The following is a contribution from Matt at Mom and Dad Money. If you’re interested in contributing to Frugal Rules, please consult our guidelines and contact us.
The world of investing can feel pretty scary sometimes. We’re reminded daily of the market ups and downs. If you flip on the TV, one talking head is screaming at you to sell while another is saying you’d be crazy not to buy. On top of that, our financial goals are very real and very important to us, and with all of this noise it’s easy to feel like if we don’t do the right thing right away, our goals and gains will all be lost.
Today, I want to face those fears. I want to recognize that there are certain parts of the investment world that we can’t control, and I want to find strength in that knowledge by letting them go. I want to embrace the few simple things we can control so that we can take charge of our financial lives and put ourselves on the right track towards achieving our goals.
There’s a lot to Investing That we Can’t Control
Let’s be up front about some of the harsh realities of investing.
We cannot control whether the markets are up or down. We cannot successfully time those ups and downs consistently over any extended time period. And yet, research shows that general market movements account for around 75% of your personal investment returns. Realizing that three quarters of your returns come from something you can’t control can be a scary proposition.
Another 10% of our returns come from the specific stocks, bonds and other investments that we choose. And yet the evidence is overwhelming that our choices here are more likely to hurt us than help us, when compared to investing in simple index funds.
This information can be disheartening. Again, our financial goals are important to us and we want to feel like we can simply try harder to give ourselves an edge. And this is in fact what many people do. Despite the evidence, they continue to look for that edge and harm themselves in the process. We need to look no further than the fact that individual investors actually earn worse returns than the mutual funds they invest in, simply because of the timing of their contributions and withdrawals. This self-defeating behavior is a direct by-product of trying to control the things we cannot control.
Empower Yourself by Focusing on What you Can Control
So how are we as investors supposed to react to all of this? How do we reconcile our desire to meet our financial goals with the reality that we have very little control over some of the major factors that determine whether we reach them? Simple. We embrace it. We embrace the knowledge that there are certain things that are out of our control and we stop worrying about trying to control them. And we find strength in the things we can control, the things that actually matter.
Take stock of your goals. Why are you trying to outperform?
Before getting into strategy, we need to step back and reflect on what we are actually investing for. Perhaps it’s retirement or our children’s college education. Maybe it’s a down payment on a house we’d like to buy in a few years. We all have different financial goals, but I would seriously doubt that any of us has sat down and said “I want to beat the market.” We all want fair returns, but as we go forward with an investment plan, we need to keep in mind the real reasons we’re investing.
Factors You Can Control
While we can’t control the market movements and we aren’t likely to pick winning stocks, there are several factors we can control that will have a big impact on our investment results. If we focus on these factors instead, not only does investing become much simpler but, we drastically improve our chances of actually reaching our goals.
Savings Rate - The amount of money we invest on a regular basis has a huge impact on the amount of money we end up with. The more money we invest, and the earlier we do it, the more time it has to earn compound returns. Simply investing money regularly is one of the most powerful tools in our arsenal.
Asset Allocation - Our asset allocation is the portion of our money that we put towards each type of investment, such as stocks and bonds. While we can’t control the movements of the market, our asset allocation allows us to control our exposure to those movements. By assigning more of our money to risky investments like stocks, we increase our potential returns but also increase our downside risk. Put more in less risky investments like bonds, and the opposite is true. This basic decision as to how we divvy up our money goes a long way towards determining our investment returns.
Costs - Every dollar we pay in fees is a dollar that doesn’t earn us multiple dollars in compound returns. A Morningstar study actually showed that cost was the single best predictor of future mutual fund performance, even better than its own star rating system. Costs come in the form of mutual fund fees, trading commissions, taxes, and any other form Wall Street can dream up. Minimizing these costs increases our chances for long term success.
Diversification - Everyone who writes about investing has said this a million times: diversification is the only free lunch in investing. It’s the one tool that allows you to decrease your investment risk without decreasing your expected returns. Picking total-market index funds allows you to benefit from the returns from every company in the world. No matter what company, what sector, or what country is currently hot, you’ll be in on the action. And whichever one is currently faltering will only represent a small part of your money. It’s a win-win.
Stay focused. Sleep well. Succeed.
Find strength in the knowledge that ignoring the things you can’t control will keep you out of harm’s way. Embrace the finite list of simple things you can control that will help you succeed. Make an investment plan that puts you in charge of your long term strategy and allows you to tune out the day to day noise. If you can do these things, you will be well on your way to reaching your financial goals.
Matt’s Bio: Matt Becker is a proud father and husband and his site Mom and Dad Money is dedicated to helping new parents build financial security for their family. You can also find him on Twitter and Google+.
Editor’s note: I want to thank Matt for focusing on something that many investors overlook – the fact that we need to focus on what we can control and not let emotion get in the way of the rest. Emotion is great, but when mixed with investing it can have a negative impact.
Photo courtesy of: StockMonkeys.com