Ten years ago, I was sure I was a genius at investing. Acting on a suggestion, I bought a stock that soared from $5 a share to $100 in just a few years. As it went hypersonic, friends urged me to sell and lock in my staggering gains. But I ignored their advice-you don’t bail out of a rocket ship when it’s halfway to the moon, I thought. I preferred to daydream instead about the things I could do once my holdings hit $500 or $1,000 a share.
You can probably guess where this story is headed. After kissing $100, my rocketing stock (a printing equipment company called Presstek) plummeted back to earth, eventually cratering below my original cost (shares have since rebounded to about $12). Far from being a stock market genius, I was guilty of a multitude of investment sins, from failing to spread my risk, to greedily assuming my stock would go up indefinitely, to ignoring its absurdly inflated valuation.
While my tale may be extreme for its folly, I am far from alone in having blundered at managing money. In a country where 42 percent of workers aren’t saving at all for retirement and where personal debt is at an all-time high, multitudes of people need-or will need-help. I asked some money pros in Chicago to identify the mistakes they see people making most often, and to offer some insights and suggestions to get better results. Some of their tips-be frugal, save more-boil down to common sense. “It’s not brain surgery,” says Jim Barnash, managing director of Lincoln Financial Advisors Corp. and president-elect of the Financial Planning Association. “It’s basic blocking and tackling.” And much of the pros’ advice is rooted in an understanding of investor psychology. Investors are prone, for example, to wide mood swings-euphoria when stocks are rising, despair when they’re falling-that cause them to buy high and sell low, exactly the opposite of what they should be doing.
Our financial pros aim to get you to curb your enthusiasm-and your despair-and to focus on doing the calm, rational, little things that will win out big in the long run. They’re not offering a rocket ride to instant riches. The good news, though, is that almost anyone can achieve outstanding results with proper discipline, patience, and perseverance. And you don’t have to be a stock market genius to do it.
1. First, save thyself.
Although the best way to build financial security is to invest in a diversified portfolio, you can’t invest what you don’t have. So the first step is to have more money coming in than flowing out. Yet last year, the savings rate in the United States turned negative for the first time since the Great Depression, meaning Americans, in aggregate, spent all of their after-tax income and either dipped into savings or borrowed to finance purchases. “Many people don’t understand the basics of paying yourself first-of saving money,” says Barnash, who recommends coming up with a plan to trim expenses and boost savings. Fine, you say-except that you’re pretty stretched right now. Barnash is unmoved. “We all can make cuts,” he says.
2. A venti skim caffe latte saved is $3.50 earned.
Maybe you have a habit of hitting the company pop machine a few times a day or the nearest Starbucks for your morning caffeine jolt. Maybe you buy your lunch every day instead of packing it sometimes, or you work out at a fancy health club instead of the YMCA. If you could move just $100 a month from the consumption side of your life to the savings and investment side-a cut of just $3.30 a day-it could translate into tens of thousands of dollars over time. Save even more, say $500 a month-a bit more than $16 a day-and you may be on the road to becoming a millionaire, as we’ll see below.
3. Put yourself on an allowance.
Brad Rosley, a certified financial planner who is president of Fortune Financial Group in Glen Ellyn, suggests some tricks to enforce discipline in spending and saving. One is to divert half your annual raise into a savings program. Another trick is to withdraw enough cash to cover your basic spending needs each month, such as dry cleaning, gas, and groceries. Divide the cash into four envelopes, one for each week, and make do only with that week’s allotment. By having a finite amount of cash to spend, he says, “you pay for your priorities and take a pass on the things that aren’t.” And you can’t cheat by charging stuff (see item 4).
4. Credit cards are the devil’s tools.
Rosley calls credit and debit cards instruments of Satan, because “they get otherwise good people to do things that are bad for them.” And he’s not talking about carrying high-interest credit card debt. Charge cards are pernicious, even for people who pay off their balances each month, because they make it so easy for their owners to yield to temptation and buy things they don’t need. Rosley’s own “unscientific study” shows that a fifth to a third of all plastic-fueled purchases could be eliminated from most people’s budgets, leaving them with more money for savings, investments, and life goals, not to mention less clutter in their garages and basements. Thus, a hypothetical couple who rack up $2,000 a month in credit card charges might be able to eliminate $500 in “marginal” monthly expenses without undue hardship, he says.
5. Returns don’t matter. Savings do.
How much difference would $500 a month make? Let’s say our hypothetical couple get fiscal religion and start saving that much each month. Because they haven’t learned yet about getting the most out of their money, they simply stuff the cash under their mattress. After five years, besides having a lumpy bed, they will have socked away $30,000. Rosley points out that people often think the best way to get rich is to hit it big in the stock market. But to him, “the fastest way to grow your portfolio is to systematically increase your savings.” If you have not saved much money yet, cutting back on unnecessary expenses “blows away any returns you’ll get on Wall Street,” he says.
