Our principles of investing provide insight into our core beliefs. When it comes to investing, Hedgehog believes in keeping concepts simple. While there are many different rules and strategies for different investors, we have boiled down five of the most important investment rules.
Investment Rule #1: Get in the Market!
Since 1929, the S&P 500 has spent 80% of its time in a bull market. Without being invested, as a basic investment rule, you have no opportunity to participate in any price appreciation. Of course, there are times where an investment’s risks may outweigh the rewards. In these cases, you may need to assess proper timing for entry; particularly if you require short-term liquidity from your investment. Reading the Market Risk Indicator may help determine whether the market holds an unfavorable risk-reward ratio. Overall, the market goes up more often than it goes down.
Investment Rule #2: Discipline Yourself as an Investor
The other 20% of the time has been spent in a bear market. These bear markets are quicker and more volatile than bull markets. Avoiding them is crucial as we will talk about in Investment Rule #3.
Discipline will help you look past the day to day noise of the stock market. Things like market and geopolitical news, such as the current U.S. – China trade war, only serve to distract investors from the bigger picture. Economic and market data like expected gross domestic productivity, inflation and corporate earnings hold the final hammer of judgment for the markets.
Initiating a systematic approach to your investment selection will help you stay disciplined. Whether you plan to use an advisor or implement your own investment rules and strategies, a disciplined approach will make sure you are in the market more often than not.
Investment Rule #3: Avoid Large Losses
Duh, right? Avoiding large market corrections is the most important piece of the puzzle. Once you have established your disciplined investment strategy, this part is a piece of cake. The market will take you up, the knack is in not riding it down.
The trick of avoiding large losses in your portfolio comes in two parts.
Firstly, hold little to no individual stocks in your portfolio. This may sound like a less than appealing rule of investing, indeed. However, there are simply too many factors beyond your control that exist when picking individual stocks.
Let’s say the company you’ve selected could be the fastest growing company no one has ever heard about. The valuation is low, the arbitrage is great, and the stock is ripe for the picking. What could go wrong? No company’s Treasurer has ever embezzled corporate money, right? Natural disasters have never negatively impacted corporate profits, correct? I think you see the point.
Secondly, our research shows it is more beneficial for investors to be consistently late rather than consistently early when selling due to a market downturn.
The table above shows the compounded annual growth rate of two different strategies. The “Late” strategy assumes the investor continuously sells out of the market “X” months after the top of a bull market cycle while the “Early” strategy assumes the investor consistently sells “X” months before the top of a bull market. Back testing both of these strategies, using closing week values of the S&P 500 since the 1980s, you can see that it is favorable to be consistently late in attempting to time the market.
Rarely does the strategy of correctly predicting market tops go well for investors. Remember rule #2 and let the market tell you when it’s time to sell. Want to know what the market’s saying? Check out our Equity Warning Signal.
Investment Rule #4: Risk Over Reward
A well-cultivated investment strategy helps to avoid large market corrections just as avoiding large market corrections helps you to focus on risk over reward.
Most investors, whether a rookie or a seasoned vet, tend to focus more on the latter than the former. Truly no reward is worth taking if the risk is too great. Therefore, it is best to balance the potential of greed with a cautious attitude. Prioritizing the examination of potential threats to your game plan helps to remove emotion from the driver’s seat.
Investment Rule #5: Tax-Free is Your Favorite Flavor
There are many ways to get your investments to a tax-free status. Contributing to a Roth IRA or Roth 401(k) is one of the easiest ways to take advantage of tax-free loopholes provided by the IRS. Regular IRA and 401(k) accounts are only tax-deferred. Meaning, that the tax on your investment is yet to come. Taxes on these investment accounts are due once funds are disbursed from your account; likely at a higher tax rate than when you initially contributed.
An increasingly popular product to generate a tax-free investment bucket is the Indexed Universal Life Insurance or IULs. An IUL is a life insurance policy whereby paying into the policy generates a cash value that you can use to invest in a product tied to an index. Here’s the kicker, when the index goes up you participate in the gains of the market. However, when the market goes down, you have absolutely no downside risk. You are guaranteed to make no less than 0.00% on your investment in any given year. On top of this, many policies allow you to take up to 80%+ of the value of your policy as a loan while remaining in force. Of course, there are crafty ways insurance companies can do this, but the benefits to investors are a tax-free source of funds while being able to participate in the market with no downside.
Both of these strategies hold more power if you are younger and have more time to implement them. However, it is often the case that a savvy financial planner can work with you in one or more of these ways to help you generate sources of tax-free funds.
As always if you have any questions please feel free to contact us.