Whether you’re a market-tested veteran or new reader putting together a plan for the first time, foundational principles are worth reviewing. And, as you get older and navigate changes in your circumstances, it’s wise to periodically re-evaluate — and perhaps tweak — your long-term investing approach in light of those principles.
We hope this guide will help.
Investing is not for the faint of heart. Because it always involves an element of risk, it’s an uncertain activity that often feels uncomfortable. Just think back on recent history.
After reaching a new high in September 2018, the market sold off, falling nearly 20% to end the year in the red. If investors thought the carnage would continue into the new year, they could be forgiven. After all, many market watchers believed the bull market had gotten a little long in the tooth, and everyone knows good times don’t last forever. But the market quickly found its footing, hitting fresh highs by the spring of 2019 and ending the year with huge gains. (More recently, the market bounced back from the COVID crash — with a big boost from the Federal Reserve and Uncle Sam — to end 2020 with significant gains.)
Now think back even further, to 2016. At first glance, that looks like a wonderful year to have had money in the market. The S&P 500 tallied a 12% gain. However, as is often the case, the path leading to that result was far from smooth.
In late June of that year, UK voters surprised the world by opting to leave the European Union (“Brexit”), sending markets reeling. That turmoil was followed by Donald Trump’s surprise election in November, which took Dow futures down nearly 800 points. While the market quickly recovered from both surprises, the temporary downward moves they created took a toll on many investors’ emotions.
The field of behavioral economics suggests that investors suffer the pain of losses twice as acutely as they feel the joy of gains. So, while the market’s ups and downs may offset each other financially, they don’t necessarily offset each other emotionally. Instead, the sharp down days do “double damage” — the corresponding up days only offset half the effect. The market may go sideways, but investor sentiment falls nonetheless.
Unfortunately, you can’t control the stock market. But there are many aspects of investing you can control. Focusing on the things you can control is an effective counter-weight to concerns about the market (or the economy, or the Middle East, or the next election, etc.).
We thought it would be helpful to step back and review the core building blocks of successful investing. Newer readers will surely benefit from a quick survey of these core principles. Seasoned investors should benefit as well — it’s all too easy to get bogged down by increasing layers of complexity as the years pass. Even if you’ve been at this investing thing for a while, consider this an opportunity to review your past big-picture decisions and decide if they still make sense given your current season of life and the progress you’ve made toward your goals.
We could include a great many items in a list of “core” principles. But to focus this discussion more firmly on the investing process itself, we’ve made a few assumptions up front. We’re assuming you’re already utilizing a spending plan (aka a budget). Creating a budget and living by it likely will make a more significant impact on your financial life than anything else you can do. It will enable you to have a monthly surplus that makes financial progress possible. Without a budget, you’re likely trying to harness the wind.
While on the subject of tilting at financial windmills, if you’re not giving generously, make this the year you begin. Scripture makes clear that we were designed to live generously, and it is full of promises for generous, cheerful givers. Though counter-intuitive, giving generously is a key component of building financial security because it invites the Lord’s blessing.
We’re also assuming you’re rid of most, if not all, consumer debt. (If you still have debt other than your mortgage, focus your efforts there first.) Likewise, we’re assuming you have a reasonable savings reserve. Building a reserve is your next priority before beginning to invest.
Living on a budget, giving generously, living debt-free, and having a reasonable emergency savings reserve comprise the bedrock we’re building on. From there, you’re ready to begin your investing journey. Here are five foundational principles to help get you where you want to go.
1. Write it down! The importance of your long-term plan
Many people think they have a long-term investing plan. And they do — sort of. At least until the market drops -10% in two weeks. Then they realize they really only have a collection of ideas about how they might want to invest. Guess how much those vague ideas are worth at 3 p.m. on Friday when the market is down –4.5% for the day with no bottom in sight?
In contrast, SMI is built around the idea of creating a personalized, long-term investing plan and putting it in writing. Don’t neglect this last part. Putting pen to paper (or pixels to screen) forces you to become much more precise, concise, and specific. These are the qualities your plan will need to be truly helpful at 3 p.m. on the aforementioned Friday when the market is tumbling and your emotions are screaming at you to end the pain.
What needs to be included in your long-term plan? A good place to start is with a few brief financial goals. Prayerfully set, and agreed upon with your spouse if you’re married, these written goals can motivate you to stick to your plan.
