1. Be humble
When you do not know a thing, to allow that you do not know it--this is knowledge.
--Confucius
Investing is a big bet on an unknowable future. The mark of wisdom is accepting just how unknowable it is. Granted, that's not easy. Our brains are built to think the future will be like the near past. And we're too ready to act on the predictions of pundits, who are no more clued in than we are about what lies ahead.
Being humble in the face of uncertainty keeps you from costly mistakes. You won't jump on yesterday's bandwagon. And before you invest, you'll be more likely to ask a key question: "What if I'm wrong?"
2. Take calculated risks
He that is overcautious will accomplish little.
--Friedrich von Schiller
The returns you get are proportionate to the risk you take. This is a fundamental law of the markets. It's why five-year CDs typically pay more than six-month ones and why you're disappointed if your emerging markets fund does no better than its stodgy blue-chip stablemate. History unequivocally supports this "no free lunch" principle. Going back to 1926, stocks (high risk) have paid more than government bonds (medium risk), which in turn have beaten low-risk Treasury bills.
Among many, many other things, this law suggests:
- To earn returns high enough to build true wealth, you have to put some of your money in risky assets like stocks--the only investment to handily beat inflation over time.
- If a financial salesperson tries to tell you his product offers a high return with no risk, get that claim in writing. Then send it and his business card to the
- SEC.
3. Have an emergency fund
For age and want, save while you may; no morning sun lasts a whole day.
--Benjamin Franklin
The first step in constructing any serious financial plan is to create an emergency cash fund--ideally, three to six months' living expenses--stashed in a low-cost ultrasafe bank account or money-market fund. Without this financial cushion, any unexpected expense can derail your long-term plans.
These days, happily, that emergency stash won't just sit idle. Top bank accounts like the one at UFB Direct (888-580-0049) and perennially competitive money funds like Vanguard Prime (800-851-4999) now pay more than 5%.
4. Mix it up
It is the part of a wise man to keep himself today for tomorrow and not to venture all his eggs in one basket.
--Miguel de Cervantes
Nothing can break the law of risk and reward, but a diversified portfolio can bend it. When you spread your money properly among different asset types, a rise in some will offset a fall in others, muting your overall risk without a commensurate drop in return. It's the closest thing to a free lunch there is in investing. To make the alchemy work, you must load up on assets whose up and down cycles don't run in sync: stocks (both U.S. and foreign, as well as large-company and small), bonds (of varying maturities), cash, real estate and commodities.
5. It's the portfolio, stupid
Asset allocation...is the overwhelmingly dominant contributor to total return.
--Gary Brinson, Brian Singer and Gilbert Beebower
Most investors concentrate on trying to choose the best stock and pick the perfect moment to buy or sell. It's a waste. What really matters to your long-term returns is asset allocation--that is, how you split up your portfolio.
Since researchers dropped this bombshell 20 years ago, experts have debated the size of the asset-allocation factor. Some say it accounts for 40% of the variation in investors' returns; others (like the original researchers) say 90%. But no one refutes that it's major. For help getting the best mix for your goals and risk tolerance, see the Asset Allocator
6. Average is the new best
The best way to own common stocks is through an index fund.
--Warren Buffett
Here's the logic behind index funds, which aim simply to match the return of a market index: The average fund in any market will always earn that market's return (because in aggregate investors are the market) minus expenses. Since index funds match the market but have much smaller expenses than other funds, they will always beat the average fund in the long run. It's hard to argue with the math, and history bears it out (see the performance stat at right). Besides, if the Greatest Investor of Our Time believes that index funds are superior for most investors, shouldn't you?
7. Practice patience
It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!
--Edwin Lefevre
This blunt warning was issued in Lefevre's 1923 fictional memoir, reportedly based on legendary trader Jesse Livermore and treated by many financial advisers like the Bible. Some 77 years later, behavioral finance professors Terrance Odean and Brad Barber's research into transactions by some 66,000 households between 1991 and 1996 found that those who traded least earned seven percentage points a year more than the most frequent traders. Moral: Once you arrange your assets into your ideal allocation, don't tinker. Rebalance once a year to keep your mix on track, but otherwise, listen to Livermore and sit tight.
8. Don't time the market
The real key to making money in stocks is not to get scared out of them.
--Peter Lynch
It would be so nice, wouldn't it, to sell before every market downdraft and then get back in just as the good times roll again. But it's too hard to pull off. Nobody knows when markets will turn (see Rule No. 1). And when they do, they tend to move in quick bursts. By the time you realize an advance has begun, most of it's over. Miss that initial stretch and you'll miss out on most of the gains. The lesson: The surest way to investing success is to buy, then stick to your guns.
9. Be a cheapskate
Performance comes and goes, but costs roll on forever.
--Jack Bogle
If you choose a fund that eats up 1.5% a year in expenses over one that costs 1% (let alone the 0.2% that index funds may charge), your fund's return will have to beat the other's by half a point a year just for you to come out even. Past returns are no guarantee of the future, but today's low-cost funds are likely to stay low cost. Buying them is the only sure way of giving yourself a leg up.
10. Don't follow the crowd
Fashion is made to become unfashionable.
--Coco Chanel
Or, as the legendary financier Sir James Goldsmith has said, "If you see a bandwagon, it's too late."In the late 1990s, there was no more fashionable bandwagon for investors than Firsthand Technology Value fund. It returned 23.7% in 1998, but investors really piled into it after it rocketed an incredible 190.4% in 1999. But by then, the bust of 2000 was about to unfold, and Firsthand was soon to become as passé as plaid trousers. The result was a chilling example of the perils of following the herd: While the fund posted a respectable 16% annualized gain over the four years through 2001, the average shareholder in the fund actually lost more than 31.6% a year.
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