Personal finance is said to be disproportionately more about behavior and significantly less about actually having the necessary knowledge. It explains why so many people don’t even have $400 to cover a small emergency and also why the majority of investors lag the stock market returns each year.
If we go back to the absolute basics of personal finance, there are 2 undebatable principles:
- Don’t spend more than you earn
- Save at least 10% of your income for the future
How many people are even doing this though? Very few according to recent studies.
When it comes to investing, the behavioral aspect is particularly important to research. There are several studies, such as Dalbar’s annual investor behavior study that show that those who don’t actively manage their investments by frequently buying and selling are significantly better in the long-term. In fact, this study shows that the broad market return is more than double that of the average stock investor.
Many people focus way too much on historical returns, especially recent ones, and make decisions based on these results. They might purchase individual stocks based on which ones are hot or invest in markets or funds that have done well in the past.
However, these same people are also likely to panic when the stock market falls. This is referred to as buying high and selling low. That’s exactly what you don’t want to do in the stock market.
How Historical Returns Are Useful
Historical returns can show us that even through major economic recessions, the stock market is still the best place for the long-term investor. Mama Fish Saves has a phenomenal post showing how it is still worth it to invest in the worst times in history, as long as you’re investing for the long-term.
Other than looking at the historical returns of the stock market as a whole, there isn’t a huge benefit to looking at historical returns. Making investment decisions primarily based on historical returns isn’t really a very good idea. There are many other factors that are far more important to look at that will have a bigger impact on your future returns.
What You SHOULD Be Doing
Instead of focusing on historical returns, it will be much more beneficial to examine some things that will truly increase your potential to earn more in the stock market.
There are a few things that are essential to your financial success:
- Create a budget so that you maximize the money you can put toward your goals and minimize unnecessary spending that doesn’t align with your core values
- Focus on your cash flow, including your savings rate
- Know your true risk tolerance
- Check your investments and rebalance quarterly at most
- Diversify your investments according to your risk tolerance and how much volatility you can handle without panicking when the stock market drops
- Invest in low-cost, high-quality index funds
- Learn the basics of personal finance & investing, including the fundamentals of stocks and bonds.
- Don’t be greedy (jumping in and out of the market is not going to make you extra money!)
If these sound simple, it’s because they really are. Sometimes actually doing less will do more for you!
What You SHOULD NOT Be Doing
If you do those things listed above, you’ll be in great shape. However, there are some potential dangers to look out for when it comes to investing.
Make sure that you avoid doing the following:
- Putting all of your investments in one “basket”
- Speculating, day trading
- Panicking and selling when the market drops
- Listening to the media to find the next hot stock or mutual fund to buy
- Investing in something that you don’t fully understand
- Trust and verify if someone else is managing any portion of your investments for you
Not doing these things is just as important to financial success as actively doing the previous items. We’ve all heard stories about people that have lost all of their money in risky investments or by listening to the bad advice of others!
As you might expect, the most important thing in personal finance is not necessarily what you know, but how you apply the knowledge that you already have. It doesn’t take a genius to learn to save and invest, it just takes a little bit of knowledge and a lot of behavior modification.
If the saying goes that knowledge is power, you now have the power to double your returns by keeping your investments simple. Don’t expect historical returns to predict future returns and instead let the market take its course.