Long Term Investing
Short term investing, trading in an out of the market, trying to pick winners is for experts
and even they often lose. It's risky business. But over the history of the US stock markets,
with all the ups and downs, the long term trend has always been up. We are counting on
the US economy to continue to grow and with it the markets as they always have but we still
have to say past performance is no guarantee of future performance. A good long term
investing strategy can reduce risk and maximize gains. When you are young you can
invest in the riskier sectors of the market where there is the opportunity for the greatest
gain. As you grow older you have to shift to less risky sectors of the market, quality bonds
and even cash. The last thing you want to be doing is trying to wait out a market dip after
you retire. Adjusting your portfolio to match your life stage is one of the strategies you
need to understand to successfully use long term investing for reaching your retirement
goals. Now lets examine some other risk reducing strategies.
We have all heard the recent stories of how folks lost their retirement because their
companies failed through fraud, bad management or both. Companies can also lose value
because of market forces. US car manufacturers are a shadow of their former self. Their
are even many once great companies that no longer exist. What about the start up
companies. How do you pick the winners. Many bet on the hot Internet startups and lost.
The answer to this is diversification. It's as simple as the common sense advice that we
have heard for years. Don't put all of your eggs in one basket. But where would you get
the money to invest in thousands of different companies in all different sectors of the
market as well as bonds and other types of investments. The answer is mutual funds.
Few would have the money to diversify buying individual stocks. The answer is mutual
funds. You can buy into a mutual fund investing in hundreds and even thousands of
companies for much less than a hundred dollars. In a diversified fund no more than 5% of
the fund's assets can be invested in any one security. Mutual funds come in many flavors
allowing you to pick your level of risk level. There are equity funds that only invest in
stocks. Even here there are different levels of risk because different funds invest in
different market sectors. You can have funds that invest in various foreign market.
Balanced funds invest in both equity and income securities for lower risk. For those like
retirees who need current income with moderate risk you have income funds. You can find
a mutual fund to meet almost any objective. Mutual funds are marketable. The mutual fund
company will buy your shares back from you at current market value and must mail you
your check within seven days. You can make money from mutual funds in three ways. The
fund shares can increase in value like the individual stocks. You can also make money
from capital gains distributions and dividends.
Dollar Cost Averaging
You can put a chunk of money into a mutual fund all at once. You can voluntarily put
money in from time to time. But one of the best ways to invest in a mutual fund is through
systematic investment. By putting a set amount into the market on a regular schedule, you
take advantage of a risk reducing strategy called dollar cost averaging. Would you rather
invest in a market that goes up and up or in a market that goes up and down and up again.
The fact is that you can make more money in a market that goes up and down as long as it
eventually gets back to or surpasses it's former high point. The good news is that over the
long term that is what the market has done through out it's history. Of course as always I
have to say that past performance gives no guarantee of future performance but as the
economy grows we expect that the market will behave as it always has. Below I have given
an example of how dollar cost averaging works.
On the chart above we have idealized two types of markets. One keeps going up and up.
The other drops and just returns to it's original level. What type of market would you like
to see as an investor. It you investing the same amount at equal time periods over an
extended period of time, you will make more money in the market that just goes down
and up with no real gain. Lets compare the two types of markets for a six month period
of time. We are going to invest $100 a month or $600 total. We graph results for three
investors on the chart above. The tables below show how many shares each investor
purchased per month. Now lets multiply the total shares purchased by the ending price
for each investor to see how much each portfolio is worth. Investor A acquired a total of
42.28 shares and at a final price of $20 a share had shares worth $845.60. Investor B
acquired a total of 88.45 shares and at a final price of $10 a share had shares worth
$884.50. Investor C acquired 178.09 shares and at a final price of $10 a share had
shares worth $1780.90. Notice that the investor that had the biggest gain was the one
that suffered through the worst market dip but even the investor that went through a
smaller dip made more than the investor in the rising market. The secret is the more the
market dips the more shares you acquire. When the market recovers you own more
shares and so you make more money.
Mutual Fund Expenses
For the small investor a mutual fund is the equivalent of a managed account and some of
the expenses associated with it are management fees. Mutual fund managers buy and
sell stocks and this trading cost is part of the funds expenses. Some funds depend on
brokers to actively market their funds and they are rewarded with an up front commission
called a sales load. The higher all these cost are, the fewer actual company shares the
fund purchases for the mutual fund holders. There are ways to control these cost. There
are no load funds. There are index funds, that have lower management expenses. Some
types of funds do less trading and so have lower trading cost. I will discuss some of this
on this page and recommend books to complete your education.
Managed funds have a fund manager who picks investments and tries to do better than
average. People will flock to a fund that has a star manager that can beat the street. If
you are attracted to a fund that has shown exceptional performance, make sure the
management hasn't changed. Managed funds generally have higher cost for a number
of reasons. First you have to pay the managers. Second because they are trying to do
better than the markets average performance, they do more trading. Trading cost are
part of the funds expenses. Often managed funds are marketed by brokers, so in
addition there is an up front sales charge. All of this can be avoided in an indexed fund.
Index funds save you money in a number of ways. They buy and hold a basket of stocks
to reflect a particular market index, so the trading cost are minimal. They are expected
to perform as well as that sector of the market. They don't need to be managed so they
don't have high management expenses. They can be bought without a load so there is
no sales charge. This means that more of your money goes into buying the mutual fund
shares. Everything that you pay out extra in expenses has to be made up in
performance. Is that high expense managed fund going to out perform the market
enough to make up the difference? Many long term investors, think that index funds are
the best way to go.
This has been a brief discussion of long term investing. We've talked about the
advantages of systematic investing with dollar cost averaging. We've talked about mutual
funds as the best way to achieve diversification We've talked about keeping expenses to
a minimum. The goal is to make sure that as much money as possible goes into the
actual purchase of shares. I will be discussing other money topics in the future
Long Term Investing