Investing can be thrilling, right? Watching your favorite stock drop in value just to shoot up is like watching your favorite team come back from being way down to win the Super Bowl. However, this excitement isn’t exactly your ally, as those emotional highs and lows that come with the rise and fall of your favorite stocks can lead to poor investment decisions.
While it’s true that you could potentially make a fortune in the stock market, the most reliable and consistent path to investment success is one that is guided by a disciplined approach and a few core principles rather than by emotions.
Admittedly, this method may not be as exciting as chasing after the latest hot stock tip. However, it will significantly increase your chances of achieving your financial goals and avoiding financial disaster.
Why Invest in the First Place?
That dollar you have in your hand today – it’s the strongest it will ever be. Tomorrow, it will be worth just a little bit less, and, in a year, it will be worth a lot less. Inflation eats away your purchasing power year after year, so simply stuffing dollars under the mattress doesn’t do you any favors.
Investing, at the minimum, can help you sustain your purchasing power, meaning you will still be able to purchase the same amount of goods and services in the future with an equivalent amount of money as you have today. Making this possible is the dividends some stocks generate and the interest interest bonds generate, plus the growth potential of stocks.
Of course, you have your pension. But that’s for retirement, not to help you reach your major financial milestones, such as purchasing a home or funding your kid’s college education. Investing can potentially help you reach those goals much, much faster than you would by simply setting funds aside in a savings account.
But before you begin investing, you need to have foundational knowledge so you don’t make the same mistakes amateur investors consistently fall prey to. But don’t worry, it’s surprisingly uncomplicated. Let’s break down the steps to start building your savings with the power of compounding returns in a safe and reliable manner.
Create a Budget
Before purchasing a single share or a single bond, we need to have a tidy financial home first. One way to gain financial clarity is to implement a 50/30/20 budget: 50% to your living expenses, 30% to entertainment, and 20% to getting out of debt or investing. You can adjust those numbers as necessary according to your financial situation. For example, if you have high-interest debt, consider cutting down on entertainment expenses and doubling down on that bad debt. There’s no point in investing when your credit card interest rate outpaces your investment rate.,
Basically, you won’t get anywhere as long as you’re still in debt. Before you do that, though, it’s still usually recommended that you build up an emergency fund first – that way if you need funds fast, you don’t resort to the credit card again.
What Stocks Should I Purchase?
Professional stock traders typically utilize one of two methods of stock analysis to help them pick what stocks to buy: fundamentals vs technicals. Fundamental analysis involves reviewing a company’s management structure, cash flow, business plan, liabilities, and a slew of other things you probably don’t have time for. Technical analysis ignores those fundamentals and tries to find patterns in stock charts to determine when to sell or buy. Again, you probably don’t have time for that. You’re a firefighter; when you’re not on call or training, you want to spend time with family and friends, right?
Fortunately, you don’t have to be a professional stock trader to be successful at investing.
First, picking individual stocks is probably a bad idea as you’ll likely encounter concentration risk, i.e., too many funds consolidated within one company or position. A $10,000 investment in Stock XYZ can quickly become a $0 investment.
Diversification is your best friend when it comes to investing. As legendary investor and founder of Vanguard Jack Bogle once exclaimed: “Don’t look for the needle in the haystack. Just buy the entire haystack!” Instead, we should consider ETFs and Mutual Funds that pool funds from investors to purchase baskets of various assets, spreading risk amongst the collective rather than bearing all the risk on your own shoulders.
Let’s look at the S&P 500 SPY ETF, for example. By purchasing only one fund, you’re exposing yourself to the returns of 500 companies at once. Yes, you’re also exposed to their respective losses, but the chances are that the other companies’ gains will make up for any losses. Even if an entire industry goes into a slump, the gains made by other different sectors may serve as a cushion against your losses.
Watch Out for Fees
ETFs and Mutual Funds can be either actively or passively managed. In short, a passive fund tracks a chosen benchmark – such as the S&P 500 – and doesn’t try to beat those returns or losses. These are referred to as index funds. Actively managed funds are operated by fund managers who try to outperform a given benchmark by analyzing companies’ fundamentals and charts and purchasing and selling stock as necessary.
While we won’t comment on what will get you better returns, we will mention fees, as they’re easy to spot and can significantly affect your portfolio’s performance.
Let’s consider a $100,000 investment growing at an average annual rate of 8% over 30 years. Here’s how different fee levels can impact your final portfolio value:
0.5% Annual Fee: $100,000 grows to approximately $875,000
1% Annual Fee: $100,000 grows to approximately $761,000
1.5% Annual Fee: $100,000 grows to approximately $661,000
2% Annual Fee: $100,000 grows to approximately $574,000
As actively managed funds have a team of financial professionals constantly analyzing, purchasing, and selling stocks, they tend to have higher fees to pay out their salaries. All that research and analysis comes at a price. As passive structures, index funds merely have to replicate a benchmark, so little research or analysis is necessary.
