For many long-term investors, several strategies work, as well as one of the simplest: averaging dollar spending into a cheap index fund. If you stick to this strategy throughout your career, you can be a millionaire by the time you retire.
However, for a select few investors, this strategy alone is not enough. Maybe it’s because you want to try and beat the market. Maybe it’s because you need more control over your investments. Maybe it’s because you enjoy analyzing businesses and building portfolios. Whatever your reason, here are three signs that you are ready to upgrade your investment.
# 1: you are ready to practice basic diversification
One of the biggest advantages of index funds over individual stocks is that index funds offer some level of automatic diversification. If you own an index fund and one company in that fund falls apart completely due to its own problems, you may not even notice the impact on your net worth. If, on the other hand, you only own one share and the business behind that share crashes, your overall portfolio will be devastated by that loss.
Typically, you need somewhere around 20 roughly equal weighted stocks across different industries to be adequately diversified. In terms of the logic of the kitchen table, this means that any given stock will account for about 5% of your portfolio. If this company crashed, you would still notice a loss, but you would have a decent chance of getting it back in less than a year, based on the long-term historical market return.
This leads to the collapse of one company many more vitality for your portfolio. It also makes diversification a very important strategy that you must follow if you are going to upgrade your investment and start choosing your own stocks.
# 2: you are ready to follow the rules for wise asset allocation
While stocks can be incredibly powerful tools for creating wealth over time, they are terrible when it comes to protecting your ability to spend money right now. Market crashes happen and your accounts don’t wait for a strong stock market before they hit.
Because of this harsh reality, you need to have a reserve fund of three to six months in cash and cover the five years you need to cover your investment in something less risky than stocks. Cash, a savings account or CDs, Treasury or investment grade bonds that mature just before you need the money may be a smart place for the money you need during that time window.
These recommendations are important for all investors, but especially important for those who choose their own investments. In the end, it is likely that you will face more volatility than an investor who only sticks to broad indices, so you need to be prepared for the ups and downs that this entails.
# 3: you acknowledge your edge over Wall Street
Index investing usually trumps professional active fund management. There are three main reasons for this.
First, active investment managers must cover their costs from the profits they make. It makes the battle for average active investment manager to benefit from these structural costs
Second, the more you trade, the more difficulties you face. Although the commissions are not as high as they used to be, spreads between buyers and buyers still exist, and the more the investor turns the portfolio, the more of these friction costs the investor will face.
Third, professional money managers are responsible for other people’s money. These other people tend to wrest their money out of the control of the pros if they lag significantly behind the market for a period of time. As a result, these professionals tend to be focused on the short term and are often unable to buy companies they believe will be long-term winners if they don’t perform well right now.
This is the last problem that gives you the edge over Wall Street: patience. As an individual investor managing your money, you can afford to ride out the short-term ups and downs in the market. If the long-term outlook for the company remains strong and its valuation looks good compared to that outlook, you can buy and wait for the market to understand this fact.
You are not pressured to manage other people’s money, and you can use this to your advantage by looking for a potential edge over the market. Add to that the fact that following a good asset allocation strategy means you don’t have to rely on the stock market to cover your immediate costs, and you have a solid foundation for success.
Are you ready to upgrade your investment?
If all three of them apply to you, then you are most likely ready to start raising your investment level. As you move forward, realize that we all make mistakes. This explains in part why recognizing the benefits of diversification is a key sign that you are ready for the next phase of your investment. The important thing is that you learn from these mistakes and don’t let them get big enough to ruin your overall portfolio.
If you’re not quite there yet, that’s okay too. Averaging the dollar value into a low-cost broad base index fund remains a viable long-term strategy that deserves your consideration as well. When you are ready, you will recognize these signs and can take the next step into the world of buying individual stocks.
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