If you’re new to investing, it’s pretty easy to feel overwhelmed. The factors of sound investment may seem complicated, but here’s the truth: It doesn’t take a Ph.D. in finance to be a good investor. In fact, the most important investment decisions you have to make are actually pretty simple.
The 5 Most Important Factors For Sound Investment
1. Your Savings Rate
The amount you save is far and away the most important factor as you start investing. Nothing else comes close.
You’ll hear plenty of people talk about ways they think you can get better returns. And you’ll hear plenty of other people who warn you away from the stock market because you could lose your money.
I’m here to tell you that neither of those things matters. At least not very much when you’re starting out.
According to retirement researcher Wade Pfau, your investment return over the first eight or nine years of investing accounts for less than 1%of your final outcome. In other words, good or bad, your early returns won’t have much of an impact on how much money you end up with.
This basically means you can spend the first decade of your investment life worrying less about your returns and more about your savings rate. Because even if you don’t make the best investment decisions, it simply doesn’t matter that much. Your savings rate will far outweigh the returns you earn.
So how much should you save? There are many different calculators out there to help you figure it out, but even if you can’t hit their suggestions right now, you can start saving something and slowly increase that amount over time. Maybe you increase your savings rate by 1% each year, or put 50% of all raises towards savings (or both!). Those small changes can really add up over time.
However you do it, focus first and foremost on the amount you save. No other factor will have as big of an impact.
2. What You Invest In
Asset allocation is the fancy term for how you decide to divvy up your money among different types of investments. And this is an important decision, since the research suggests that 90% of the investment return you receive is dependent on the kinds of things you invest in, rather than the specific investment choices you make.
In other words, deciding to invest in the stock market will have a big impact on your returns. But the specific stocks you pick matter a lot less.
And at the highest level, your main decision will be how to split your money between stocks and bonds.
Stocks represent ownership in a company. They offer the highest potential return, but also the highest risk of loss. Stocks are typically a good place to invest some of your long-term money, but are riskier when dealing with shorter-term goals.
Bonds are actually loans you give to companies. Just like a loan you would take out personally, they pay an interest rate and over time the entire loan is paid back. They don’t offer as much return as stocks, but they also carry less risk.
Your big decision is essentially how much of your money to put toward each. The more you put toward stocks, the higher your potential return, but the higher your potential loss as well, especially in the short term.
A good rule of thumb is to be comfortable losing half the money you have in stocks in any given year without changing your plan. So if you have 60% of your money in stocks, you should expect to face about a 30% loss in your investments at some point in your life (though it may bounce back over time).
3. How You Diversify
Diversification is another fancy word that investment people like to throw around. But all it really means is investing your money in a lot of different things instead of putting all your eggs in one basket.
And diversification is important because it's the only way to decrease your investment risk without decreasing your expected return. In other words, diversification is pretty darn cool!
One way to diversify is with your asset allocation. Putting some money into stocks and some into bonds means you’re diversified across different types of investments. You could even go a little further by splitting those into U.S. stocks and international stocks, and U.S. bonds and international bonds, just to make sure you have everything covered.
But you can also diversify within those major categories. For example, instead of picking just a few U.S. stocks to invest in, you could pick an index fund that invests in the entire U.S. stock market. When you own a little bit of every company in America, no single company can send your investments into the tank.
This kind of simple diversification has the benefit of decreasing your risk of loss without decreasing the return you expect to receive.
4. What You Pay
With most things in life, you can expect that higher quality comes at a higher price.
Not so with investing. As Vanguard founder John Bogle once said: “In investing, you get what you don’t pay for.”
It turns out that one of the best ways to increase your returns is to lower your costs. In fact, the investment research company Morningstar found that cost is the single best predictor of a mutual fund's future return, even better than its own star rating system!
The less money you pay for the privilege of investing, the more you have available to invest in your future. Watch fees like a hawk and watch your returns improve.
5. Sticking to Your Plan
“Lethargy bordering on sloth remains the cornerstone of our investment style.”
— Warren Buffett
There will be many times where you’re tempted to change your investment strategy. When the market is up, you may want to be more aggressive. When the market is down, you may want to get out. When your co-worker is bragging about the stock he just bought, you may be tempted to buy it, too.
Many investors give in to those temptations and end up with returns that lag the market as a whole. They end up buying high and selling low, just the opposite of what you want to do.
To avoid that, you’ll have to tune out the noise and keep doing what you set out to do, no matter what kind of craziness is happening all around you. Stick to your contributions. Stick to your investment choices. Don’t let the news of the day change your mind.
It’s not easy, but that consistency will keep you on track through the ups and downs.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents build a better financial future for their families. His free book, The New Family Financial Road Map, guides parents through the most important financial decisions that come with starting a family.