The 401(k) changed everything. In a recent interview with "Today Show" financial editor Jean Chatzky, she identified defined-contribution plans like 401(k) and IRA accounts as a key catalyst in personal finance. Unlike past generations, today everyone is or should be an investor.
As we start a new year, it's an opportune time to identify the habits that will serve investors well:
1. Invest early. Successfully investing takes time. Lot’s of it. Time is needed to understand the risks of the stock market that, in the short run, can devastate a portfolio. Time is also needed to enjoy the benefits of compounding.
If you are in your twenties, start investing now. The same is true for those in their thirties, forties, fifties and sixties. Many people failed to invest at an early age. But putting off investing even longer surely is not the answer.
2. Save more. Effective investors spend less than they make and invest the difference. Here the key is to appreciate the effect of “small” expenses. By reducing cable, cell phone and insurance premiums by $200 a month, one can expect to generate about $35,000 in investments in 10 years, assuming 8 percent or higher annual returns. The portfolio could grow to nearly $700,000 in forty years. If you need some inspiration in this department, one family that saved 65 percent of their income retired at 30.
3. Always stick to a plan. The worst mistake investors make is to buy high and sell low. They buy with confidence when the market is rising and then sell in fear as it falls. Effective investors have an asset allocation plan, and they stick to it regardless of how the market is performing.
4. Keep fees to a minimum. Fees are to investments what termites are to a home. While the damage may seem small at first, fees can bring down a portfolio if given enough time. By using low cost index funds investors should be able to keep expenses extremely low.
5. Reinvest your dividends. For the magic of compounding to work, investment returns must be reinvested. Most mutual funds make reinvesting dividends easy. Unless you want a payout, dividends are automatically reinvested.
The difference between reinvesting and not reinvesting dividends is stark. One analysis looked at a $10,000 investment in Coca-Cola in 1962. Fifty years later that investment would have been worth about $500,000 if dividends were not reinvested. Reinvest the dividends, and that same investment would have been worth about $1.7 million.
6. Prefer index funds. Index funds have several advantages over actively managed funds. First, they are typically much less expensive. Second, over the long run their performance beats most actively managed mutual funds. Third, they tend to have low turnover, which makes them ideal for taxable accounts.
There is an additional benefit to index funds. As noted above, effective investors stick to their investment plan regardless of the market. It’s a skill few people have mastered. Investing in index funds can help investors stay the course because they don’t have to wonder if a fund manager has lost the Midas touch.
7. Rebalance periodically. Rebalancing a portfolio is a critical component of sticking with a plan. As asset classes move up and down in price, an investor’s asset allocation can shift away from what was planned. By rebalancing periodically, an investor can make sure that his or her investments are in line with the investment plan. Rebalancing also results in selling high and buying low, which is exactly what an effective investor does.
Rob Berger is an attorney and founder of the popular personal finance and investing blog, doughroller.net. He is also the editor of the Dough Roller Weekly Newsletter, a free newsletter covering all aspects of personal finance and investing, and the host of the weekly Dough Roller Podcast.