What’s the key to making good investment choices? It isn’t necessary to understand the inner workings of the securities markets or the mathematical economies underlying investment theory. Instead, 10 axioms of effective investing provide the critical cornerstone for guiding investment philosophy and making decisions. This will ensure that you meet the universal goal of creating financial wealth for retirement.
Unfortunately, these principles are easier to understand than to implement. For many individuals, it is easier to plan to save and invest next month rather than to begin immediately. However, visualizing the peace of mind and security that comes with maintaining a disciplined, successful savings program can help you get started.
Axiom 1: Start now, not later.
By investing early, you are using the greatest tool available to an investor—the power of compounding, where invested money grows exponentially, not algebraically. The basic principle: START NOW, NOT LATER.
Axiom 2: Set reasonable savings goals, then live below your means.
Being frugal is the cornerstone of wealth-building. Those individuals who gain financial independence do so by budgeting, controlling expenses and saving a reasonable portion of their income. They value thrift and discipline. The key to wealth accumulation is to set reasonable savings goals and then to “pay yourself first” by setting aside that savings amount with each paycheck you receive. Each time you get a pay raise, increase your monthly savings by an amount with which you are comfortable. The amount you save need not be large, but if you pay yourself first each time you receive a paycheck, the magic of compounding will help you build wealth.
Axiom 3: Know what to expect based on a long history of investor experiences.
There are many places where individuals can and should invest. What rates of return should you expect? The word “expect” is important here, because seldom do investments provide us with the exact rate of return we thought they would. Therefore, looking at average rates of return over long periods of time is extremely helpful in setting expectations.
Axiom 4: Manage risk wisely—it cannot be avoided.
Investment risk has two important components: volatility risk and inflation risk. Volatility risk is the risk that actual returns vary compared to expected returns over time; in general, higher returns go hand-in-hand with greater volatility risk. Inflation risk relates to a loss in purchasing power through general price inflation. While you cannot eliminate either volatility risk or inflation risk, you can minimize both by understanding the nature of investment risk and selecting investments suitable for your investment time horizon. For shorter-term time horizons, volatility risk is more of a concern; for longer-term time horizons, inflation risk becomes a greater concern.
Axiom 5: Diversify, diversify, diversify.
Portfolios should be diversified at all levels. By allocating among the major asset categories (stocks, bonds and cash), you diversify the two kinds of investment risk that we identified in Axiom 4. Risk can further be reduced by diversifying within those asset categories. For example, a stock portfolio should be built by investing in the common stock of firms in different industries. Buy only “good quality” firms that will have an increasing demand for their products. Set a goal of 15 to 20 different industries. Broad-based mutual funds offer significant diversification benefits to investors in all asset categories. A solid investment vehicle for the investor who wants to diversify broadly without attempting to purchase individual stocks is to purchase shares in a market index mutual fund, with low management fees. In particular, a single share of an S&P 500 index fund is widely diversified and represents the equity market nicely.
Axiom 6: Maintain a long-term perspective—over time, the stock market rewards the patient investor.
Investors are rewarded for assuming some kinds of risk. Patience is a virtue, even when investing. The market rewards patience.
Axiom 7: Avoid the temptation to time investments based on what you—or the experts—”expect” the overall market to do.
Frequently, you hear an economist or a financial consultant in the news making projections about the financial markets. However, investors, even the professionals, do not have some “super vision” when it comes to knowing the direction of the markets. You cannot expect to do better by timing investments than if you routinely invest each and every month because the market moves in fits and starts. Missing the few good days because you are out of the market can seriously reduce your return. Therefore, don’t worry about timing your investments, instead just invest regularly, and be cautious of listening to all the “experts.”
Axiom 8: Know what you are paying for and don’t pay for what you don’t receive—avoid loads, commissions, and expensive investment advice.
Brokers, distributors and others charge a commission for putting you into mutual funds that, on average, perform below other available funds. Most load (commission) funds will also charge you a distribution fee (the shareholder is forced to give up income to pay brokers and distributors for selling shares to new shareholders).
Why should you pay more in continuing expenses to receive returns that are not necessarily better—particularly since your bottom line return is reduced by those expenses?
Axiom 9: Beware of the experts and “hot hands.”
You may be surprised to know that you can do better than the professional money managers most of the time. Over several time periods of 10 years, an investment in a S&P index fund outperformed the great majority of the actively managed stock funds. Finding a good mutual fund for long-term investing takes less time and effort and reasonable success can be expected if you do not talk or listen to commissioned brokers.
Axiom 10: Don’t pay taxes unless unavoidable and then pay them later, not sooner.
The simplest way for an investor to defer or avoid taxes is through a 401(k) retirement plan, which is available for most corporate employees. Additional tax-favored plans include regular IRAs, Roth IRAs, SEPs, and Keogh plans.
Money saved outside of tax-favored retirement plans receives more favorable tax treatment if it is invested in common stocks than in bonds or bank savings accounts or CDs. Increases in the value of common stocks due to a company’s retention of earnings are not taxed until the stock is sold, which can result in the deferral of federal income tax for many years. In addition, long-term gains on the sale of common stock are typically taxed at lower rates than ordinary income.
Reprinted with permission, AAII American Association of Individual Investors www.aaii.com
Original Article Reference Source: https://www.aaii.com/Evergreen/article/reach-your-retirement-goals-by-following-10-basic-axioms