The following article comes from the U.S. News ebook, How to Live to 100, which is now available for purchase.
Being a successful investor is not about picking the right stocks, mastering some arcane investment vehicle, or guessing when the market will rise or fall. Success for most individual investors stems from investing at an early age, setting aside new investment funds on a regular basis, and seeking low-cost and diversified investments that aim to equal but not beat market averages.
"The first thing to do about investing is to save some money so you have something to invest," says Princeton University economist Burton Malkiel. His trail-blazing 1973 book, A Random Walk Down Wall Street, documented the tiny odds of picking winning stocks and paved the way for today's reliance on low-cost index funds. "The savings that one does early in life is particularly important" in building wealth, he adds.
Often, when the economy and investment markets are uncertain, "people don't make their contributions or, what's worse, they cash out. It's very important to resist that impulse," Malkiel says. "Dollar-cost averaging," or investing regularly without regard for the markets' ups and downs, helps investors avoid buying high and selling low.
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When deciding where to invest, there are three basic factors to consider, says Christopher Jones, chief investment officer of Financial Engines, an online investment advice company. "The first [question] is what risk do you want to take with your financial investments? If you want higher expected returns, you will have to take on higher risks," he says. "There is no way to avoid that trade-off." Most studies show stocks to be the highest-return investment over the long haul, although they carry more risk. However, Jones says, the odds of stocks going up or down in any given year "gets closer to a coin flip."
"Risk is an area where people make lots of mistakes," Jones adds, especially when they take risks that are inappropriate at their stage in life. Spooked by the market meltdown, some young investors have become too conservative, loading up on bonds, and some older investors have sought riskier investments to make up for market losses.
The start of many people's investing experiences is in 401(k)s and other employer retirement programs. Within 401(k)s, target date mutual funds have become a popular and frequently recommended investment option. These funds reflect Jones' advice by automatically shifting their risk profile between stocks and bonds as their owners age. They are always issued in five-year time frames—2015, 2020, 2025 and so on—and each time period is designed for investors who reach retirement age during that period.
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Jones also recommends paying close attention to expenses associated with various investments. Over time, the difference in annual fund expenses can have a huge impact on the size of your investment nest egg, Jones says. Mutual funds typically charge between one-tenth of one percent to twenty times that, he adds.
Actively managed funds can beat market averages and justify higher expenses, he notes. But it is hard to identify the winners, and the odds are that their managers will not be able to sustain those results. "The reality is that in any given time period, about three-quarters of the active managers out there will be outperformed by a passive index of investments," Jones says.
Passive funds aim to match market averages. Because the composition of index funds, such as those that track the S&P 500, is already defined, they are cheap to manage and have lower fees. In picking a passively managed fund, investors can choose between two types of funds: an index mutual fund and an exchange traded fund, or ETF.
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"Typically, ETFs are baskets of a portfolio that trade on a stock exchange just like a security," says Kevin Simpson, chief investment officer of Capital Wealth Planning in Naples, Fla. The major difference between an ETF and a mutual fund is that ETFs can be bought or sold at any time during the trading day, while mutual funds can only be bought or sold once a day after the close of trading.
ETFs tend to have lower expenses than even passively managed index mutual funds, but the difference may not be great. Because they trade on exchanges, ETFs may incur a trading commission each time they're bought and sold. Some brokerages provide free ETF trades, but many don't. Commissions can add up, especially when investors are making regular fund purchases.
Beyond the investment vehicle you use, maintaining an appropriate mix of stocks and bonds is crucial. Bonds have long been advised for older investors seeking safe sources of retirement income. But this rule is harder to follow today. Interest rates have been low for several years and are near and even below zero for the safest U.S. government bonds. Furthermore, the Federal Reserve has said it intends to keep rates unusually low at least through the end of 2014.
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"Normally, I and other advisers would have suggested a heavy allocation of bonds" for older investors, Malkiel says. "I would urge them to think about fine-tuning" that allocation. "For some, high-dividend stocks might be substituted for bonds," he says.
For the same reason, Moshe Milevsky, a finance professor and annuities expert at York University in Toronto, can no longer trumpet his fondness for U.S. Treasury Inflation Protected Securities (TIPS) and some other traditional inflation hedges. The yields are just too unappealing.
The same goes for the types of safe annuities favored by Milevsky. He normally recommends what are called "income annuities," or immediate annuities. An investor approaching retirement can convert some of her retirement nest egg into a stream of guaranteed income payments for the rest of her life.
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"These annuities are basically pensions," he says. "I think those are great instruments. Everybody should have a pension." But perhaps not now. "The payouts on immediate annuities are so unbelievably low right now that I'm hesitant to advise people to go out and buy what is a great product today." Milevsky says he would like inflation-adjusted interest rates to go from negative territory today to 2.5 to 3 percent before he would strongly recommend income annuities.
Beyond these standard investments, Malkiel has some passionate advice that's particularly aimed at younger investors: The much-maligned American home may once again be a smart investment.
"For young people, homeownership is more attractive today than at any time in decades. Home prices are down, mortgage rates are at all-time lows, and there are tax advantages to homeownership," he says. "I think today, with prices being down as far as they are now, that it will be a wonderful inflation hedge."
Reader Comments Read all comments (1)
tonywilliams525 of CA 10:41AM May 14, 2012