a portfolio that’s 75% stocks is much riskier than one that’s 50% stocks.
If you think for a moment about what you’re doing when you rebalance, you’re “buying low and selling high”. You’ve almost certainly heard that cliché before, and everyone know it’s a good thing. But “buy low and sell high” is the flip side of, “sell what has done well, and buy what has done (less well, or done) poorly”. And that sounds much less appealing, right? This is why individual investors often struggle to properly manage their own portfolios in a prudent manner. They’re reluctant to rebalance when it’s needed, and oftentimes are inclined to do exactly what they shouldn’t: buy high and sell low.
Control what you can control
One of the more sobering realizations for investors is that there is really very little they can control. You can’t control what the equity markets are going to do. Bull and bear markets are inevitable, but you simply can’t influence their timing, size or duration. You can’t control interest rates, and therefore what you’ll earn on your cash and bond investments. You can’t control inflation, or its impact on your purchasing power. You can’t control currency exchange rates, and their influence on the global economy, interest rates, or global trade flows. The list goes on and on…
Since we know there’s so much we can’t control, it makes much more sense to focus on what we can control. We’ve already reviewed the keys to successful investing; let’s now look at some pitfalls to avoid.
Don’t Chase Performance
We know from our Keys to Successful Investing that different asset classes will perform differently over time. We may see riskier asset classes do relatively better when the economy is on an upswing, and more conservative ones do better when the economic cycle slows. Many investors, though, make the mistake of extrapolating recent past performance into the future. This so-called “recency bias” causes them to want to invest more into the asset classes or funds that have performed best over the past quarter or two, and to pull money out of those that have lagged. Yet we know that this action – buying high and selling low – is the exact opposite of what you should be doing.
Forget Trying to Time the Market
Market timing involves trying to out-perform the market, or a particular benchmark, by trying to predict its movements and buying and selling accordingly. If this sounds difficult, it’s because it is – exceedingly so.
If this is a strategy that you think might have some merit, you should recognize that for it to be successful, you have to be right twice – first, when you sell, and second, when you buy back in. Industry research has shown that for a market-timing strategy to be successful, an investor would need to be right over 70% of the time, to account for fees, taxes and other costs. An annual study by Morningstar shows how costly bad timing by investors can be.
Don’t Gaze at Your Crystal Ball (Stock-picking)
Stock-picking – more formally known as security selection – involves trying to identify mis-priced investments, and buying or selling them accordingly to generate superior investment returns. To understand why this strategy is a mistake, let’s take a moment to consider conceptually how a security’s price is determined.
Every day, around the world, there are literally millions of investors – many of them full-time, experienced professionals – trading securities on markets like the New York, London and Tokyo stock exchanges. These investors have access to enormous amounts of data about the securities in which they’re investing, and they use that data to help them decide what a “fair” price is for each. Every security’s price reflects the consensus view of the investors. As new information about a company or security becomes public – say, a new product, a corporate merger, or the death of a key executive – it’s quickly incorporated into the security’s price by investor trading.
This means that it must be new information that moves a stock’s price, as investors incorporate the information into their estimate of the stock’s new fair price. And, by definition, new information is unknown.
So, stock-picking or security selection as a viable investment strategy is based on two premises, both of which seem highly implausible. First, that an investor can consistently identify mis-priced securities that millions of other market participants have missed. And second, that an investor can trade successfully in advance of new information, which is by definition unknowable.
The better strategy, as we noted before, is to use mutual funds or ETFs to own large baskets of securities in every asset class we want, and to accept the market’s return.
Don’t Let Your Emotions Drive Your Decisions
Emotions are an essential part of what makes us human. We achieve some of our greatest accomplishments when we let our passions drive our decision-making.
But when it comes to investing, emotions can be a problem. When faced with market volatility or uncertainty, you may be tempted by your emotions to sell when markets are trending down or to buy when markets are rising.
If you think you may be inclined to let your emotions impact your investment decisions, consider working with a financial advisor, and before making any decisions, discuss your fears or concerns, to help keep your emotions in check. You and your advisor can work together to keep your long-term investment strategy on track.
