The power of long-term compounding
Compounding returns can be robust. The longer you leave your money working for you, the more exciting the numbers get. Compounding pays you earnings on your reinvested earnings. For example, imagine an investment of $10,000 at an annual rate of return of 8 percent. In 20 years, assuming no withdrawals, your $10,000 investment would grow to $46,610. In 25 years, it would grow to $68,485 (+47%) over the 20-year figure. After 30 years, your account would total $100,627. (This is a hypothetical example that doesn’t reflect the performance of any specific investment.)
This example assumes that no taxes are paid along the way, so all money stays invested. That would be the case in a traditional IRA or qualified retirement plan. The compounded earnings of deferred tax dollars are the main reason experts recommend funding all tax-advantaged retirement accounts available to you.
While you should review your portfolio regularly, the point is that money left alone in an investment offers the potential of a significant return over time. With time on your side, you don’t have to go for investment “home runs” to be successful.
Stay invested during volatile markets
Riding out market volatility sounds simple enough. But what if you invested $10,000 in the stock market and the price of the stock drops? On paper, you’ve lost a bundle, offsetting the value of compounding you’re trying to achieve. It can be tough to stay the course. In learning how to be a successful investor, it’s important to remember two things.
First, the longer you stay with a diversified portfolio of investments, the more likely you are to reduce your risk and improve your opportunities for gain. Though past performance doesn’t guarantee future results, the long-term direction of the stock market has historically been up. Take your time horizon into account when establishing your investment game plan. For assets you’ll use soon, you may not have the time to wait out the market and should consider investments designed to protect your principal. Conversely, when considering how to be a successful investor, think about long-term for goals that are many years away.
Second, during any given period of market or economic turmoil, some asset categories and some individual investments historically have been less volatile than others. Bond price swings, for example, have generally been less dramatic than stock prices. Diversification alone cannot guarantee a profit or ensure against the possibility of loss. However, you can minimize your risk somewhat by diversifying your holdings among various classes of assets.
Don’t put all your eggs in one basket
Diversification is the process of spreading your dollars over several categories of investments, usually referred to as asset classes. The three most common asset classes are stocks, bonds, and cash or cash alternatives such as money market funds. You’ll also see the term “asset classes” used to refer to subcategories, such as aggressive growth stocks, long-term growth stocks, international stocks, government bonds (U.S., state, and local), high-quality corporate bonds, low-quality corporate bonds, and tax-free municipal bonds. A basic asset allocation would likely include at least stocks, bonds (or mutual funds of stocks and bonds), and cash or cash alternatives.
There are two main reasons why asset allocation is essential. First, the mix of asset classes you own is a significant factor — some say the biggest factor by far — in determining your overall investment portfolio performance. In other words, the fundamental decision about how to divide your money between stocks, bonds, and cash can have a bigger impact than the specific investments you choose.
Second, by investing in different asset classes that don’t respond to the same market forces in the same way, you can help minimize the effects of market volatility while maximizing your chances of return in the long term. Ideally, if your investments in one class are performing poorly, assets in another class may be doing better. Any gains in the latter can help offset the losses in the former and help minimize their overall impact on your portfolio.
Consider how long you’ll be investing
When it comes to determining how to be a successful investor, you’ll have to consider how long you will invest. Generally speaking, the sooner you’ll need your money, the wiser it is to keep it in investments whose prices remain relatively stable. You want to avoid a situation, for example, where you need to sell an investment that declined in value just because you need the cash. Therefore, your investment choices should take into account how soon you’re planning to use your money.
If you need the money within the next one to three years, consider keeping it in a money market fund or another cash alternative. These investments are aimed at preserving your initial investment. Your rate of return may be lower than that possible with more volatile investments, but you’ll breathe easier knowing that the principal you invested is relatively safe and quickly available, without concern over market conditions on a given day. Conversely, if you have a long time horizon — for example, if you’re investing for a retirement that’s many years away — you may be able to invest a greater percentage of your assets in something that might have more dramatic price changes, but that might also have greater potential for long-term growth.
Invest consistently and often
Dollar-cost averaging is a method of accumulating shares of an investment by purchasing a fixed dollar amount at regularly scheduled intervals over an extended time. When the price is high, your fixed-dollar investment buys less; when prices are low, the same dollar investment will buy more shares. A regular, fixed-dollar investment should result in a lower average price per share than buying a fixed number of shares at each investment interval. A 401(k) plan that deducts the same amount from each paycheck and invests it through the plan, is one of the most well-known examples of dollar-cost averaging in action.
Remember that, as with any investment strategy, dollar cost averaging can’t guarantee a profit or protect against a loss if the market is declining. To maximize the potential effects of dollar-cost averaging, you should also assess your ability to keep investing even when the market is down.
Review and adjust
Your long-term success is dependent on periodically reviewing your portfolio. There are several reasons to review your portfolio. Maybe economic conditions have changed the prospects for a particular investment or an entire asset class. Also, your own circumstances will change over time. Your asset allocation will need to reflect those changes. For example, as you get closer to retirement, you might decide to increase your allocation to less volatile investments, or those that can provide a steady stream of income.
In addition, your various investments will likely appreciate at different rates, which will alter your asset allocation without any action on your part. Here’s an example. If you initially decided on an 80-20 mix of stock investments to bond investments, you might find that after several years the total value of your portfolio has become divided 88 percent to 12 percent (conversely, if stocks haven’t done well, you might have a 70-30 ratio of stocks to bonds in this hypothetical example). You need to review your portfolio periodically to see if you need to return to your original allocation.
How to Be a Successful Investor: Consider Help
If you need assistance reviewing your holdings to make sure you are appropriately diversified, contact us. We offer an initial complimentary consultation and will walk you through how to be a successful investor.