Use these investment guidelines to help prepare for your retirement:
- Identifying the time-frame of financial goals as either long or short-term is the first step in achieving success as an investor. Since stock market cycles tend to extend for four to seven years, a short-term goal like a house down payment or early retirement may be coming too soon to outlast a temporary market decline. Retirement scheduled for years in the future, however, will benefit from regular deposits made into an investment program that includes expected volatility.
- Stocks, bonds, and cash are the three basic investment categories. Stocks create ownership of companies which creates growth in value. Bonds are loans and interest on the loans creates the investment return. Cash is risk-free but earns far less than stocks or bonds.
- Over most rolling ten-year periods, US common stocks average 10% per year. Bonds earn about 4%-6% and money market funds (cash) normally earn at the inflation rate.
- Money earning 10% per year, doubles every 7.2 years. The arithmetic is simple. Each year’s percentage of earnings adds to the account balance, and subsequent years’ earnings percentage is applied to an ever-increasing account balance. Coincidentally, money earning 7.2% doubles every 10 years.
- Stock markets sometimes “crash” and can lose more than 20% in value. They recover, on average, within 18 months. Declines of more than 10% are called “corrections” and at least one correction per calendar year is to be expected.
- There have been 8 major crashes in the 44 years since 1974. From the day each crash hit the lowest point, the average market gain over the following 12- month period was 37%. Over 24 months, the total average recovery was 48%. This is known as the “snapback” effect.
- The market goes up as fast as it goes down. Of the 37% first-year snapback gain, 20% of the 37% happens within the first 6 to 8 weeks.
- The “risk premium” explains why stocks earn more than other investments. This premium is the additional profit investors on the whole enjoy who can live with the possible short-term loss of money while waiting for a reward. It’s also known as the “invisible hand” of economic forces --- namely, it’s the “behavior of crowds” that motivates humans to take risk. If risk was never rewarded, there would be no incentive to take risk and economies would stagnate.
- Stock market risk can be reduced by “diversification.” This means spreading investments across different types of stocks --- or different investment “styles.” Further diversification can include adding bonds to a portfolio of investments.
- Companies can be categorized into 9 different styles. Mutual funds specialize in choosing stocks that represent a specific style. The fund itself then is categorized as offering one of the nine basic styles to investors.
- Investors create a “path of minimum regret” when combining different investment styles. Today’s winning style will be tomorrow’s loser. In most cases, all stock styles will be moving up or moving down together --- just that some will be moving more than others. The combined effect of joining relative winners and losers creates a composite result resembling more of a straight line than that of any single style. A straighter line of results means less overall volatility, less risk, and “less regret.”.
- Seventy percent of any stock’s gain or loss is based upon the movement of the entire stock market. In short, if the market is rising in value, there’s a 70% chance that a stock or mutual fund will also be rising regardless of its style --- and in falling markets the same rule applies. The tide raises and lowers all the ships.
- Adding bonds (loans) can reduce risk of an otherwise all-stock portfolio. Bonds are loans that pay interest. They are valued and traded just like stocks so they fluctuate in value. A 10-year bond can experience rising and falling values from their inception until they “mature” at the end of 10 years. Meanwhile, changes in market interest rates effect the value of a bond during its life. Like a rope on a pulley, if interest rates go up, the value of the bond drops because it is stuck paying the previous lower rate. If interest rates go down, the value of the bond rises because the interest it pays is now greater than the lower market rate. At the end of 10 years, in this example, the loan is paid in full and the bond is “retired.” This explains why bonds involve less risk than stocks.
- A 50/50 mix of stocks and bonds earns an average of 7.5% compared to 10% for all stocks. However, the potential loss is roughly half of what an all-stock portfolio would have suffered in a “correction” or a “crash.” If 100% stocks lost 15%, a 50/50 mix would have lost 7.5% on average. Depending on their goals and time frames, people elect to invest more conservatively when the time-frame is short.
- The Sweet spot” is one-third bonds and two-thirds stocks. Expected return is still 9% (instead of 10% for all stocks) and the impact of a stock market crash is typically only one third of what an all-stock portfolio might have lost.
- “Dollar cost averaging” is an easy technique that makes investing simple and automatic. In building a retirement account, per-pay-period fund deposits of the same dollar amount continue regardless of share prices. As “goofy” as it may sound, investors with a long time-frame should pray for stock market crashes. Why? Because each market crash, “correction” or minor downdraft adds new shares purchased at lower prices. Taking advantage of this periodic “sale pricing” reduces the average purchase price of all shares in the account. It sets the stage for “buying low and selling high” --- the basic goal of all investors.
- “Timing the market” is a fool’s errand. Those who feel that they can sell at a high and buy back at the bottom tend to lose money. Markets move too quickly --- both up and down. Most sell only AFTER the market is heading down and their loss is 15% or more. Getting back in at the bottom is almost impossible to time, because the market, when it rises, goes up very rapidly. (See Concept #7)
- Public companies are valued based on a concept called “marked-to-market.” This means that every outstanding share of a company is valued based on the price per share of the miniscule portion of a company’s total shares traded on the stock market from second to second. A sudden demand for a company’s shares can cause the market price to rise. The reverse can happen on the report of some bad news. Unfortunately for investors who have no plans to sell, the values of their shares from day to day bounce around based on the thin sliver of the company that is actually changing hands in the stock market. This valuation mechanism causes stock volatility --- the companies themselves are far more stable.
- Major stock market crashes (“panics”) occur when stock prices become disconnected from their true value. A company’s true value is reflected in financial statements that state the income, expenses, profits, capital and liabilities. That financial statement is said to be a “weighing machine.” Stock prices, by comparison are determined by the “behavior of crowds” and either “irrational exuberance” or despair propelled by greed. fear, optimism or pessimism. In other words, stock values are determined by a “voting machine.” Sooner or later, these two forces come into alignment. This explains why “buy-and-hold” investors are more successful over time than “day traders.”
- Successful investing requires confidence, and confidence begins with an appreciation of the fundamentals and history of financial markets. Warren Buffett, the country’s most successful investor, suggests that investors always stay the course with a diversified mix of stocks and bonds. He cites the long-term performance of the markets. Mr. Buffett points out that the Dow Jones average (a measure of overall stock market value) was $50 in 1900. In the 119 years since then, there have been world wars, atomic bomb blasts, depressions, recessions and financial collapses. In spite of it all, the Dow today hovers around 25,000 --- up 500 times the value in 1900. Buy and hold and let time do the work.
|Large Cap Value||Companies that don’t have to borrow and that have brand name recognition or patent protection|
|Large Cap Growth||Companies that borrow as much as possible and the reinvest profits in more employees, more space, more capital equipment, etc.|
|Large Cap Blend||A combination of Blend and Growth|
|Mid Cap||The same categories above except applied to medium sized companies|
|Small Cap||The same as above applied to small companies|
|“Out of the Box”||Specialty funds like foreign, real estate, technology, healthcare, etc.|
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Illustrations in this document are for educational purposes only and is not a guarantee of future performance.
Investments in Retirement Plans: NOT FDIC INSURED ∙ NO BANK GUARANTEE ∙ MAY LOSE VALUE