Investing is a critical part of any financial plan. While it is only one piece of the puzzle, it is an important one as it directly leads to the long-term preservation and growth of wealth. While saving money and increasing your earnings potential are essential, you need to invest that money you save or earn if you want to watch it grow.
While I am certainly no expert, I have a few guidelines that I think would help anyone. I hesitate to call these rules as that means they should be strictly followed. There is always wiggle room here, and relaxing one guideline could mean more strictly following another.
1. Don’t invest in something you don’t understand
This is perhaps the most important one to follow. If you don’t understand what a particular investment does or how it can make, or lose, you money, then you shouldn’t be putting your money into it. Investing in vehicles you don’t understand or can’t figure out is the quickest way to separate you from your money.
Now, no one can fully understand or know everything, and some investments out there can be quite complicated, so this is the time to learn by using online resources. Interested in a stock or ETF because you read about it somewhere? Use google. Read up from trusted sources or crowdsourced reviews to see how it works. Talk to a financial adviser (a fee based one preferably). Or find a few people and get a few different opinions. Don’t just dump your money into some hot stock tip or the newest cryptocurrency because you heard about it at a party.
2. Know your risk tolerance
Once you understand what you are investing in, the next question is, how much risk can you handle? Your investments can nearly always lose money, and your tolerance for risk is how much you can watch that value erode before you bail or drive yourself crazy.
Risk is driven by a lot of factors, but there are two main questions you should ask to help you figure this out. First, when would you need the money back? The longer your timeline, the more likely you can tolerate short-term drops. Second, how far can you watch your investment drop before you would give up in frustration and sell? This is much more subjective, but important nonetheless.
Depending on how much risk you can tolerate should determine your overall investment strategy. If your risk tolerance is low, you shouldn’t have the majority of your money in the stock market.
3. Diversify
This plays into knowing your risk tolerance. No matter what, you want a diversified portfolio that exposes you to broad categories that have as little correlation as possible. This way, even if some of your investments go down, others would go up.
In general, these are the categories I usually invest in: US Stocks (large cap to small cap), International Stocks, Bonds, Real Estate, Commodities, Peer-to-Peer Lending, and cash. The percentages of these will depend on your risk tolerance, so it is impossible to spell out what they should be for you. A conservative approach may only put 40% or 50% in stocks, while an aggressive plan may put 80%-90%.
You also need to rebalance over time, that is make sure your diversity stays roughly constant. You can do this by selling some assets and buy others. A better approach may be to change your future purchases to rebalance, which means you wouldn’t need to sell potentially winning investments.
Beyond investment types, you should also be diversifying the types of accounts you have. You want to consider taxes and other benefits and drawbacks of having different accounts. For example, you may want to split your employer offered 401k into both a traditional and Roth account, thus saving yourself some taxes later.
Diversifying both your investments and account types can lead to minimizing risk and providing more choices for a particular financial task.
4. Don’t try to time the market
Almost any investment type will be volatile in the short term, but (hopefully) trend up in the long term. That is the game you are playing: put money in long enough that long term gains overpower short term fluctuations. The reason? You can’t beat short term volatility. No one can. Some people get lucky here and there, but there is no tried and true method for beating any market over a short period of time.
Buying stocks or ETF’s and then holding them over time will give you your best shot at large gains. Better yet, dollar cost average your money in, that is keep buying in small increments over time instead of large moves at once. This will further help beat short term fluctuations and average out your buying power over time.
Buy and Hold also doesn’t mean you can’t sell a losing bet. If an investment changes and is no longer as attractive, it is ok to sell. Don’t hold on in hopes of recovering your losses, always think about the best way to grow that money, event if it means selling that investment at a loss and buying a better one.
You’re playing the long game, so don’t worry about the short term changes.
5. Plan for Wildcards
Even with the best laid plans, something will change. Perhaps a business in your city or town goes up for sale and you want to take ownership. Or you or a colleague come up with the next brilliant product and need money to build a company around it. Whatever it is, something will lure you away from your well-structured financial plan. And that is ok, as long as you plan for it.
Having money set aside for these wildcard scenarios is the best defense against letting them spoil your plans. Always have a small pot of money that is meant for just such occasions. Slowly add to it over time, and when a wildcard pops up, you know precisely what you can spend. This will prevent you from selling other investments or compromising your portfolio to chase down some dream, but give you the flexibility to take those chances.
Summary
While certainly not a comprehensive list or an exact roadmap to riches, these guidelines should help anyone get on, and stay on, a sustainable investment path. Remember, investing is for money that you don’t need right now or even in the short term, it is to grow wealth over time. Don’t rush out and buy investments you don’t understand, do your homework first. Make sure you understand your risk tolerance and adjust your investment accounts accordingly. Don’t time the market, instead buy in small increments over time and hold on to them. Finally, plan for those wildcards, they will pop up and you don’t want to raid your portfolio to chase a dream.
These are the guidelines I try and follow, I hope they work for you.