Follow this step-by-step investing strategy to create a portfolio suitable for your needs.
In last week's post, we already set up the four reasons why dividend stocks are your best investment. Stocks of dividend-paying companies have beat the rest of the market with less volatility and protection against stock market crashes.
We'll get started this week by putting together a step-by-step investing strategy to help you meet your financial goals. This week will reveal why investors lose money in the stock market and how to match your financial goals with your investments.
Next week, we'll wrap up the step-by-step investing strategy with two posts on three great dividend strategies and how to maintain your investments. We'll cover the best investments in dividend stocks and how to know when to sell your assets.
Step by Step Investing and Why Most Investors Lose Money
Despite all the analysis of investments on TV and across the internet, investing isn't about the stocks and companies – it's about YOU!
The stock market and other investments will provide a return for a certain amount of risk. Some assets may (or may not) offer excellent double-digit returns, but the risk of negative returns is also very high. Other investments will almost certainly provide modest single-digit returns. The only question you need to ask is how much risk you will take for how much return.
Most people miss this point and invest haphazardly across a bunch of stocks. They get beaten and bruised by the market because their investments aren't customized to their needs.
That's why the first step in any investment strategy is to create a personal investment plan. This written plan will look at how much you need for your specific goals and how much risk you'll be comfortable with in investing. It's only by knowing these two key elements that you'll be able to pick the suitable investments for you.
Step 1: Step by Step Investing Strategy – Creating a Personal Investment Plan
A personal investment plan is one of the most critical concepts in personal finance. Unfortunately, it's also one of the most neglected. Instead of taking the time to figure out what people need to reach their financial goals, it's far easier to throw out stock recommendations and create hype.
That's why the average investor return was just 2.6% annually for the decade to 2013, even as the stock market returned 7.4% and the bond market offered a 4.6% annual return over the period.
Investors don't know where they're going, so they trade in and out of stocks, hoping to appear at their destination in retirement magically.
A personal investment plan is your roadmap to meeting your financial goals.
That roadmap starts with finding your destination.
- Estimate how much you'll need in retirement and for different financial goals.
- Be sure to include any significant expenses like education and financial gifts.
- The general rule is that you'll need 80% of your current income in retirement. This estimate may not work for everyone, but it's an excellent place to start.
- TD Ameritrade offers some helpful calculators to get you started. Check out the retirement planner calculator to determine whether you are on track to saving and how much you should invest each year to meet your goals.
You'll also need to review your budget and decide how much you can save for your financial goals each year. Your monthly savings might rise and fall slightly, but you want a rough estimate of how much you can save.
Many people don't realize how much of a return they need, so they load up on risky stocks, hoping for double-digit gains every year. They end up taking too much risk and panic-selling when the market crashes.
If you can quickly meet your financial goals with less risky investments, why not put most of your money in those investments and not worry about what happens to the stock market?
The final piece of your investment plan is finding the level of risk you're comfortable with taking in investments.
Are you comfortable with significant changes in your wealth, or would you rather have a slow and steady approach? Are you a gambler or someone that prefers the insured and certain paths?
There are Risk Tolerance questionnaires available on the internet. I've created a simple 10-question survey to help you find your risk tolerance. Answering the questions will take less than ten minutes and guide your step-by-step investing strategy.
Putting your Needs in Action with a Step-by-Step Investing Strategy
Use the annual return you need and your risk tolerance to decide how much of your total portfolio you need in different asset classes.
There are five general asset classes – stocks, bonds, real estate, commodities, and alternative investments. Each asset class comprises investments that share familiar growth drivers and differ from the other assets. There will be some overlap between assets. For example, real estate and commodities react similarly to inflation but differ in most respects.
Within each asset class, investments are further separated into groups that share similarities. Within bonds, you can invest in foreign or domestic issues, debt specific to an industry, or different types of debt. Commodities can be agricultural, precious metals, or metals used in industrial production.
The asset classes are essential for a couple of reasons:
- Different assets offer different returns for different levels of risk. I've included a comparison chart of risk and returns. If you have a low tolerance for risk and do not need a high return to meet your financial goals, you'll want to invest mostly in assets on the left side of the chart.
- Investing in different asset classes helps to diversify your risks. Even holding some of the more risky assets may not be too risky if you have other assets like bonds and real estate. Some prices will go up while others go down depending on the economy and other factors. The result will be a smoother, upward climb in your overall wealth.
Diversification is the key to any investment strategy. The idea of diversification is that not all investments will react similarly to changes in the economic environment or sentiment for stocks. By combining different assets within a portfolio, you can smooth out your returns even over the worst times.
Of course, your portfolio has a price to pay for lower risk. If you were to invest in only one stock and it soared three-fold, your returns would be fantastic. If you spread your investments over ten stocks or three times that number, your average returns across the portfolio would be less spectacular. The price of averaged returns is well worth it because you remove the risk of catastrophic loss if any stock stumbles.
Most investors only need a mix of stocks, bonds, and real estate to meet their financial goals. Investing in commodities and stock options opens your portfolio to more risk than they are worth, and I recommend against it.
How much you invest in each asset class will change as you get older because your risk tolerance will change. As you get closer to needing the money from your investments, you won't be able to withstand the greater risk in stocks.
This example is a guide for changing your allocation to stocks, bonds, and real estate.
Step 2: Creating your Stock Investing Plan
Once you know how much of your money you want to put in stocks, it's time to think about which stocks you should buy.
We carry the idea of diversification into stocks as well. The stock market is separated into nine different sectors of companies.
Companies in each sector serve or produce a common product category. The sectors are further separated into hundreds of industries focusing more closely on a standard product or service.
You will want to invest in a mix of stocks from all the sectors but may want to invest more in specific sectors depending on your risk tolerance.
Stocks within utilities, healthcare, and consumer staples tend to be less risky than other sectors. Stocks within technology, consumer discretionary, and financials may be riskier but may also provide higher returns.
When deciding how much of each stock to buy, I would start with around 2% or 3% of the total amount you want to invest. That means even a total loss in one stock will not be catastrophic to your portfolio. It also means that a stock has to nearly double before it gets too large a percentage of your portfolio, and you need to sell.
That's enough for this week and our step-by-step investing strategy. You should have a good idea of your financial goals and how much you need to invest. Using the concept of risk tolerance and return, you should also know how much you want to invest in the separate asset classes and within stocks. Next week, we'll continue the step-by-step investing strategy with three dividend strategies to get you started.