A friend at lunch last week told me, “I have a black thumb with investments.” After he saw in my eye that I had no idea what he was talking about, he continued, “Some people buy and inadvertently kill plants; I buy and sink investments.”
Does that sound familiar? Are you sure the investments you pick are going to immediately drop through the floor? Worry no longer because we have you covered.
Picking investments is easy when you begin, as legendary motivational coach Stephen Covey famously said: “With the end in mind.” With thousands of choices, a better approach than researching everything is to start eliminating all of the investments that won’t fit your goal. This process helps you quickly narrow your focus and kiss that overwhelming sense of fear goodbye.
[See: 12 Terms Every Investor Needs to Know.]
Sound like fun? Let’s try it. All you have to do is answer the following three questions:
Do I have a long- or short-term goal? If it’s a long-term goal, stocks and real estate historically are good choices. According to REIT.com, real estate investment trusts averaged 12.87 percent in the period from Dec. 31, 1978 through March 31, 2016, while stocks (as measured by the Russell 3000, which tracks 3,000 U.S. companies) gained an admirable 11.64 percent per year.
However, over a one-year period, both of these investments can be roller coasters. In 2008, during the real estate market collapse, the Vanguard Real Estate Investment Trust exchange-traded fund returned an ugly -39 percent while the Russell 3000 lost -37 percent.
On the other hand, savings accounts are designed to never lose money, and certificates of deposits or money markets can help short-term savers increase rates while still protecting principal. However, over long periods of time, cash investments like CDs will struggle to beat inflation. (Five-year products currently average 1.72 percent.)
The point? If you have a short-term goal, you should rule out stocks and real estate because you could lose significant sums. Long-term goal? Rule out cash products because your average return won’t be competitive.
If you follow this exercise with any investment type you discover, asking first “Does this investment perform well over MY timeframe?” you’ll quickly eliminate most of your homework. Efficiency wins the day!
Do I want to micromanage my portfolio? If you have consistent time to invest in tracking results and monitoring funds, then you might pick a single stock, piece of real estate or bond.
[See: 11 Tips for Investors in Their 30s and 40s.]
Picking your own investments can yield tremendous upside. I’m sure you know people who’ve picked stocks that have doubled, tripled or maybe even earned more! However, even if you spent lots of time, you still might struggle. Every piece of data about a company could potentially become important later, and whenever you buy individual investments, if you miss a single item or there’s one surprise headline, you could lose much or maybe even all of your money.
When I was a financial advisor I’d meet some of these people. They’d tried and failed to pick individual winners and lost, which in some cases meant they’d ruined their chance of achieving some of their biggest life goals. This isn’t meant to discourage you, though. While in some ways stock picking might sound like gambling (and in some ways, it is), some seasoned stock pickers know how to track enough data and follow larger market conditions to at least partially protect their downside.
For most people, all that tracking and studying sounds like a huge pile of work. If that’s you, instead leave the picking to experts or simply diversify baskets of investments. If you choose mutual funds instead of individual stocks or bonds, they often come with a manager who’s required to provide you with their history of picking investments. You’ll be able to easily compare track records to choose reliable managers, and you can leave the individual picking to them. Historically, most of these managers are beaten by the average non-traded investment, so many investors will instead choose either a passive mutual fund or an exchange-traded fund, or ETF. These investments swap out a manager for a diversified basket of investments that align with an index, like the S&P 500 (which tracks the largest 500 companies in America).
[See: How to Build a Fidelity Portfolio With ETFs.]
Whether you choose an active or passive fund, by diversifying your portfolio you’ll give up the huge win, but you’ll also lessen your chances of catastrophe. If you buy a fund that tracks the S&P 500, for example, you’ll own a slice of every one of the 500 largest companies in America. What’s the chance you’ll lose your money with that investment? Not great.
See how this works? After two steps, now we’ve focused first on the time frame, which narrowed the field of investments, then we decided how diversified and personally involved we want to be with individual investment selection.
Only one step left!
What tax shelter should I use? Here’s a step lots of people miss. Choosing a tax shelter can save you from yearly capital gains or interest income taxes on your hard-earned savings. If you’ve chosen investments with the end in mind, ask yourself if the investment for that goal is eligible for special tax treatment. Saving for retirement? If you have a 401(k) or similar account at work, that’s a great place to start. You can invest money pre-tax and you won’t be taxed until you take the money out. Saving for a child’s education? Try a 529 plan.
Each tax shelter has rules and restrictions, so read up on those before investing (as an example: If 529 plans aren’t used for qualified expenses you’ll pay penalties). However, you don’t need to know how every tax shelter works, only the ones that apply in your situation.
There’s more good news, too. Many tax-shelter plans have a limited buffet of investment choices, which makes it much easier for you to research which are best for your goal.
That’s it! Easy, huh? While you’ll still have to work, picking investments isn’t as hard as many people make it seem. Arm yourself with data from morningstar.com, Yahoo! Finance or another free, third-party website that analyzes many of the investments you might pick, and you’re off and running.
Just remember this key: By limiting your choices, you’ll also limit the amount of panic you’ll feel when it’s time to invest, and you’ll do a better job of picking because you’ve just used a process that helps you narrow the field to those choices with the right investment time frame, that are diversified appropriately and are tucked away in the right tax shelter.
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Podcast: The Easy (and Effective) Way to Pick Investments originally appeared on usnews.com
