The Essentials: 5 Fundamentals of Investing
My two sons are right in the middle of basketball season right now. This is their first year playing and they are having such a good time. After games and practices, the car ride home is always filled with them telling me all about the great plays they made as they are imagining their own highlight reel in their mind. As a parent, it is so fun to watch them improve and learn the game from the ground up and it has been a good reminder for me of just how much hard work and repetition goes into becoming good at something. The greatest basketball player of them all, Michael Jordan (yep, I said that) once said: “Get the fundamentals down and the level of everything else you do will rise.” While we all can’t be Michael Jordan, most anyone can learn a good jump shot if they practice the fundamentals. The same idea can be applied to investing. If you know and practice some fundamentals, you can build wealth to reach the goals in your financial plan. In this post, we are going to talk about five investing fundamentals everyone needs to know.
Know the relationship of risk and reward
Let’s use basketball again to understand risk and reward. Let’s say that our team is down by two points, we have 5 seconds left in the game and we have the ball. The coach calls time out to draw up our last play. The coach has a choice to make. She can give the ball to our best shooter and go for the 3-point shot or she can give the ball to our tallest player down on the post (by the basket) for a 2-point shot. The 2-point post shot is a safe high probability shot. However, the result is that we tie the game and get another chance to win in overtime. If we go for the 3-pointer, it is the more risky, low probability choice, but if we make it, we win the game! This is the direct relationship between risk and reward. Because the longer shot is riskier, it is worth more points. As investors, we expect that the more risk that we take, the greater the reward should be that we can receive and vice versa. I remember this in simpler terms: We always want to get paid for taking risk. This means that if we put our money at risk, we should expect to be compensated with higher interest or average returns. We utilize the concept of risk and reward in the next fundamental, asset allocation.
Use asset allocation to invest for your goals
Asset Allocation is the concept of investing your money in different types of assets. This is important because the average long-term rate of return that you earn will depend greatly on how you allocate your money. In the simplest form, we can separate assets into three classes: high risk assets, moderate risk assets, and low risk assets. As you can see, we divide up assets by risk. High risk assets mean that there is a higher probability that you can lose money, while low risk assets will typically provide some safety to your invested principle.
If you remember the first fundamental, risk and reward, you will remember that we will expect higher returns for high risk assets and lower returns for low risk assets.
The image above shows the growth of $100 over the history of the modern stock market. The blue category represents US stocks which we would categorize as high-risk assets, the green category represents bonds which we would categorize as moderate risk assets, and the yellow represents cash equivalents which we would categorize as low risk assets. You can see that the greatest reward came from a long-term investment in the high risk asset category.
Here is how I recommend approaching asset allocation:
Think of the purpose for your invested money are you going to use it for short term or long-term goals. If any of the money is going to be used for goals within 2 years, put that money in the low-risk asset class.
With rest of the money think of a scale from 1 – 10. 1 is low risk meaning that you can’t lose money, but you also won’t earn that high of return (maybe 0 – 2%). 10 is the highest risk, meaning that you have an opportunity to hit the 3-point shot investment or you may lose everything. Where are you on the scale? Whatever number you choose should be the proportion you put into the high-risk asset class. If you choose 3, you should put 30% of your money into high-risk and 70% of your money into moderate risk. If you are an 8, you should put 80% of your money into high-risk and 20% into moderate risk.
See below for how I typically categorize common asset classes:
Rebalance to stay on track
Once you choose your asset allocation and invest your money, the value of your assets will change daily. Over time your original allocation will become out of balance. This is important to understand because we may find ourselves with an asset allocation that is too risky for our intentions or maybe not risky enough. We may start with an allocation of 60% Stocks and 40% bonds, then six months later our stocks have grown to 75% of our portfolio value leaving us with 25% in stocks. If your risk profile on the scale of 1 – 10 has remained the same, then you will want to rebalance your portfolio to 60% stocks and 40% bonds. You do this by selling the asset class that has grown and buying the asset class that has gone down in value. This provides two benefits. It helps you stay within your target risk and it creates a system for you to take profits buy selling high and buying low. I recommend having a systematic process for doing this. A simple rebalance system is to do it annually.
Invest consistently to dollar-cost average
Remember that mastering the perfect jump shot doesn’t happen overnight. It takes consistent practice. It is the same with investing. Trying to time the perfect investment is extremely difficult. We usually have a better chance of building wealth through a consistent investment plan. When we invest systematically through regular intervals we also take advantage of dollar-cost averaging. This means that we are smoothing out the purchase price of our investments by buying them at different times and different prices. Here is an example:
The latest closing price of Apple stock (AAPL) is $318.31. This means if I invested $10,000 in AAPL at this price, I would have 31 shares. However, what If I would have invested my $10,000 in increments over the last 3 months? If I purchased one third on the 1st of each previous month, the price of AAPL would have been $255.82, $264.16, and $300.35. This means for the same $10,000 I would have 37 shares.
The best way to dollar-cost average is to participate in a company retirement plan if you have access to one.
Let your money work through compound interest
Early in my career, I read a book called, The Richest Many in Babylon by George S. Clason. In this book, there is a line that says “…Learn to make thy treasure work for you…Make its children work for you and its children’s children work for you." I thought that this was an interesting thought of putting your money to work so that it can earn in itself. The author is explaining compound interest. As your money grows or earns money for you, those earnings are reinvested and grow earnings upon earnings. This is a powerful force that grows exponentially over time. Even a small start can turn into a valuable nest egg if given enough time to compound. It is important to invest early and consistently to take advantage of compound interest.
These are five fundamentals that are at the foundation of every investment plan. If you consider your goals in relation to how much risk you are able to take, allocate your money to the right assets, rebalance to stay on track, invest consistently and re-invest your earnings you will begin to see results in your financial plan.