Your application of the remaining four steps (i.e., core principles) discussed in this article will constitute a significant portion of your long-term plan. Before moving on to those, here are four keys that will help ensure that your plan is effective.
- Key #1: Success in investing comes not in hoping for the best, but in knowing how you will handle the worst. No one knows what is going to happen next year, next month, or even next week. Your plan must allow for the fact that the investment markets will experience unexpected rough sledding now and then. That’s where diversification comes in. The idea is to pick investments that “march to different drummers.” Your strategy should involve owning a mix of investments that are affected differently by economic events. For example, your portfolio might include both a bond fund and a gold fund. When inflation heats up, bonds go down (due to rising interest rates); at the same time, gold goes up (because investors want a secure “store of value”). To the extent that the price changes in the two funds offset one another, you have added stability to your overall portfolio.
- Key #2: Your investing plan must have clear-cut, easy-to-understand rules. You must be able to make investing decisions quickly and with confidence. This means reducing your decision-making to numerical guidelines as much as possible. A strategy that calls for a “significant investment” in small-company stocks is not as helpful as one that calls for “30% of your portfolio” to be invested in small-company stocks. Insofar as possible, your strategy should not only tell you what to invest in but also offer precise guidance in telling you how much to invest and when to buy and when to sell.
- Key #3: Your investing plan must reflect your current financial limitations. Your plan should effectively prevent you from taking risks you can’t afford. The words “higher risk” mean there’s a greater likelihood you can lose part or all of your money. Every day, people who mistakenly thought “it will never happen to me” find just how wrong they were. Money is not an abstract commodity. For most of us, it represents years of work, hopes, and dreams. Its unexpected loss can be devastating. Only when you are out of debt and have an emergency reserve are you financially strong enough to bear the risk of loss that is ever-present in the stock market.
- Key #4: Your investing plan should reflect a balance between your emotional “comfort zone” and your need for capital growth. Your plan should prevent you from taking risks that rob you of your peace. That is why, as part of our “getting started” process, we help you identify and understand your tolerance for risk (see next section). We don’t want you to embrace a strategy that takes you past your “good-night’s sleep” level. If you do, you’ll tend to bail out at the worst possible time. On the other hand, you can’t set your risk level so low that you have no chance of meeting your long-term goals.
The process of thinking through and writing out your long-term plan will help create the “inside-out” perspective that SMI believes is so important. And the process of periodically referring back to your plan helps maintain that focus as the years pass and you’re tempted to add complexity to your investing efforts.
2. Carefully consider your most important investing decision
What determines the performance of your investment portfolio more than any other single factor? Many investors think it’s the specific investments they choose. Those choices can make a big difference. But this is more crucial: How much of your portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. Academic studies suggest that as much as 90% of your long-term results will be traceable to this fundamental allocation decision.
A portfolio’s stock-to-bond mix does more than dramatically influence future returns. It also tells you how those results are likely to be obtained. Generally speaking, the more bonds in your portfolio, the smoother the ride. By contrast, the higher your stock allocation, the more you can expect returns to come in a “two steps forward, one step back” fashion.
If owning stocks subjects you to larger swings in performance and produces losses more frequently, why use them at all? Because that’s where the biggest long-term gains are! The net effect of all those stock market ups and downs is greater overall returns. So, on the one hand, we have stocks, which are volatile but produce high returns. On the other, we have bonds, which are relatively stable but generate lower returns. How should you go about combining them in a portfolio?
The key ingredient in this recipe is time. Over shorter periods, stock returns are more variable. Maybe you’ll do great; maybe you’ll do poorly. Given a long time frame, however, you can be confident that stocks will provide higher returns than bonds.
Here’s an example to illustrate this point. Think about tossing a coin. You know that the probability of getting heads on any single toss is 50%. So if your goal is to get 50% heads, then what matters most to you is having a lot of tosses. If there are only going to be two tosses, you should be much less confident of getting 50% heads than if there are going to be ten tosses. With 100 or 1,000 tosses, your confidence should grow correspondingly that the long-term averages will emerge.
So it is with investing. The more years (“tosses”) you have ahead of you to invest, the more confident you can be that you’ll benefit from the higher average returns stocks have historically provided. The fewer years you have to invest, the more you need to protect against the possibility that the results over your shorter time period may not match the long-term averages.
