Young Investor’s Guide to Building a Financial Future Part 2: Making Smart Investment Choices
In the first installment of our Young Investor’s Guide to Building a Financial Future, we looked at avoiding credit card debt to set you off to a healthy start, the benefits of investing over the long term, and the advantages of doing so in a retirement account, such as a 401(k) or IRA.
In this second part, we dive into three more investment concepts every young investor should embrace:
The importance of diversification
The dangers of market timing and stock picking
The benefits of investing according to a plan that fits your personal goals
Get Diversified
Stock market swings can test even the strongest-willed investor in the short term. But over the long term, the market has historically shown a remarkable ability to smooth out performance and head in an upward direction. Holding a diversified basket of many different types of investments helps your portfolio weather short-term bumps in the market and benefit from the market’s growth over time.
What is diversification? It's about spreading your risks around. In investing, it means more than just having many holdings. It’s about having many different kinds of holdings.
While this may make intuitive sense, many investors believe they are well-diversified when they are not. They might own a large number of stocks or stock funds across numerous accounts, but most of their holdings could be concentrated in large-company U.S. stocks or similarly narrow market exposures. Diversification works because different types of investments react differently to market conditions. When one investment falls on hard times, others might be performing well, buoying the overall performance of your portfolio. If all your holdings are too similar, diversification can't work its wonders over time.
So, how do you get diversified without overcomplicating your life? Invest in a few basic index and index-like ETFs and mutual funds. Seek funds that track and hold a broadly diversified basket of stocks similar to those in broad market indexes, such as the S&P 500 or the Russell 2000. Favor those with relatively low expense ratios. These days, your basic, well-diversified index ETF need not cost more than a fraction of a basis point. You can build a well-diversified portfolio with just a handful of these low-cost holdings.
As your wealth grows, you may decide to add exposure to systemic market factors that have been shown to enhance portfolios over time. For example, “value” companies have low relative prices (stock price divided by an accounting metric such as book value). Over time, such companies have delivered a built-in premium return compared to growth companies. By adding a value fund or ETF—and holding it over the long run, as described in part one—you can increase the odds of experiencing higher returns if you’re willing to accept a likely wilder ride along the way.
In short:
Investing broadly across assets of various sectors, sizes, and geographies can help you build a resilient portfolio that better weathers the ups and downs of the market over time.
Avoid Speculating
Focusing on broad market indices can also help you avoid speculative behaviors that negatively impact your long-term returns, such as market timing and stock picking.
Market timing—buying and selling stocks based on breaking news and short-term market movements—often turns out poorly. Typically, you end up buying into hot trends and selling when conditions are scary, leading you to buy when prices are high and sell when prices are low. This behavior can take a big bite out of your savings and cause major setbacks as you work toward your long-term financial goals.
In fact, investors’ poor track record with market timing is well known. A long-running annual survey by DALBAR found that the average equity fund investor trailed the S&P 500 by roughly 5.5% in 2023 due to poor decisions around when to buy and sell.
Meanwhile, stock picking can overload your portfolio with too few individual securities, reducing diversification and introducing concentration risk. Investors are typically rewarded for taking on systematic risk, or risk inherent to the entire market. Concentration risk is particular to the stocks you hold, and you can't expect to be consistently rewarded for taking it on.
If you hold a large portion of your portfolio in just a few stocks, each holding can have an outsized effect. Should something happen to just one of the companies you hold—bankruptcy, for instance—you could lose a significant chunk of your savings.
It's also exceedingly difficult to pick stocks that will outperform the broader market over time. In 2023, more than 70% of companies in the S&P 500 Index underperformed the index. These results vary from year to year, but since a handful of companies often drive most of the stock market’s returns, choosing when to sell the future losers and buy the next big winners can become an impossible—and often losing—game.
In short:
Timing the market can lead you to buy stocks when they’re expensive and lock in losses by selling during downturns. Stock picking makes it difficult to find winners, and holding concentrated stock positions introduces uncompensated risk. Instead, build a diversified portfolio as part of your long-term financial plan.
Follow a Plan That Fits Your Goals
So how should you divvy up your diversified investments? Start with your asset allocation, which is how your portfolio is spread among asset classes, including stocks, bonds, and cash. Then, base your asset allocation on your personal goals, tolerance for risk, and the length of time you have to invest.
If you search the internet, you’re likely to come across various rules of thumb to help you choose how to allocate your funds, such as the “your-age-in-bonds” rule. This rule suggests you hold a percentage of bonds equal to your age. A 30-year-old would supposedly hold 30% of their portfolio in bonds and 70% in stocks, for example.
Be wary of rules of thumb like these. They depend on broad averages, not your individual circumstances. Also, it can be ill-advised to reconfigure your portfolio too frequently or based on something as distracting as whether you’re 29 or 31 years old. With years ahead of you, if you’re able to remain calm and invested during the market’s inevitable rough patches, a healthy dose of stock market returns can take you far.
In short:
Build your portfolio based on your personal goals, risk tolerance, and time horizon rather than chasing or fleeing hot or cold investments or focusing on generalized rules of thumb.
Interested in learning more about how to take the first steps toward pursuing your personal financial goals? Reach out to set up a time, and let’s talk.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform anon-diversified portfolio. Diversification does not protect against market risk.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
Stock investing includes risks, including fluctuating prices and loss of principal.
Asset allocation does not ensure a profit or protect against a loss.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Bonds are subject to availability, change in price, call features and credit risk.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.