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10 Steps to Investing Success

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“…the issue isn’t managing your investments, it’s managing yourself while you manage your investments.” –Charles Hugh Smith

I started investing in my mid-30’s and became financially independent at age 50. Over that time, I learned much, had my share of successes, and made some big mistakes. But I reached my goals, despite two of the worst market downturns in history — the Dot-com Bust and the Great Recession. Common sense, consistency, and caution won the day.

Here I’d like to show you the core investing principles I used. They’ve stood the test of time. They don’t require clairvoyance, luck, or genius. Instead, they rely on simplicity and statistics. These are the exact principles that helped me grow my portfolio and retire at age 50 with security and confidence. Here then are my top ten steps for investing success:

1. Understand your asset allocation

How you allocate your money to different asset classes is one of the most important factors in your long-term investing success. In particular, know your percentages of cash, bonds, real estate, U.S. stocks, and international stocks. For asset allocation purposes, manage all investment assets, retirement and non-retirement, yours and your spouse’s, but not home equity, as one big portfolio. That means you need a spreadsheet or tool that shows your asset allocation across all your holdings.

Without that complete, up-to-date picture, you’re flying blind — you can’t make critical investment decisions. Beware the allocations shown by brokerage statements or investing web sites. They’re rarely accurate, in my experience — leaving large percentages uncategorized, and mislabeling others. And beware aggregation tools that require consolidating all your financial login credentials in one place. For me, at least, that’s an unacceptable risk given the routine massive security breaches in today’s world.

2. Choose a bond allocation

The division between stocks and bonds is the single most important choice in asset allocation. The old rule of thumb, a good starting point and still touted by John Bogle, founder of Vanguard, is to “keep your age in bonds.” So, if you’re 40, you’d have 40% in bonds; if you’re 60, you’d have 60% in bonds. But there are other worthy asset allocation strategies.

Many experts caution against being too conservative, especially if you’re young: You stand a better chance of outpacing inflation if you keep more in stocks. Technically, they are correct. But the bigger question is whether you can tolerate, and afford, the greater risk of stocks. You must have the fortitude not to sell out at the bottom of a market cycle, and enough liquid assets in bonds or cash to live through the cycle.

Whatever you decide about your allocation to bonds, consider holding some U.S. government bonds (Treasuries) — for the ultimate in safety, and some inflation-indexed bonds (TIPS) — as a hedge against surprise or runaway inflation.

3. Own only baskets of stocks

Buy mutual funds or exchange-traded funds (ETFs), rather than individual securities. Most investors do not have the time or expertise to choose among individual stocks for an adequately diversified portfolio.

One of my most important financial mentors recommended holding no less than 32 individual stocks for adequate diversification. That’s an enormous amount of financial data to digest and monitor on your own: I never tried it!

It’s better and easier to choose very low cost index mutual funds or ETFs. The majority should have expense ratios of 0.2%, or less. The differences between mutual funds and ETFs are generally negligible: Choose whichever is more convenient for you.

4. Keep it simple

Hold as few positions, in as few accounts, as possible. Each one of your holdings requires some overhead and management from you. The fewer moving parts, the better.

In my opinion, it’s possible to construct a well-diversified portfolio for the long term with just three holdings: a U.S. stock fund, an international stock fund, and a bond fund. You can make that even simpler by investing in a balanced fund, that combines even those different asset classes into one.

In my case, a portfolio constructed over two decades, and suitable for sustaining a 40-year retirement, now contains just 7 funds. Keep an eye on the size of individual positions. Those smaller than about 5% are usually a distraction. Those greater than about 20% can increase risk to an unacceptable level, unless they are internally diversified — such as a balanced fund.

5. Befriend your holdings

Don’t make investments you don’t understand. Know your investments like family members, or employees. Expect a long-term relationship. Understand their strengths and weaknesses, and don’t ask every one to be good at every thing.

Beware “recency bias” — judging your financial progress and your portfolio based on how it did last year. Don’t judge your investments by whether they are up or down in the short term, but by whether they behave predictably, and complement each other’s performance.

