This article originally appeared on The DIV-Net on September 15th, 2008.
A frequent topic I’m asked or receive emails about from individuals looking for advice on investing focuses on what simple strategies one can follow in order to become a better investor.
Investing shouldn’t be a complicated process despite the lack of initiative found in the financial industry to properly inform the public and educate clients of the simplicity in creating individual wealth over time. Each investor begins their journey anxious to start a path to wealth immediately, but with seemingly unlimited amounts of information in so many locations it’s easy to become overwhelmed, confused and frustrated on where to begin.
My view of investor education is identical to my approach of patient education. When I speak with a patient about their health I provide the best tools necessary for educating and empowering them to make positive changes in their life. When I discuss blood pressure with a patient I don’t start by providing only a medical definition, assume that they know how to interpret the numbers or expect them to understand all the impacts to their health right away. I take the time to explain what everything means in simple terms, how changes to your lifestyle can positively impact your body, the repercussions of not doing so and where they can receive additional information or resources. The information may be a simple review to a patient who knows a lot about blood pressure already or something completely new that provides insight into a topic that they may have been unaware of before.
My belief is that when someone is properly informed (medically or financially) they are able to make better decisions that affect the lives of themselves and those around them. Just as with educating patients, investors can benefit from simple information that helps them to develop clear objectives and avoid excessive complications. Investing isn’t difficult, but investing with some common sense can go a long way to improving returns over the long-term.
Here are fifteen fundamentals for an investor to remember and reviewed on a regular basis:
1. Focus on What You Do Best
In an earlier series I shared with readers one of my Value Rules that focuses on companies that do one thing as best as they can. As a new investor you will slowly find a comfort zone that you lean towards in a style of investing that builds confidence into your investing activities over time. There’s always room for improvement where you lack confidence or ability, but concentrating on a core focus has many benefits that allow an investor to set clear objectives and attain measurable results. Find a comfort zone and go with it. Instead of trying to do many things at once that you don’t do well or understand, attempt to concentrate on one or two that you can perform to the best of your ability and expand from there.
2. Know Your Limitations
Not only should an investor focus on what they do best, but they should also be aware of their individual limitations. It’s important to recognize what your limitations are so that you can minimize mistakes that lead to losses or diminished returns. If you don’t have the time, knowledge or desire to invest on your own then likely you should seek a certified financial professional. You can always work on areas you feel need improvement over time, but investing should always focus on your main core competencies to achieve the best results possible.
3. Consider the Benefit of Cashflow
There are three main methods of growing your investments: capital gains, income (interest or dividends) and savings. Investors often focus solely on investing what they save and the gains from those investments, but a passive method of increasing the value of your portfolio in all market environments is to consider the benefit of cashflow. The portion might be small or appear insignificant at first, but over time both dividends and income (when considering taxation) can lead to meaningful increases in your annual returns that pay dividends over the long-term.
4. Incorporate a Balance of Active & Passive
The couch potato portfolio draws on effective simplicity and the fact that the majority of professional managers (mutual funds) fail to outperform their respective index on a short or long-term basis. While you may enjoy picking individual equities or mutual funds for various reasons, investing a portion of your portfolio in passive investments (ETF’s & index funds) will help you to benefit from the long-term performance of the markets in a very cost effective manner.
5. Look to Minimize Cost
Cost is a major factor that many investors fail to recognize in the first few years of investing. Cost is important because it creates drag on an investors’ ability to generate returns through a number of methods. These can include paying for advice, professional management or transactional costs of purchasing your investments. If you invest in a mutual fund that charges a 2.5% MER (management expense ratio) for 10 years over that time frame the potential return that you would have lost would be an astounding 25%. Where did this go? Right into the pockets of the professional managers who you paid to invest money on your behalf. If a fund out performed its index and peers by 50% over that time frame then 25% may be worthwhile, but the majority of the time managers fail to outperform. Whenever possible an investor should consider the impact of expenses (MER), commissions (DSC fees & trading costs) and taxation.
6. Keep it Simple
This follows the “Keep it Simple” analogy. Too often an individual will complicate the investing process by trying to get fancy with a strategy or group of investments to the detriment of their returns. There are a number of times when the simplest strategy is the easiest to implement and rewards an investor with the best returns. An individual investor can’t match the financial resources that professional experts have access to, but often that abundance of information simply muddies the water so that a clear decision is difficult to make. When you keep your investing objectives, process and activities simple the returns often will take care of themselves.