That’s why it’s generally recommended that younger investors take advantage of the many “tosses” in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it’s prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.
The allocation of a portfolio is the primary driver of both its expected returns and volatility. If you’re nearing the end of your investing time frame (whether for retirement, college, etc.), this information should give you confidence that you can keep growing your money at a reasonable rate even if you decrease your stock holdings to reduce the chance of short-term losses. Conversely, if you still have many years to invest, understanding this should liberate you from worrying too much about short-term stock market losses and help you focus on the higher long-term returns stocks have historically provided.
SMI provides tools to help you determine the optimal stock/bond allocation given your risk tolerance and current season of life. See the “Start Here” section of the SMI website for these tools. (Note that our Dynamic Asset Allocation strategy does not require you to predetermine your optimal asset allocation. So, if you plan to use that strategy exclusively, you don’t need to go through this process. However, if you are using any other SMI strategy, solely or in addition to DAA, you should go through the process to determine your optimal asset allocation.)
3. Maximize tax-advantaged opportunities
Taking maximum advantage of the opportunities provided by the government to delay or avoid taxation of your investment earnings is a crucial component to building long-term wealth. Yes, you can invest in a regular taxable brokerage account, but you’ll advance much more quickly — and likely wind up keeping much more of your earnings overall — if you take full advantage of the retirement savings plans provided by employers (401k, 403b, etc.) and/or IRAs.
Describing all the account types and how to decide between them is too detailed a discussion for this article, but here’s a broad overview. 401(k) plans and IRAs come in two types — “traditional” and “Roth.” Traditional 401(k) plans and IRAs allow savers to defer taxes now and pay them later. Retirement savers get an up-front tax deduction when they deposit into the account. Their earnings then grow tax-deferred, and they pay tax on all of the withdrawals (both their original principal and all earnings) in retirement. The Roth versions of these plans flip the tax equation: pay taxes now, make tax-free withdrawals later. After-tax money is deposited initially, which makes all later withdrawals (principal and earnings) tax-free in retirement. Which approach is better largely depends on whether you end up in a higher or lower tax bracket in retirement.
Roth accounts would seem to be more advantageous, but that isn’t always the case. With “traditional” accounts, it may appear that you’re merely postponing your taxation day of reckoning. But keep in mind that most people are likely to be in higher tax brackets now (while working and saving) than during retirement (when their employment income has stopped). This means they may pay significantly less taxes on investment gains later, as opposed to paying them each year while earning employment income.
Granted, non-taxable accounts have more strings attached than taxable brokerage accounts, so you lose some flexibility. But that’s a reasonable tradeoff for most people.
It’s also worth noting that these tax-advantaged accounts have income and contribution limits, so it’s wise to start utilizing them sooner rather than later. If you delay making these deposits until you achieve other financial goals, you may find yourself unable to take maximum advantage. If you forgo making a contribution one year, it’s gone forever — you can’t make a double contribution the next year.
4. Choosing the right investment strategy
What makes an investment strategy the “right” choice? It’s not always an easy decision. The most important point is that you believe in your chosen strategy enough to stick with it during the inevitable downturns. Every strategy will falter occasionally. Bailing out at those times in search of a better-performing approach isn’t a formula for building long-term wealth.
Sound Mind Investing offers two “Basic” investment strategies: Just-the-Basics (JtB) and Upgrading. Our two “Premium” strategies are Dynamic Asset Allocation and Sector Rotation. Here’s a brief overview.
- Just-the-Basics is the epitome of simplicity. Using just three or four Vanguard index funds (depending on your chosen portfolio mix), JtB seeks to match the return of the overall market. Research repeatedly shows that the average investor typically trails the market’s rate of return, usually by a significant margin. JtB ensures this won’t happen to you by delivering returns roughly equal to that of the market. As a bonus, it’s an easy, low-maintenance way to invest, requiring attention only once a year.
- Upgrading is a trend-following strategy that attempts to beat the market by adjusting to the types of investments the market is currently favoring. In Upgrading, we rank more than 1,500 mutual funds by type each month and determine which ones have been delivering the best recent performance. We recommend the purchase of the highest-momentum funds in each of three SMI stock-risk categories. These funds are held until they stop outperforming. At that point, we recommend replacement funds showing stronger recent performance. (As of January 2021, the Fund Upgrading strategy also uses two index funds as longer-term holdings.)
