A Little Education Goes a Long Way
There is a fairly long list of ways money can be invested these days. The returns on investments such as fine art and classic sports cars may be quite attractive. However, the large outlay for these two groups put them out of reach for most. History has shown that investing even small amounts in a combination of stocks and bonds is a tried and true way of building wealth over time. And fortunately, the stock market is much more accessible than a vintage Chevrolet Camaro.
Of course, those wading into the stock market for the first time should educate themselves on some of the basic tenets that lead to successful investment strategies. This doesn’t mean that they need to earn a degree in finance. But they should make themselves aware of how their wealth is expected to grow over time and be comfortable with their chosen strategy.
How Long Is Your Runway?
Among the several factors that need to betaken into account when it comes to investing are the ages of the investor (or the beneficiary, in the case of a young child) and their investment horizon. Investment horizon simply refers to how long they anticipate the funds will be invested. This is important because although we can’t predict with much accuracy how stocks will perform over a period of one or two years, there is much more certainty over how they will do over periods 10 years or more. This is based on the long history of the U.S. stock market.
When parents invest money on behalf of their child, the investment horizon is usually long term. It is not uncommon to begin investing for a child’s education, for example, when the child is very young.In this case the investment horizon is often more than 10 years. So while during the course of the investment there will likely be periods when stocks do not perform well, a well balanced portfolio of stocks and bonds is much more likely to have grown considerably by the time the funds are needed for that child’s education.
Does the Stock Market Keep You Awake at Night?
A couple of other factors that need to be considered is how knowledgeable the investor is when it comes to investing and how comfortable they are with the volatility of the stock market. This latter comfort level is commonly referred to as risk tolerance. Investors that are more familiar with how stocks typically behave over time tend to have greater tolerance for risk. This is important because it goes a long way in determining the breakdown of their investments.
Investors that have a greater risk tolerance will be comfortable with an asset mix that is more tilted towards stocks over bonds. This is because stocks tend to perform better than bonds over time, but they will also be more volatile than bonds. This asset mix is known as asset allocation. As discussed above, the investment horizon also needs to be considered in determining the asset allocation. A portfolio designed to grow the wealth for a child’s future warrants an asset allocation that has a larger portion in stocks.
How Do You Slice Up the Pie?
So, for example, a parent investing for their child’s education may be comfortable with a portfolio that has a greater allocation to stocks. A higher weighting in stocks means that there will likely be periods when the portfolio will see dips in value. However, given the longer investment horizon, such an allocation is very reasonable.
Those new to investing often ask, ‘What is the correct asset allocation?’ There is no right answer to this question, as every investor has a different tolerance for risk. However, there are ‘rules of thumb’ as to what the appropriate range should be for stocks, bonds and other asset classes that may be included in the asset allocation. This asset allocation is not set in stone and, in fact, should be adjusted over time. As the child gets older and approaches the time when the funds are needed, the allocation to stocks will likely decrease.
Keep the Fees to a Minimum
Over the last 10 to 20 years, it has become a lot easier for individuals to gain exposure to a wide range of investments.This includes investments in different regions and countries throughout the world and different types of investments within the United States. It has become easier because investors are now able to do this even with smaller amounts of money. And here’s the good news. The cost of these investments has decreased substantially.
This has all been made possible thanks to the increased use of index funds. While index funds have been around for some time, they have become much more popular and widely accepted by the investment management industry. They are now seen as not only a sound way to invest, but also preferable to mutual funds. This is largely due to the fact that the management fees for index funds are substantially lower than mutual funds. This difference in fees means that investors see higher growth in their portfolios - especially over longer periods of time.
And Finally, Stick With the Game Plan
Investors usually come up with an asset allocation that they are comfortable with quite readily. Of course, portfolios should be reviewed on a periodic basis. But this only needs to be done once or twice a year. Over time, the performance of stocks and bonds tend to diverge, which leads to an increase (or decrease) in the allocation to stocks. Some adjustments may be necessary in order to maintain the desired asset allocation.These adjustments are known as rebalancing and they are part of the portfolio management process.
A problem sometimes occurs when investors don’t see results right away. That is, they tend to forget that their investments are meant for the child’s future, which may be 15 - 20 years from the present. This leads them to believe that ‘there must be something wrong’ with their strategy and they begin tinkering with their investments. These alterations come in the form of more trading and paying more in fees. This is often the undoing of what is likely an already solid investment strategy. Although most begin by saying that they are in it for the long haul, some investors need to keep in mind that they won’t see attractive returns every three to six months and that the stock market doesn’t go up in a straight line.
Conclusion
The investment landscape can be daunting for first-time investors. This is partly due to the constant flow of news and information about the day-to-day movements of the stock market. This only serves to instill confusion and fear. Those new to investing should make themselves familiar with the handful of fundamental principles that are known to be compelling. This will allow them to drown out the noise and stay focused on building significant wealth over time.
Photo by S&B Vonlanthen on Unsplash
