Having a set of principles or rules about how you invest can make decisions easier when you have extra money to put to work in the stock market. A good set of principles will also prevent you from making big mistakes with that money, squandering it or the opportunities it may present.
Here are three principles you might consider adding to your rules in order to prevent you from making a big money mistake.
1. Avoid frequent trading; invest with a time horizon in mind
Trading frequently rarely leads to outperforming the overall market.
A 2000 study found that households that traded most frequently underperformed the market by an average of 6.5 percentage points and underperformed the average household's returns by 5 percentage points per year.
If you underperform the market by 6.5 percentage points per year, you'll have about half as much as someone who invested in a simple index fund after 11 or 12 years. When your principal investment could be tens of thousands of dollars, that's a massive money mistake.
What's more, frequent trading can typically result in a higher tax bill for investors. Short-term capital gains (for assets held less than one year) are taxed at your regular income tax rate. And while your frequent trading may result in more losses to offset your gains, the gains you do have will likely come with a higher tax bill, further reducing the capital left for future compounding.
When you make an investment, you should do so with a time horizon in mind. Short-term time horizons might require you to make an investment with less downside risk. If you invest with a long time horizon, you ought to give the investment decision time to play out.
2. Don't time the market
Similar to avoiding frequent trading, investors should avoid trying to time the market.
If you find an opportunity to invest in a stock that you think the market is undervaluing — or even fairly valuing — it's best to put your money to work right away.
This ought to make sense logically. You have a positive expected value for investing in an individual company or an index fund. The longer you wait, the higher the likelihood that you will miss out on gains.
The inverse is true, too. If you want to sell a stock, it's likely because you expect it to return less than other opportunities in the market going forward, or it's too heavily weighted in your portfolio for your risk tolerance. Why would you hold on to it if you could be invested in something better suited for your portfolio?
Putting cash to work as soon as you have it will maximize your total returns over the long run. This is why dollar-cost averaging a lump sum can be a suboptimal decision in terms of maximizing your returns.
3. Keep a trade journal and review it
A trade journal can help you think through your investment decisions, and reviewing it can help you assess your current portfolio. A journal can also help you determine how good you are at making investment decisions.
When you make an investment you should note down your thesis for why it makes a good investment, your time horizon for the investment, and the factors that would make you reassess the investment. When you review your journal, you can check to see if the investment thesis still stands.
A trade journal can also help you determine whether or not you consistently pick stocks that outperform the market. You won't beat the market 100% of the time. In fact, the majority of your picks might come up short of market returns if you're swinging for home runs.
If your overall portfolio consistently underperforms, you need to find where you've gone wrong or switch to a more passive investment strategy.
Stick to your principles when emotions take hold
The important part of maintaining a set of rules or principles for investing is that you have something to reference when your emotions run high. It's hard to stay consistent when market volatility is making you anxious. Keep your principles in mind when you're investing, and you can prevent some big money mistakes.
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