Investing is rather like riding a roller coaster while wearing a blindfold. You can’t tell when a steady incline will give way to a precipitous decline. And while hurtling downward on an actual roller coaster can be fun (for some folks anyway), market plunges are anything but.
There’s no way to make market volatility go away. It’s an unavoidable reality of investing. But you can stay steady through the ups and downs by employing a defined and disciplined investing strategy such as those SMI offers.
No single strategy is right for everyone, but every good long-term strategy incorporates six core principles.
- Principle #1: Success comes not in hoping for the best, but in knowing how you will handle the worst. A reliable plan will accommodate the fact that the investment markets will experience downturns. How? Through diversification — i.e., purposely selecting a range of investments that “march to different drummers.”
Holding different types of investments that tend to respond differently to economic events helps to smooth out the overall volatility of your portfolio. The hope is that if some of your investments “zig,” others will “zag.” Surprisingly, it’s possible to assemble lower-risk investment combinations of investments that give much the same returns over time as higher-risk combinations.
SMI’s Just-the-Basics strategy diversifies widely across various stock and bond categories. Our other two core strategies — Fund Upgrading and Dynamic Asset Allocation — combine stocks, bonds, and other asset classes (as appropriate).
- Principle #2: Your investing plan must have clear-cut, easy-to-understand rules. A plan with specific numerical guidelines will help you make investing decisions quickly and with confidence. A strategy that calls for “30% of my portfolio to be invested in small-company stocks” is straightforward. In contrast, one that calls for a “significant investment in small-company stocks” is too open to interpretation.
Your strategy should not only tell you what to invest in, but it should also offer precise guidance in telling you how much to invest and when to buy and sell. SMI, of course, offers this kind of detail via regular updates in the monthly newsletter and on our website.
- Principle #3: Your investing plan must reflect your financial limitations. Never ignore the words “higher risk.” They mean something — namely, that there’s a greater likelihood that you could lose money. Every day, people who thought “it’ll never happen to me” find just how wrong they were.
Investing in the stock market isn’t a game in which gains and losses are just the means of keeping score. Money isn’t an abstract commodity. For most of us, it represents years of work, hopes, and dreams. An unexpected financial loss can be devastating. Therefore, a good investing plan should discourage you from taking risks you can’t afford.
SMI’s “sound mind” approach establishes getting debt-free and building an emergency reserve as your two top financial priorities. Only then are you financially strong enough to bear the risk of loss that is ever-present in the stock market. That’s why we encourage you to not invest discretionary funds in the stock and bond markets until your debt and savings goals are met. The one exception is making investments via a workplace retirement account, especially if your employer matches your contributions.
- Principle #4: Your investing plan must keep you within your emotional “comfort zone.” Don’t adopt a strategy that robs you of your peace and takes you past your “good night’s sleep” level! If you do, you likely will bail out at the worst possible time.
The amount of risk you take should be consistent with your “investing temperament” and your season of life. That’s why SMI provides a temperament quiz and season-of-life table in the Start Here section at soundmindinvesting.com.
- Principle #5: Your investing plan must be realistic concerning the level of return to expect. Sometimes people ask us to recommend safe investments that will guarantee annual returns of 10%-12% or more. If by “safe” they mean there’s no chance of the value of the investment falling, we don’t know of any investments like that. Investments that are “safe” in that sense typically pay much less than 10%-12%. (Recent inflation has created a rare exception: I-Bonds, issued and guaranteed by the U.S. government, currently are yielding close to 10%.)
Return and risk are inextricably linked. Investment vehicles that offer a higher rate of return than is “normal” do so to entice investors into accepting a higher level of risk. SMI’s goal is to help you incur the least risk that will still get you to your financial destination safely.
To let you know what expectations are reasonable over various time frames, we regularly report on the historical performance of our various strategies (see, for example, our latest quarterly report card).
- Principle #6: Your plan should encourage you to begin investing with small amounts, so you can get started as soon as possible and take full advantage of the power of compound interest. Consider this updated version of the saga of Jack and Jill. Jack started a paper route when he was eight years old and managed to save $1,200 per year. He deposited his money in an IRA and earned an average annual return of 8%.
Young Jack continued this pattern through high school and “retired” from the paper-delivery business at the ripe old age of 18. All told, he saved $13,200 during that time. His savings continued to compound in his IRA until he reached 65, though he never added another dollar during the intervening 47 years.
Jill didn’t have a paper route, and she waited until her post-college days to start her savings. At age 26, Jill was sufficiently settled to start putting $3,000 a year into an IRA. This she continued to do for 40 years. Like Jack, she earned an 8% compounded return on her savings.
Which IRA was larger at age 65? Jack’s, into which he put $13,200? Or Jill’s, into which she put $120,000?
Jack is the winner. His IRA has grown to $894,000, about 68 times more than what he put in as a child. Jill did almost as well. Her IRA grew to $878,000. But Jack’s earlier start, even with smaller amounts and fewer deposits, enabled him to accumulate even more thanks to the power of compounding.
That’s a fanciful story, of course. It’s unlikely a child would have earned income to allow for IRA contributions like that! But there’s nothing fanciful about the tremendous power of compounding. Over many years, small amounts can grow to substantial sums. As Proverbs 21:5 (TLB) says, “Steady plodding brings prosperity.”
Whatever investing strategy you choose to follow, be sure it reflects these six principles. They will help you stay level-headed through the many financial and emotional ups and downs of being an investor. Even as the “market roller coaster” rolls on, you’ll be building on a firm foundation.