6. We lied. Returns do matter.
Of course, our money pros don’t recommend turning your mattress into an investment ac-count, since inflation would erode your money’s value over time. Barnash recommends keeping enough cash in the bank to cover six months’ worth of living expenses. But anything beyond that should go into a diversified portfolio of stocks, bonds, and mutual funds based on your financial objectives, time horizon, and risk tolerance. Historically, stocks have outperformed all other classes of assets. Since 1926, Standard & Poor’s composite index of the 500 largest companies in the United States has returned an average of 10.4 percent a year, according to Ibbotson Associates. Small-company stocks have performed even better, returning 12.7 percent-though owning them requires steadier nerves because they’re riskier and more volatile than large-company stocks.
Let’s assume our hypothetical couple can’t tolerate the price gyrations of the stock market, so they put the $500 a month they’re now saving into ultrasafe government bonds, which have averaged annual returns of about 5 percent historically. After five years the $30,000 they saved would now be worth $34,144. That sure beats mattress stuffing. But let’s say they were willing to risk the ups and downs of the stock market in order to average 10-percent growth over the long term. After five years’ compounding at 10 percent, their money would be worth $39,041-14 percent more than bonds would have given them and 30 percent more than the mattress method.
7. Time is the great multiplier.
Clearly, a higher rate of return can make a difference in the size of a portfolio. But that difference becomes more pronounced over time, thanks to the effects of compounding. If your money appreciates by 10 percent this year and 10 percent the following year, it hasn’t gone up 20 percent. It’s gone up 22 percent because your principal isn’t the only thing appreciating; the appreciation on it is appreciating as well, and therein lies the beauty of compounding. Money growing at the rate of 10 percent a year will double every 7.2 years; over a period of decades, the effect is exponential. To return to our hypothetical couple investing $500 a month, after ten years’ compounding at 10 percent per annum, their account would swell to $103,276; after 20 years, it would be worth $382,848. The math of compounding “confounds people,” says Mark Hutchinson, managing director of wealth management at Smith Barney in Chicago. “It’s not addition. It’s multiplication.”
8. Start early.
Maybe you have every intention of embarking on a savings and investment plan. Good for you. But you intend to start next year. Too bad, because that single year of delay can cost you big over time. Let’s return one last time to our couple, who have continued dutifully saving and investing $500 a month, compounding at 10 percent a year. But let’s say they started a year earlier and have now been at it for 21 years instead of 20. Although they added the usual $6,000 of new cash in year 21, their account grew by $46,424 in that year, giving them a total of $429,272. And, of course, the acceleration in the size of their holdings will continue with each passing year. By year 30, they’ll surpass $1 million. And they’ll get there not by hitting home runs in the stock market but by clocking average returns and letting time provide the long-ball power. The bottom line: no matter how old you are, the best time to start saving and investing is now.
9. Take as much risk as you can bear.
Although stocks have outperformed other asset classes over time, even diversified stock portfolios can be prone to wide price swings from year to year. That’s great when stocks go up, gut-churning when they plunge-the S&P 500 lost half its value from early 2000 to late 2002. The cure for that volatility is time. If you can put money aside for at least ten years, you have a high probability that it will achieve stocks’ long-term average annual growth. “As you lengthen your time horizon, you reduce the risk of owning stocks,” says Sandy Lincoln, managing director and chief market strategist with Wayne Hummer Asset Management Co. in Chicago. “But you have to be prepared to hang in there” during bear markets.
“If your investments are keeping you up at night, you’ve got too much risk,” says Patrick Lynch, president of Chicago Equity Partners, which manages $11 billion for large institutional clients. Diversification across many kinds of stocks can dampen some of that volatility. Adding bonds to your portfolio can provide even greater stability. The highs may not be as high, but the lows won’t be as low.
10 Preserve capital.
If a stock drops in value by 50 percent one year and rises by 50 percent the following year, it hasn’t made it back to where it started; it’s still down by 25 percent. To recover from a 50-percent loss, an investment must appreciate by 100 percent. Many investors don’t understand how difficult it is to recover from big losses, says Mark Hutchinson.
To make sure your money lives to fight another day, he says, “be willing to take small losses regularly, but never be willing to suffer a large loss.” The problem for most investors is that it is psychologically painful to incur even a small loss. Instead, many hang on to losers in the hope that they will rebound and prosper. That happens sometimes, but more often “it’s like waiting for Godot,” Hutchinson says. “Taking a 10- or 15-percent loss protects your capital better than watching something go careening south for months or years. And by avoiding major mistakes, you’ll radically enhance your investment performance.”
