5 Investing Basics That Can Make You Rich
So you want to become a better investor, build more wealth, and gain financial freedom?
Where do you begin? There's tons of advice out there about how to make money in the market. And sadly, not all of it is good advice. In fact, some of it is downright damaging. (See also: Investing Concepts to Ignore and to Follow)
But don't worry, there's good news: If you boil all the advice down to a few key fundamentals, what's left is a short list of true words of wisdom — real advice that'll put more money in your pocket over a lifetime of investing.
1. Start Early and Invest Regularly
If you start at age 25 and put in the maximum to your Roth IRA ($5,500 in 2014) every year for just 10 years (until you're 35, and then stop contributing), and your money grows by 8% each year, by the time you're 65 you'll have over $865,000. (See also: Retirement Planning If You’re Under 30)
But if you procrastinate for 10 years, start investing at age 35, and invest the maximum every year until you're 65 (30 years), you'll have just under $673,000 — a difference of over $192,000.
How much would it hurt to lose $192,000?
By starting a bit earlier, you put in less of your own cash, and end up with more money than if you started later and had to put in more of your own cash.
2. Choose Your Asset Allocation
This refers to how you split your money between the two main types of investments — stocks and bonds. (See also: Asset Allocation Basics)
To highlight the importance of this decision, here's what William Bernstein, author of "The Four Pillars of Investing," says about it: "The fundamental investment choice faced by any individual is the overall stock/bond mix."
So how do you choose?
Here's a rule of thumb recommended by John Bogle, founder of the Vanguard, the world's largest mutual fund company: Put your age in bonds. So if you're 30 years old, put 30% in bonds and 70% in stocks. Once you turn 60, put 60% in bonds and 40% in stocks.
3. Rebalance Yearly
Rebalancing means restoring your investment portfolio to its original asset allocation. For instance, if stocks have a good year, they'll increase in value and make up a larger percentage than your original allocation.
To rebalance, simply sell the appropriate amount of your stocks and buy more bonds (or, to avoid capital gains tax on the sale, try this contributions rebalancing trick). By doing this, you're also following another investing idiom: buy low, and sell high.
4. Make Index Funds the Core (or All) of Your Portfolio
Here's what Warren Buffet, second richest man in America, has to say about the effectiveness of index funds for building wealth: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."
5. Keep Costs Down
When it comes to fund investing, your costs are the fund's expense ratio. According to a report from the Investment Company Institute, the average actively managed fund costs 0.92% a year. With index funds (see #4 above), however, you pay a lot less. The average index fund costs just 0.13% a year.
Why does this matter?
Suppose you invest $5,500 each year for the next 20 years. Also, let's assume that both the actively managed and index funds grow by 8% each year.
If you chose the actively managed fund, at the end of the 20 years you'd have just under $242,000 — a fair amount. But if you invested in the lower-cost index fund, you'd have grown your wealth to the sum of over $267,000 — a difference of over $25,000.
Could you use an extra $25,000?
Following these investing fundamentals, and you'll be sure to gain the financial freedom you're seeking.
Anything I've missed? What additional fundamental investing rules do you follow?