- Dynamic Asset Allocation (DAA) is also a trend-following strategy. However, instead of rotating into the highest-momentum funds within different stock risk categories, DAA rotates among entire asset classes — U.S. Stocks, Foreign Stocks, Real Estate, Gold, Bonds, and Cash — keeping those following the strategy invested in the three best-performing classes. As a somewhat defensive strategy, DAA enables investors to participate in some of the gains of a growing market while providing strong protection against loss during market downturns.
- Sector Rotation (SR) is SMI’s highest-risk, highest potential reward strategy. By investing in a single highest-momentum fund among a universe of focused, industry-specific “sector” funds, SR has generated a remarkable +13% average annual return since the strategy launched in 2003. Because of its high-risk profile, investors are encouraged to put no more than 20% of their portfolio’s optimal stock allocation into SR.
- 50/40/10 refers to a way of blending SMI strategies that involves putting 50% of your portfolio in Dynamic Asset Allocation, 40% in Fund Upgrading, and 10% in Sector Rotation. While it requires a little more work to manage your portfolio this way, the benefits can be substantial. SMI research suggests this approach should reduce portfolio volatility while increasing returns.
5. Run your retirement numbers and make adjustments
This step may seem a bit tricky, but it doesn’t need to be. First, you need to periodically revisit the first four steps on this list (as well as revisiting your budget). Your budget won’t likely be the same at age 30 as at age 50 — and neither will your asset allocation. Life happens — an illness, job change, unexpected blessings that cry and need their diapers changed — these and a thousand other factors may cause you to adjust your plan as you go. That’s okay. Just don’t abandon your old plan without putting a new plan in place.
On the purely investment side, things are a little more rigid — you shouldn’t make changes to your plan just because the market is down –25% and you’re feeling queasy. But if you come across new information or a new strategy that makes you honestly (and unemotionally) believe that a change is warranted, there’s flexibility to build it into your plan. Circling back to where we started, however, make sure any changes are inside-out (based on your needs and goals), not outside-in (based on the news of the day).
In addition, we recommend running your retirement-savings numbers periodically. Every few years may be enough for some; others may prefer more often, perhaps annually. SMI offers two ways to do this. First, you could use the MoneyGuidePro® software, to which SMI Premium-level members can gain access for a one-time $50 fee. This powerful tool allows you to do thorough retirement-related investment planning and to store your information for easy updates in the future.
The second method is to use an old-fashioned pencil-and-paper approach. Chapter 19 of The Sound Mind Investing Handbook includes retirement worksheets for this purpose.
The challenging thing, of course, is knowing what to do when reviewing your numbers reveals a shortfall. If you find you’re behind schedule on your retirement-savings goals, the safest approach is to increase your savings while keeping your portfolio allocation and strategy selection unaltered. While it’s not easy, it is safe because you aren’t asking too much of yourself emotionally, as can be the case when you step beyond your ideal allocation or strategy selection.
If you absolutely can’t find the extra savings to plug the hole, either you need to scale back your retirement assumptions (when you will retire or how much income you hope to have in retirement), or you need to add more risk in pursuit of higher investment returns. We write it that way intentionally to drive home the riskiness of this approach. Boosting your stock allocation from 60% to 80% may not seem like a big deal — until the next bear market rolls around and you’re outside your emotional comfort level. Similarly, adding a higher-risk strategy, such as SMI’s Sector Rotation strategy, may seem like an easy way to boost returns. Just be aware that with those higher returns comes higher risk and volatility.
Higher risk always accompanies higher-return strategies. Attempting to recover from investment declines by pursuing higher-risk approaches has been the downfall of many investors throughout the ages. Better to make realistic adjustments to your retirement plans by delaying retirement an extra year than risk blowing up your portfolio in pursuit of higher “make-up for lost ground” returns.
The five steps described above aren’t comprehensive in terms of taxes, estate planning, insurance, and so forth, but they do provide a helpful guide for gauging your fundamental investing needs and getting started. The primary obstacle for most people as they travel down the road to financial freedom is not a lack of a “perfect” plan — it is inertia. Get going with these bases covered and you’ll find there’s plenty of time to fine-tune things as you go.