Being a successful investor over the long term is actually fairly simple, anyone can do it!
The key is to do as little as possible — which doesn’t actually sound like good advice, but hear us out.
Fidelity, a large asset manager in the US, has done a study to find out which accounts had performed the best.
What accounts do you think they were? — maybe accounts fully invested in technology, a day trader’s accounts or maybe it was an account being managed by a world-famous professional money manager. Well, it was none of these.
What did they find?
The accounts that had done the best were the accounts belonging to people who had forgotten they had an account at Fidelity. They hadn’t touched their investments for years. They took doing as little as possible to the extreme. The reason for their incredible performance is that compound interest was allowed to work over the long term. For us to allow the same to happen, we need to stay invested.
The easiest way to stay invested and “forget” about your investment, is to have a diversified portfolio which reduces the volatility of your investment value. Volatility in this context means that the value of your investment is always increasing and decreasing in an unpredictable way. Many people think they can handle volatility but seeing your investment rising rapidly and fall rapidly will affect you emotionally and tap into fear and anxiety. Emotional decision making and investment don’t mix well and often leads to the wrong actions, like cashing out your investment at the wrong time.
We need to diversify investments to improve our chances of long-term investing success while not allowing our emotions to work against us.
Whether you’re just starting investing or already have an investment portfolio, understanding what a diversified portfolio looks like is important. Unfortunately, many people think they are diversified when they actually aren’t.
There are three ways to diversify:
- Across asset class
- Across assets
- Across time
Across asset classes
A portfolio diversified across asset classes will tend to give you higher returns. Each asset class behaves differently. When one is down, the others may be up. Think about it as being part of a team. If everyone in the team is the same, a bad performance will result in a substantial loss. If everyone is different, each team member brings a unique feature to the team. If someone isn’t performing well they are supported by the rest of the team. It’s the same with investing, you need a solid team of asset classes to keep winning over the long term. There are five asset classes of importance to us, which are illustrated below.
In each asset class there are a variety of assets to choose from. Although they are part of the same asset classes they have their unique characteristics. For instance, if you want to invest in the property asset class you could:
- Purchase direct property — buying a house or investment property.
- Purchasing indirect property — buying a share of a company which operates and owns property or a fund (Unit trust or ETF) that owns property companies.
To illustrate what the main assets in each class are, we’ve put together the diagram below:
The third way to diversify doesn’t receive as much attention. It’s best to start investing as early in your career as possible — giving compound interest time to work, and then to consistently keep investing.
Most of us don’t have a large sum of money to invest right now but if you do, it’s best to put that money to work as early as possible. This can unnerve some, as they tend to think “what if” the market falls the day after you invest your lump sum? “Dollar-cost averaging” is a popular way to avoid this: it entails breaking the lump sum amount into smaller amounts and investing over a period of time.
The alternative to a lump sum (or in addition to it) is most likely that you earn a salary and you have the opportunity to invest a little each month. It’s best to automate this process: every month regardless of what’s happening in the market, an amount should be invested automatically. This way you’re diversifying your investment over a long period of time.
Sleep well at night
Using these three ways to diversify is the key to long-term investment success. You’ll be subjected to less volatility, insulated from large losses and will be more likely to stay invested. This means that compound interest will really work for you!
Written by: Ross Reid