Today, Jacob from Cash Cow Couple and I are doing a blog post swap. Show him some bloggerly love. Enjoy!
What are you views on investing? How have they been shaped? These are complex questions that can be difficult to answer, but they deserve your attention.
There are countless books written on the finance theory, the stock market, investors, valuations, economic indicators, and hundreds of other related topics. With so much information, it becomes difficult to separate trash and treasure. This leaves the average American with quite the dilemma.
Sadly, many turn to the television for help where they find talking pundits who are nothing more than salesmen in pretty suits. They know very little about modern portfolio theory or financial planning, but they are quick to recommend unrelated rules of thumb and hot button stocks.
The point I’m trying to make is that it might be beneficial to have a look at your portfolio and decide if it were created based on researched facts or commonly espoused fiction.
This is an oversimplification, but for most people, picking individual stocks is bad. The reason is because investors are exposed to different types of risk. There is systematic risk, or market risk, which is common to all investors, and unsystematic risk, which is bad.
Unsystematic risk is a result of improper diversification and it is unrewarded. Meaning an investor who holds only a few different companies in his investment portfolio is taking additional risk which should not result in additional gains. Typically in finance theory, greater risk should result in greater reward.
The reason for this underperformance is quite simple – different stocks, in different countries, in different sectors, of different sizes all like to behave differently. When one category goes up, often times another goes down. This is diversification and when combined with asset allocation, it’s probably the most important piece of portfolio construction.
The takeaway is this. Hold diversified investments, like index ETFs. You can own hundreds or thousands of companies with just 1 ETF, eliminating unsystematic risk.
In continuing with what is stated above, it is also wise to hold various asset classes. This also provides diversification benefits. Historically, when stocks have increased in value, bonds have sometimes decreased. Throw in real estate and commodities and you have a lot of variability. This is why investors choose to own all of these asset classes and more.
Bonds are usually considered a safer investment than stocks, so they provide protection against stock market declines. The percentage of stocks and bonds you should hold is entirely dependent on you and your risk tolerance. If you don’t mind the possibility of losing 50% of you money in a one month span, then own all stocks. They have outperformed bonds over the long haul.
Construct a portfolio that makes you comfortable. It’s all about tolerance because if the market crashes, the absolute worst thing you can do is sell out. You lock in the losses and you’re sure to lose over time. Stay the course and hold your investments over the long haul if you want to build wealth.
Like stocks, all other asset classes should be diversified. If you want to own bonds, own a good bond ETF that owns hundreds or thousands of bonds. Diversification is still paramount.
How to Get Started
If you’ve never managed your investments, it can appear daunting at first. It’s really not that hard. The two areas outlined above make up a large part of the battle.
There are several good places to buy index ETFs for a portfolio. We are huge fans of Vanguard and Motif Investing. Vanguard actually allows you to buy and sell ETFs for free if they are owned by Vanguard. Motif Investing allows you to buy and sell up to 30 ETFs for under $10, which is far cheaper than anywhere else.
Keep transaction costs and fees low. If you don’t, they will erode your returns and eat away at your portfolio.
Author Bio: I’m Jacob, Ph.D. student, husband, and one half of the Cash Cow Couple. My wife and I enjoy teaching others how to live an abundant life on a very modest salary through proper saving and investing.