Investing was designed to be a long-term strategy you can use to grow wealth, combat inflation and preserve purchasing power, save for retirement, and meet your other financial goals.
As you think about your own relationship with investing, it’s helpful to consider different types of investing philosophies and decide what’s best for you and your financial life.
Why Do You Invest?
Some people tend to correlate the idea of “investing” with having lots of starting capital or a high net worth. But the reality, you achieve a high net worth through thoughtful, long-term investing decisions — but you don’t have to have a great deal of money to get started. In fact, it’s not necessarily how much you put into your investments that dictates success, it’s often how much time you give your investments to grow.
Everybody’s investment strategy is unique to them and should be based on their personal and financial goals. For example, you can determine your investing strategy by thinking through your major life goals such as:
- Saving for retirement
- Building an alternative form of income to achieve a work-optional lifestyle
- Pay for a child or grandchild’s college education
- Build generational wealth
The long-term timeline of investments lends itself to earning additional money through compound interest, even if you start with small amounts of money invested.
What Is Compound Interest?
Compound interest is the secret ingredient to meeting your investing goals! Essentially, it’s the interest that you earn on the interest from your initial investment.
For example, say you deposit $1,000 into an account that earns 5% interest. At the end of the first year, you have $1,050 (the initial deposit plus interest). Moving into the next year, you again earn 5% interest. But now, you’re earning 5% interest on $1,050, for a total year-end amount of $1,102.50 ($1,050 plus $52.50 in interest).
Your interest is compounding each year, which grows your investment without you ever having to add another dime. Of course, the more you contribute to the principal, the faster that compounding interest will grow your investment.
Understanding Risk Tolerance, Risk Capacity & Loss Aversion
What, exactly, is an investment? It’s the purchase of physical goods (such as real estate or gold) or assets (such as stocks, bonds, ETFs, etc.). The assumption or intent is for these goods and assets to appreciate in value over time.
When selecting the right investment opportunity for you and your goals, it’s helpful to understand a few key principles: risk tolerance, risk capacity, and loss aversion.
Risk tolerance refers to the amount of risk you’re comfortable taking with your investments. Essentially, it’s the amount you could afford to lose without jeopardizing your quality of life or ability to meet current financial obligations.
Typically, the more time you put between the initial investment and the need to withdraw from it, the greater the tolerance for risk. This is because markets have a historical tendency to trend upward, even as short-term performance fluctuates.
Risk capacity is the amount of risk you must take with your investments to see returns. Investments vary in risk level, from conservative vehicles like bonds to more volatile vehicles like stocks, mutual funds, ETFs, etc.
So while bonds are considered a conservative option, that security comes with a drawback — historically low returns that may not exceed (or even meet) yearly inflation growth. By comparison, stocks are riskier in nature, and therefore have the potential to earn greater returns.
Loss aversion is a behavioral phenomenon where an actual or potential loss is perceived by the investor as psychologically or emotionally more severe than the gain. For example, a loss-averse person would consider losing a $20 bill as significantly more upsetting than the happiness they’d feel from finding a $20 bill on the ground.
This fear can cause investors to make irrational decisions that are based on fear rather than fact. For example, they may be more inclined to hold onto a stock that isn’t showing signs of growth or let a risky stock go because they’re afraid it won’t recover from a sudden loss.
How can you avoid loss aversion? By establishing an investment strategy that’s tailored to you, working with a trusted financial professional and making investment decisions that are based on your long-term goals, rather than emotions.
What Does Timing the Market Mean?
“Timing the market” refers to the idea of moving your investments in and out of the market based on predictions of how the market will perform. It’s considered to be the opposite of the more long-term “buy and hold” strategy.
For example, investors may purchase more of a stock if its value is projected to rise and sell a stock that’s predicted to go down.
Many financial professionals believe that timing the market is impossible, but some investors still utilize it as a technique.
Potential Pros of Timing the Market
High risk has the potential for high reward, and those who time the market can potentially see bigger returns. When working strategically, these investors may be able to avoid losses or bypass market volatility. Typically, timing the market is best suited for short-term investments that are more at risk of the day-to-day ups and downs of market performance.
Potential Cons of Timing the Market
Timing the market requires extreme daily attention to the market and your own investments. It’s not typically feasible for the average investor to maintain. Not to mention, buying and selling often can incur hefty transaction costs and trigger short-term capital gains, which are taxed at a higher rate than long-term capital gains.
Stay Invested Long-Term
When you’re set on staying invested long-term, you’re more likely to use a “buy and hold” strategy.
There’s no magic sign that the market is going to change. And while we can look to past performance for certain indicators, it does not predict future results. In other words, there’s always some form of risk involved with investing funds.
A recent study by JP Morgan actually found that most of the best days in the market come directly after the worst. In fact, six of the 10 best market days occurred within two weeks of the 10 worst days.1
In addition, this study found that over a 20-year period, those that missed the top 10 best days in the market had their returns cut in half.1
What’s the takeaway here? It makes more sense to stay invested through the ups and downs of the market, rather than trying to time it. If you’re not paying attention, or if you miss even one of those best days, you could be potentially causing a huge loss to your portfolio.
3 Tips to Set Your Portfolio Up for Success
So how can you set your portfolio up for long-term growth and success? We suggest diversifying, keeping a long-term outlook, and focusing on cost efficiency.
You’ve likely heard the phrase, “don’t put all your eggs in one basket.” Well, that’s diversification! By spreading your money over multiple investment types, you’re protecting yourself from large losses.
As we’ve mentioned earlier, you want to ensure that your investments will continue to grow over time. Keeping that long-term outlook helps investors bypass the emotional rollercoaster that comes with closely monitoring day-to-day market performance.
And finally, being cost-efficient with your investments means you’re making sure your gains outweigh the cost of maintaining your portfolio. If you’re paying more in fees, taxes, and operational expenses than you’re getting in returns, something probably needs to change with your portfolio.
Our Investment Philosophy at PIFP
At Partners in Financial Planning, we see investing as a long-term commitment. When working together, we can help you evaluate your goals and risk tolerance, while using that information to create an investment allocation that works best for you.
We are not believers in market timing. Rather, we prefer sticking with the allocations that are created just for you and designed to outlive the inevitable ebbs and flows of the market. If you’d like to learn more about our investment philosophy, don’t hesitate to reach out.
Partners in Financial Planning provides tax-focused, comprehensive, fee-only financial planning and investment management services. With locations in Salem, Virginia and Charleston, South Carolina, our team is well-equipped to serve clients both locally and nationally with over 100 years of combined experience and knowledge in financial services.
To learn more, visit https://partnersinfinancialplanning.com