That’s not to say that every index fund has low fees or every active fund has high fees – you have to look at the prospectus, where you can find the expense ratio and total fees. Suppose you’re interested in a fund, and you see the total fees amount to 2%. In that case, you should consult with a professional to help ensure that investment is appropriate for your investment strategy. There may be similar funds with lower fees that won’t drag down your investment performance quite as much. Alternatively, sometimes you get what you pay for; a fund with low fees doesn’t guarantee better returns or performance.
Dollar-Cost Averaging
Now that you’ve determined how much you can invest each month, it’s time to implement a disciplined approach. Every month, take the allocated percentage of your salary and immediately invest it. Better yet, you can even automate the process.
No matter the news, no matter the movements of the market, stick to your strategy. We’re thinking long-term, so even if there’s a market crash, then you’ll just be purchasing assets at a discount, and history shows that the markets always recover eventually.
Consistent purchasing also helps to smooth out a stock’s average price over time.
Imagine you’ve decided to invest $200 each month in Stock XYZ. Over the next six months, the stock’s price fluctuates:
January: $50 per share
February: $40 per share
March: $60 per share
April: $45 per share
May: $55 per share
June: $50 per share
Each month, you invest $200, regardless of the stock’s price. Here’s how your purchases break down:
Over six months, you’ve invested $1,200 and purchased a total of 24.41 shares. The average price you paid per share is $1,200 / 24.41 = $49.16.
By investing consistently, you’ve smoothed out the stock’s price volatility. Even though the stock price varied from $40 to $60, your average cost per share is only $49.16.
Okay, why not just purchase the shares when they sink to $40 and sell when they get to $60? Because we can’t consistently time the market with any degree of success. Plus, some of the most significant gains are made on the heels of substantial losses, so there’s a good chance you’ll miss that upswing.
Keep in mind, too, that every time you buy or sell, you incur a fee. Those fees will eat away at your portfolio, so the more you buy and sell, the more drag your portfolio will experience.
Rebalancing Your Portfolio
Your investment timeline and risk tolerance are key factors in determining the right mix of assets for your portfolio. For instance, if you’re 30 years old, a reasonable allocation could be, say, 70% in stocks and 30% in bonds. These asset classes can be further broken down. For example, you might decide to allocate 10% of your stocks to healthcare and another 10% to IT.
Over time, the growth and contraction of these investments can cause your portfolio to drift from its original allocation. For instance, after four months, you might find that healthcare stocks now make up 15% of your portfolio, while IT stocks have dropped to 5%. To maintain your desired risk level, you would sell some of your healthcare stocks and use the proceeds to buy more IT stocks, bringing your portfolio back into alignment.
Regular portfolio balancing essentially enables you to ‘buy low and sell high’ on a regular basis, as you’re consistently selling assets that have performed well and using the funds to buy ones that have underperformed, relative to your original allocation.
As your risk tolerance decreases, you can adjust your allocation to a more conservative strategy by reducing your exposure to volatile stocks and increasing your holdings in more stable assets, such as bonds. This will help reduce the impact a stock market crash would have on your portfolio.
Diversify Your Tax Status
Different asset classes have their own tax implications, and some even have multiple tax statuses. Additionally, the type of account in which an asset is held can also affect its tax status. For example, you might qualify for a tax deduction by contributing to a traditional IRA or enjoy tax-free growth and withdrawals by purchasing assets within a Roth IRA. By carefully balancing tax-deductible contributions and after-tax purchases, you can minimize your tax burden at every stage of your life.
Having multiple accounts with varying tax statuses also allows you to strategically align assets and accounts for maximum tax efficiency. For instance, mutual funds tend to generate more taxable events than ETFs. Therefore, it might make sense to hold your mutual funds in a Roth IRA, where taxes are not a concern, and ETFs in a brokerage account, where their tax efficiency can be fully utilized.
In Conclusion
We said at the beginning of this article that the process is surprisingly uncomplicated. And it is! You don’t need to spend hours poring over financial statements or analyzing hundreds of charts just to choose the perfect stock. All you have to do is diversify your holdings, keep your fees low, utilize a dollar-cost averaging strategy, rebalance your portfolio often, and align your investments and accounts by tax status. Ok, maybe it’s not so simple – but it’s much less complicated than how a professional trader operates.
Again – these are just the basics. Investing may not even be appropriate for you yet if you have high-interest debt or don’t have an emergency fund. Additionally, investing is inherently risky, and you may seek out other ways to grow your savings in a less risky manner, such as annuities or cash-value life insurance products.
If you’d like to review your financial plan and see if an investment strategy holds a place in it, don’t hesitate to reach out. We can help you find the optimal route for your savings and help you achieve your long-term financial goals with strategies tailored to firefighters. Just click the button below!
