How To Avoid Gambling Away Your Investments
Investing has been the subject of debate between me and my colleagues, on and off throughout the years. Some of my friends consider participating in the stock market a form of gambling, while I say "it depends." While I agree that not everyone should be risking their money in certain investments, I believe that by taking on an extreme view against investing in general, you could be missing out on potential growth in your net worth. Unfortunately, in recent years, what's happened in the stock market may validate what some people already think -- that investing is indeed synonymous with gambling.
But for those who are young, able-bodied, employable and with a good income stream, putting money in the stock market is still a good bet (pun intended). For instance, while I'm pretty conservative when it comes to my money -- I'm debt free but for my mortgage -- I am one who also enjoys investing and who has happily reaped the benefits of this activity over the years. So if you're nervous about investing, here are a few tips to help you find the confidence to make that first step as a stock investor:
How To Prevent Your Investments From Turning Into A Gamble
1. Learn about investing.
These days, many online brokers and mutual fund companies offer a lot of resources and information that you can use to boost your knowledge about the stock market. When I first started investing, I only had books, magazines and publications to turn to, unlike today with the wealth of information at our fingertips. I'd encourage you to check out our TradeKing review or this coverage I have of ETrade, where you'll see the kind of resources that are available to you for free by simply joining a well rated brokerage. You'll get very strong support at mutual fund companies like Vanguard and Fidelity as well, or at independent financial sites like Motley Fool and SmartMoney.
2. Have enough of a cash cushion.
Make no mistake, the stock market is rife with risk. But don't forget that there are other risks too, when you decide to keep all or most of your money in a safe, liquid account. While it's important to ensure that you do have some money saved up in a savings account, don't overdo it because over time, you may not be earning enough in interest to make up for the effects of inflation. You'll need stocks and other investments to prevent your assets from losing ground due to inflation. For most people who earn an income or have cash flow, their emergency fund can serve as the cash cushion here.
3. Diversify, diversify, diversify.
The key to managing your risks with investing is a little thing called diversification. I've often written that diversification is the foundation of any solid investment plan. Create a portfolio that represents all the major asset classes such as stocks, bonds, cash, and maybe include real estate and gold (or precious metals) in the mix. For stocks, you'll want to diversify further by getting representation in foreign and domestic companies.
4. Gamble only with a little.
Should you trade stocks online? Some people make the mistake of equating investing with trading, which are two different animals. The prudent approach is to create what is called a "core and explore" portfolio. The one I have consists of core investments in solid, high quality investments such as index funds and ETFs, while I cap the amount of money I use for "fun, experimentation and exploration into wild investments" at 4% of my total portfolio. That way, I can indulge my interest in trading the market.
5. Stick with what you're comfortable with.
Go with the kind of portfolio that will make you sleep at night. Deciding to put most of your funds in aggressive stocks and risky investments like penny stocks or options (unless you have great experience in options trading), is gambling, if you're an average investor. Instead, use your goals and self-understanding to invest according to your risk profile.
6. Stick with easy to understand, well known investments.
What can be more popular and easy to understand than mutual funds? These boring funds often get some flack for being ... well, boring, but you'll increase your chances of making money over the long term with a simple diversified portfolio of index funds.
7. Avoid making emotional decisions.
I used to think that market timing is bad. Today, I don't necessarily think it is, unless you're timing the market based on emotion. Remember that with market timing, you risk being whipsawed by volatile prices. If you time the market by basing your decisions on a clear investment strategy and loads of analysis, then it's a different story. That said, market timing is only appropriate for skilled and experienced traders, while the average investor should probably avoid participating in such a risky exercise.
8. Understand your risks.
Know the risks you take before you put your money on the line without any guarantees, so do your research and read your prospectuses before you invest. It's also important to understand the relationship between risk and reward, as well as your own investment profile. Ask yourself: what kind of investor are you? Here's more on how to manage your financial risk as well as some basic investing tips we've shared here before.
To close, I believe that it's all semantics when one compares investing to gambling. You're a gambler if you trust luck to take care of your fortunes in the markets. You're an investor if you've put careful thought into your investment plan and decide to execute your strategies accordingly. While both actions involve risk, they don't mean the same thing to me.