7. Let Money & Debt Work for You
Here is an opportunity for an investor to maximize efficiencies by looking at how money and debt work for them. There’s always the hard way, the easy way and then the smart way when investing. Each individual’s situation will differ, but what you want to do is look for methods to increase the efficiency of how you put your hard earned money to work to minimize debt, taxation and to increase your ability to save. Debt shouldn’t be an insurmountable obstacle in your financial plan and knowing how to maximize tax benefits, pay yourself first and pay off debt in a manageable and timely manner can go a long way to improving your long-term financial situation.
8. Learn to Think Outside of the Box
Creative thinking is the hallmark of my approach and benefits the investor who has the ability to look outside the box by asking questions, looking to different options and investigating innovative methods. Developing an ability to see the big picture comes over time, but making a habit to look for alternative/contrarian views or opinions will help to expand your perspective on a number of topics and create your own individual confidence.
9. Understand Risk
Risk has the potential to decimate returns and the credit crisis of 2007-2008 is a great recent example. Investing is a balance between risk and reward and an individual investor needs to identify their risk tolerance before ever investing. Many investors find that early it’s easy to state that they’re willing to lose a certain amount of their capital only to later determine that their risk tolerance was much, much lower. Very few investments are risk-free, so an investor should examine all internal and external factors of an investment before placing money into the markets.
10. Know What You Are Investing In
If risk is an important element of investing that an individual should identify and understand, then knowing what you’re investing in becomes an absolute necessity. Whether you’re investing in mutual funds, ETF’s, individual equities or another investment you should always have a good grasp of what you’re investing in and understand it to the best of your ability. Even GIC’s, bonds and money market funds should be investigated by yourself or through a financial advisor in order for an investor to develop a comfort level and knowledge of where their money is going. If you don’t understand the security, industry or type of business then you have no business investing there no matter the implied return.
Every investor has probably heard the line “don’t put all your eggs in one basket”, yet many forget the importance of diversifying appropriately across different assets, countries, currencies or sectors in attempt to best minimize risk. An investor doesn’t want to over diversify their investments, but the focus here is to gain adequate exposure to a number of areas so that your returns will be balanced no matter what occurs in the markets. Sticking to only one or two sectors, exclusively investing in one asset group or placing all your money into one investment can lead to substantial risks that have the potential to impact your returns negatively.
12. Develop a Discipline
Discipline is a difficult task for any investor to embrace, but structure allows an individual to focus on objectives, develop and then implement a specific plan. Discipline allows an investor to avoid the temptation to invest into areas outside their comfort zone or expertise and should protect you from risk to some degree. Have the convictions to stick to your plan and you’ll be rewarded over time if the fundamentals of that decisions remain sound.
13. Patience & Time
One of the biggest difficulties for any investor in the beginning is to develop patience in all aspects of their investing activities. Whether investigating a stock, determining a buy/sell price or sticking to a strategy; we all want to see results sooner than later and can become antsy when things take longer than we anticipate. Remember back to the Rule of 72: compound interest is your best friend as an investor and over the long-term your returns will take care of themselves. Focusing on the short-term and attempting to micromanage your portfolios will likely add more harm to your returns than benefit. Patience isn’t something everyone comes by naturally, but it’s important to understand the impact that adjusting your strategy continuously can have on your potential for sustained long-term returns.
14. Focus on Quality Rather than Quantity
Whether you plan to invest in 10 stocks or 100 stocks focusing on quality has many benefits. While an ETF or index fund may give you exposure to an entire sector, market or index an investor should realize that within those investments are good and bad stocks in some unknown proportion. While indexing is a great long-term strategy that is cost-effective and simple, focusing on the best quality investments is likely your best choice for risk-adjusted returns.
15. Self Evaluate
Whether you choose to do this annually, semi-annually or quarterly, evaluating your individual performance can have many benefits for adjusting your future habits, activities and preventing mistakes when investing. Each investor should take the time to identify their individual strengths, weaknesses, opportunities and threats in an attempt to better understand how their investing activities have progressed and where they can improve in the future. Far too often investors ask the questions of why an investment or strategy has continued to under-perform only to continue making the same mistakes that negatively impact their returns. An investor doesn’t necessarily need to overhaul their approach each and every time, but gaining a better sense of where you can make improvements is a habit that many investors should consider as an important element of their activities.