Over the short term, you should expect to see prices for your holdings move in opposite directions, damping volatility. Some should go up when others go down. While you want your portfolio to exhibit steady overall growth in the long term, too many days where the prices all move in the same direction indicates a lack of diversification, and subsequent higher risk.

6. Buy consistently

When investing a fixed, recurring amount through payroll deduction, you will be taking advantage of “dollar cost averaging” — buying more shares when prices are lower. Whenever possible, add to existing positions, rather than buying new securities that you must research and then monitor.

During my accumulation years I tried to buy whatever was cheapest, comparing price-to-earnings (P/E) ratios and/or looking at 1-year price history and buying what was down. Research shows that hot asset classes tend to revert to the mean, or below, after about 3 years: Beware buying a recent hot performer! If in doubt, choose a balance of stock and bond funds, to hedge against sudden price movements in either.

When investing a lump sum, say a bonus, gift, or inheritance, prefer investing all at once, in a range of funds, or a single balanced fund. Rather than trying to “time” the market, or break up your purchases into numerous small pieces — which can be time consuming and complicate tax record-keeping — put most of the money to work, right away.

7. Sell rarely

Selling requires you to make two very difficult investing decisions: (1) What to sell? and (2) What to buy with the proceeds? Selling usually incurs expenses, and often has negative tax implications. Never sell simply based on what you hear in the news: Only sell when your fundamental understanding of a holding has changed, or you need income.

After selling, be careful not to unintentionally change your asset allocation by reinvesting in a different kind of asset. When you need to rebalance toward your target asset allocation, try to do it primarily through buying, not selling: Use new money as much as possible.

Near the bottom of the market in March 2009, I sold some positions to simplify my portfolio, reduce expenses, and harvest tax losses. But I was careful not to change my allocation to stocks. When the market bounced back, my portfolio participated fully in the recovery.

8. Keep cash on hand

In general, hold income-producing securities in tax-sheltered retirement accounts so that the steady income they generate is not taxed each year, but rather allowed to compound in full. This includes bonds, REITs, and dividend-paying stocks.

However, be sure to hold enough stable fixed-income investments — short-term bonds, money market funds, or cash — outside of retirement accounts, to cover emergencies or living expenses during a job loss or down market. The common advice for younger people is to keep a 6 month “emergency fund” on hand, but as a retiree without steady income, I prefer at least 2 years, if possible.

My second book concludes that “to outlast a run-of-the-mill bear market, you should have three years of cash on hand. And for a worst-case recession/depression, you’d better have close to a decade worth of cash plus other conservative investments you could rely on once cash runs out.” If you were forced to sell stocks for living expenses during a down market, you would be losing money, and damaging your principle.

9. Learn patience

You, and your savings, will be the prime beneficiaries of everything you learn about investing and of any improvement you make in your investing skills.

Surprisingly few concepts and techniques are required to be a successful long-term investor. The challenge lies in choosing from among the confusing universe of investing information and products, those few that will work for you. This process takes time. The sooner you start — the earlier, faster, and smaller you can make your mistakes — the better.

Learning more, while doing less, is the natural path to building investment wealth.

10. Speculate once

Yes, I know it’s a shocker to use the word “speculate” here at the end of all this prudent, conservative investing advice. A speculative investment is one with an unknown return, one where you could very possibly lose all of your principal. Such investments have little place in the portfolios of most people saving for retirement, who can’t afford even a small dent in their life’s savings. But they do have a place.

First, a speculative investment can provide a learning experience about risk and what it feels like to lose money. Many of us have paid a high price for such an education. Keep your own price tag low by speculating only with very small sums of money.

Second, if you are a seasoned investor with a large nest egg already in low-cost, predictable, broad market stock and bond funds, you might be tempted to place a bet on something further afield. Maybe you have some special knowledge from your career that gives you an edge. Assuming you understand, deeply, your personal risk and loss tolerance, I won’t try to dissuade you. A small exotic investment might satisfy an otherwise destructive itch, as long as you fully and fairly estimate the price tag!

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