At Springwater Wealth, we frequently share with prospective new clients our view that, “Short-term bumps in the road are the price you pay for long-term growth”.
We noted earlier that in order to ensure that your portfolio’s growth keeps up with inflation, you have to take some investment risk. That risk appears in the form of variability of your returns from week to week, month to month even year to year.
For example, imagine that you and your financial advisor have built a financial plan for your family. Based on your investment horizon, risk tolerance, and goals and objectives, you’ve agreed that an allocation of 60% to stocks should be sufficient for your plan to succeed. Your assumption about future inflation is 2.5% per year (lower than the long-term historical rate of about 4.0%), and about investment returns, 5.5% (also lower than the long-term historical return for a similar portfolio).
As someone fairly new to investing, you then ask your advisor how a 60% portfolio has performed in the recent past. Your advisor remarks that the past 20 years have been fairly turbulent for investors, and mentions the 2000-02 dot-com crash, the 2007-09 Great Recession, and the more recent Coronavirus-related market correction. But, your advisor says, the returns over this period have been roughly in line with the long-term historical average, and shares the following chart with you. What does this volatility look like?
Disclaimer: The returns shown above are not actual portfolio returns. They are simulations developed to illustrate the benefits of portfolio diversification, using historical returns for the included asset classes as represented by an index and its percentage weighting in the portfolio.
These indexes are not professionally managed and are not subject to transaction costs, custodial fees, advisory fees, taxes, and other fees and expenses, the effect of which would be to reduce the portfolio returns. The historical and expected rates of return stated herein are gross of any advisory fees, brokerage commissions, or other costs. These fees will reduce the return realized by you.
While you’re fairly new to investing, you’re also smart, intuitive and well-educated, and you immediately notice that while your advisor’s model portfolio has produced an average annual return of about 6.8% per year over the past two decades, only three of those twenty years produced a return that was anywhere near the average – 2005, 2007 and 2016. All the other years delivered returns that were wildly different than the average.
To enjoy a successful long-term investment experience, you’ll need to accept that, if you want to earn returns that outpace inflation and provide the growth you need, your returns will be volatile.
As a young professional, you may not have your own financial advisor. Maybe because you don’t think you need one, or because you don’t think your portfolio is big enough.
If you’re unsure whether it would be helpful to work with an advisor, here are a few questions you should ask yourself, to help you decide whether you should be managing your own investment and retirement accounts.
Do you have an aptitude for it?
It’s a big responsibility to manage your investment and retirement accounts, regardless of how much you’ve accumulated so far. You shouldn’t offload that responsibility to someone who lacks the necessary experience, even if that person is yourself. It’s true that investment management isn’t literally rocket science, but it also isn’t something that everyone can do well, either. If you’re contemplating managing your own investments, you’ll need to educate yourself about the science of investing, and keep up with changes in financial economics and investment theory.
Do you have an affinity for it?
Even if you think that you have the aptitude for managing investments, you may simply not enjoy it. If you find that you dread the time needed to manage your accounts, the results will eventually reflect it.
Do you have the time for it?
Managing your portfolio isn’t a full-time job, but it’s much more than a hobby that will only take a few minutes every month or two. With other competing priorities – work, family, leisure – you may not want to allocate the time needed to prudently manage your accounts.
Do you know how you’ll react in a stock market downturn?
One of the biggest benefits of working with an advisor is that they can act as an objective filter between your emotions and your investments. Depending on your age, you should honestly reflect on how you reacted to the March 2020 stock market correction, the 2007-09 Great Recession and, possibly, the 2000-02 dot com crash. If you let your emotions influence your investment decision-making, it will be in your best interest to work with an investment adviser.
If you can’t definitively answer yes to all four of these questions, you’ll almost certainly be better off hiring a financial advisor to help you manage your growing portfolio.
You can find a qualified, experienced financial advisor online, and the best places to start your search are the websites for the National Association of Personal Financial Advisors, the Financial Planning Association, and the CFP Board.