11. Prune your losers.
Let’s say you buy 20 stocks at the beginning of the year; by the end of the year, half are up and half are down. You sell the losers and replace them with ten new stocks, half of which turn out to be winners and half losers by the end of the following year. Meanwhile, something interesting has happened to your portfolio: it is now composed of 75 percent winners and just 25 percent losers instead of half and half. Unfortunately, most people don’t manage their investments this way. Studies have demonstrated that investors are 50 percent more likely to sell a winner than a loser, dooming themselves to lackluster results. By fighting that impulse and proactively pruning losers from your portfolio, “you never have many rotten apples, and you end up with a portfolio of winners,” says Hutchinson. “And by holding on to those winners you radically increase your opportunities to make money” thanks to the effect of compounding tax-free over time.
12. When hype is rampant, be afraid. Be very afraid.
On December 10, 1999, Amazon stock closed at $106.69 a share. A few weeks later, the company’s CEO, Jeff Bezos, was pictured on the cover of Time as the magazine’s Person of the Year. We now know that the technology stock bubble was about to burst back then. By late April 2000, Amazon shares had lost half their value. In late September 2001, Amazon closed at $5.97, more than 95 percent below its all-time high (it’s now around $39). What were those buyers of Amazon thinking in late 1999? “It’s human nature to do things that are comfortable,” says Sharon Oberlander, first vice president-investments with Merrill Lynch’s global private client group in Chicago. “When is it comfortable to make investments? When everyone is doing it, when every publication is writing about it. But you need to be very cautious when you feel that way. It doesn’t lead to buying low and selling high. It leads to buying high and occasionally selling higher because you got lucky, but more often selling low because you got in at the peak.”
13. To maintain proper asset allocation, rebalance every year.
If you have a properly diversified portfolio, you will always have some assets that are doing well and some that aren’t. Technology growth stocks in the late nineties, for example, had run circles around old-economy value stocks and bonds for several years. To prevent outperforming assets from throwing your portfolio out of balance, Oberlander and other money pros recommend annual rebalancing. “You sell the rich asset class, which is probably going to taper back, and you buy the cheap asset class,” says Patrick Lynch, of Chicago Equity Partners. “Our bodies are not wired to do that, but this reduces risk and leads to positive returns.” For the past five years, large-cap value stocks have done well compared with large-cap growth stocks, suggesting it may be time to move some money from one group to the other, says Oberlander. “When a sector outperforms, there’s a tendency to think it’s going to outperform forever,” she says. “And it never does. Being human, you’re going to want to sell your underperformers and put the money into what’s hot.” Rebalancing, she says, forces you to do just the opposite. “It’s not a technique for finding the perfect entry point or exit point,” she says. “It’s a technique to do much better than average with your portfolio.”
14. Focus on valuation.
One reason individual investors get burned buying stocks is that they fail to distinguish between a good company and a good stock, says Gautam Dhingra, chief executive officer of High Pointe Capital Management, which handles money for institutional and individual investors. Google is a great company. But people who paid $475 a share for it in mid-January may have bought a lousy stock, at least in the short term-by mid-February Google shares were more than $100 below their January peak. “A company that may be very good operationally may not be a great stock to buy, because its valuation is too high,” says Dhingra. Besides failing to focus on valuation, individual investors are also “prone to extrapolate the recent trend, assuming that because the price has gone up, it will continue [to do so],” Dhingra says. The good news, he says, is that tools are now available to help individuals focus on the quantitative side of investing and subtract their emotions from the equation. Both Morningstar and Value Line offer summaries of financial statements as a premium service to members. “Both are good, cost-effective research tools for individual investors,” Dhingra says.
15. Invest like a woman.
Despite knowing less about investing and being less interested in it, women make fewer mistakes than men, according to a study by Merrill Lynch Investment Managers. Women tend to wait too long to start investing, and spend too much time analyzing potential investments, missing out on good returns. Men are more impulsive, buying “hot” investments without researching them and stubbornly hanging on to losing ones. Women are also likelier to seek help from financial advisers. For men, doing that is “like asking for directions when they’re lost,” says Oberlander. That leads to our final tip.
16. Get help.
The single piece of advice our gurus stressed most strongly was to find a qualified professional to help you put together a comprehensive financial plan. An adviser can help an individual manage risk while working toward financial goals. And he can offer dispassionate advice where many people need it most-knowing when to sell. “Most investors tend to be backward thinking-they look at where they bought a stock and how it has performed in the past instead of weighing its prospects going forward, or considering better opportunities,” says Charles Carlson, CEO of Horizon Investment Services, in Hammond, Indiana. “The disciplined approach that an unemotional adviser can bring to the process is a huge benefit.”