Whether your goal is to beef up your retirement nest egg or start building wealth that you can use to reach other financial goals, every investor needs a strategy. Use these simple tips to develop a good investing strategy that will prime you for success, from any starting point.
Commit to investing consistently
A good investment strategy puts time on your side, so the money you invest can grow over the long-term with the help of compounding interest (also known as earning money on your money). Consider this example to see how much of an impact time and consistency has on your portfolio's growth potential:
- Kristin begins investing $9,000 each year into an account that averages a 7% annual return starting at age 25, but Sarah decides to wait to start the same plan (investing ($9,000 a year, and earning 7% annually on average) until she's 30 years old. When Kristin turns 67 years old, she will have $2,075,690 invested; Sarah will have just $1,443,036 invested at age 67. How did Kristin invest only $45,000 more than Sarah, but retire with a balance that's $632,654 higher than Sarah's? Behold the power of compounding interest.
Get a sense of your risk tolerance
Investing of any type requires some risk, but every investor has a different tolerance for it. A good investment strategy must consider your personal risk tolerance, alongside your financial goals.
To gauge your risk tolerance, the National Endowment for Financial Education (NEFE) recommends considering how worried you would be in a market decline if your investments lost money, and how often you intend to track the investments you do choose. If you’re comfortable with the fact that your investment could fluctuate in value (up or down) many times over a number of years, for example, you may have a higher risk tolerance. If the thought of losing money makes you very nervous and/or you intend to monitor your investment performance several times a week or month, on the other hand, you may have a lower risk tolerance.
The experts at NEFE explain that higher risk investors may consider high-grade common stocks, growth mutual funds, or index funds as investments; they offer the potential for a greater return on investment but may be risky or volatile. Investors who feel nervous about the prospect of losing any money may want to consider less risky investments like money market or CD accounts, bonds, corporate treasuries or balanced mutual funds.
Identify shorter and longer-term investment goals to work towards
A good investment strategy should consider how much time you have to reach the various financial goals you’re pursuing, so you can choose the appropriate investments accordingly. If one of your investing goals is to retire in the next thirty years, for example, you may want to select higher risk, higher reward investments specifically for that portion of your portfolio, since you'll have time to ride out market volatility. If your other investment goals include building a college fund for your ten-year-old son or saving money to buy a home in five years, however, you may want to consider lower risk investments for those specific goals; you’ll have less time to recover any investment losses.
Diversify your investments to manage risk
A diversified portfolio includes a range of investment classes so you aren't too overexposed or underexposed to any one market sector. In fact, some experts believe that investors can manage a great deal of their risk exposure by owning 12 to 18 different stocks at one time. You may be able to further reduce your exposure to market volatility by owning a mix of non-correlating assets that don't react the same to market conditions. Stocks and bonds, for example, are non-correlating assets; they tend to move in opposite directions. When investors sell stocks, they may buy bonds in an attempt to reduce some of their risk exposure.
In addition to a diverse portfolio, your investment strategy may include periodic “rebalancing” to ensure the investments in your portfolio remain aligned with the strategy you’ve developed. If your investment strategy is to own 20% bonds and 80% stocks to save for retirement, for example, you may find that your portfolio eventually shifts to be made up of 90% stocks and 10% bonds, due to market performance. To rebalance, you might opt to sell some stock and buy more bonds, to achieve your original 80% stock/20% bond allocation.
Meet with a financial professional to form a cohesive plan
A good investment strategy should consider other aspects of your financial life beyond investing, which may include the desire to build an emergency savings fund, or pay off debt. Regardless of how much money you have to invest, a financial advisor can help you develop a holistic financial plan that supports all of your financial goals and dreams, in tandem with your investment strategy.