It’s an exciting moment when you reach a point in your financial life when you have enough money that you can begin investing, and Ric Edelman of Edelman Financial Services wants you to think long-term as you consider your future investments.
A little history
So in 2007, the S&P 500 gained five percent. Think about that for a moment. According to Ibbotson Associates, the stock market has an average yearly gain of 10%, and has had that same steady gain since 1926, which makes that five percent not sound very good, right? And
yet it got worse. Between January and November of 2007, the stock market gained a whopping… nothing. That’s right: a big fat zero. The S&P 500 started the year on January first at 1418, and that’s where it was on November 21st, too.
Then, on November 21st, something happened: it jumped. Significantly. Between November 21st and November 28th, in the span of a single week, there was a jump of five percent in the stock market. And that was it. The remainder of 2007, from November 28th onward, nothing happened. As Edelman says, “We didn’t have a good year in 2007, we had a good week.”
How weird was that?
The thing is, that example isn’t unduly unusual. There was a similar if less dramatic flat followed by a jump followed by another flat stretch in 2006. And it’s happened in other years as well. So no, it’s not terribly weird or unexpected. And long-term investors like what’s expected, what isn’t particularly weird: that’s how they make their money.
But what if you were an investor who didn’t look at how things shake out in the long term? What if, in this example, you’d been in during the flat stretches and jumped out, unluckily, during that one week of growth? You could have missed out completely on making any profit and you might well have lost money!
Limit your exposure to risk
The reality is that there’s not an investment out there that doesn’t come with some risk: it just doesn’t happen.
Bank CDs follow inflation and task risks. Bonds follow interest-rate risk and credit risk. You’re not going to find any investment that comes with ironclad guarantees. What you can do, however, is limit your exposure to risks by diversifying your investment portfolio.
That is just common sense: it means that if one area suffers, you may be able to recoup your losses somewhere else. You really need to have only one part of your investments to achieve significant growth to “carry” the rest of the portfolio through hard times.
Buy and rebalance
Edelman recommends that your investment portfolio use up to 19 major asset classes in market sectors so that you can really attain a diversified portfolio. He says that “buy and hold” is how most people approach long-term investing, but that’s actually not the best strategy. A better approach would be “buy and rebalance.”
Why? Because over time, one of the assets (or asset classes) in your investment portfolio is sure to outperform the others, so that asset class then becomes a larger portion of the portfolio. What that means is that your investment portfolio is now out of balance.
Say the stocks outperformed bonds and other assets. You don’t want to have a portfolio that’s made up mostly of stocks—that’s a sure route to disaster, as they will absolutely not maintain that high return over time, and you’ll be left holding onto a portfolio where the chief assets are losing you money.
The solution is to rebalance the portfolio. Sell some of your stock, and replace it with some of the asset that hasn’t been doing as well. This is clearly counterintuitive: selling what’s performing, buying what’s underperforming? But look at it this way: you’re selling expensive assets that will bring you a great selling price, and you’re buying inexpensive assets that won’t cost you much.
So in the end you’re living up to the real investment adage: buy low, sell high. And that’s the way to make long-term investing work for you!