Investing your money in the stock market is one of the best ways to build long term wealth. In the short term stocks can certainly lose money and not all stocks will increase in value, but over the long haul the stock market still outshines other investment options.
Here are 5 things you can do to help maximize your chances of success:
Diversify
We’ve all heard the old saying advising us not to keep all of our eggs in one basket. But the rule doesn’t just apply to dairy products. Diversifying your stock holdings is a smart investment move because it spreads the risk around.
For example, if you invest all of your money in the stock of only one company your entire return is tied to what happens to that particular stock. If it soars to the sky like Apple you’ll be patting yourself on the back, but if something bad happens your entire investment could be wiped out. Just ask the poor folks who were ruined by the Enron collapse.
You can easily diversify your portfolio by investing in mutual funds that purchase stock in many different companies and in different economic sectors. I’m partial to index funds which generally have lower expenses and better long-term returns after taxes.
Keep Trading Costs and Fees to a Minimum
Many investors don’t realize how big of a bite fees and commissions take out of their return. But even a one percent difference in expenses could add up to tens of thousands of dollars over time. If you invest in mutual funds read the fine print and compare expense ratios to see how much you’ll be forfeiting each year.
If you use a financial advisor who earns a living on commissions you need to be extra vigilant because he could be steering you toward investments that increase his income or bonuses even if they aren’t the best option. Or he could be trading excessively in order to increase his commissions.
Pay Attention to Taxes
Just like fees and commissions, taxes can take a significant bite out of your return. When possible contribute to tax-deductible retirement accounts like a 401k or IRA to minimize your taxable income.
For money invested outside of retirement accounts, you need to consider tax consequences when formulating a strategy. If you but stock and it increases in price those are called unrealized returns. But when you sell them they become realized gains and you have to pay capital gains taxes on them. Capital gains taxes which will quickly erode your profits so many investors choose a buy and hold strategy rather than constantly buying and selling.
Don’t Try to Time the Markets
When the financial crisis of 2008 sent the stock market tumbling like a toddler down a flight of stairs, my coworker Don called me in a panic and suggested we should move everything in our retirement accounts out of stocks and into cash. His wanted to minimize his losses in case the market kept falling and then reinvest in stocks when the economy showed signs of improving.
This is where being human and having emotions can lead you to make bad decisions. By selling after the stock drops you’re locking in your losses. And being out of the market you’re guaranteeing that you’ll miss out on any gains you’d receive from a bounce back. No one ever knows for sure when the market will rebound after a large drop, but it tends to happen suddenly. If you find yourself out of the market when that occurs you’ll miss out on a big chunk of the gains.
Don’t Get Cocky
It happens all the time…an investor gets lucky and picks one winning stock that really takes off. The investor then gets cocky and thinks he’s the next Warren Buffett. Before you know it he’s dabbling in all sorts of investments that he only partially understands.
Before you know it his stock picking ability has left him and he’s broke. Or maybe he’ll fall for some kind of investment scam because he thought he knew better than everyone else. Either way, he blew his savings because he got cocky and thought he was smarter than everyone else.
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