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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Are you a good investor?
Investing well can be a daunting challenge for those new to it, but it's really not that hard, as many Fool readers have discovered. Learning to choose and hold good stocks or funds definitely takes patience and self-discipline, but plenty of people are able to do it. Many are even able beat the Dow Jones Industrial Average (INDEX: ^DJI) over time, something that a lot of highly paid professionals seem to struggle with.
Developing good investing skills is definitely a thing worth doing. But as you may have discovered, it's one thing to be a good investor, another thing entirely to build wealth through investing.
The first takes skill, knowledge, patience, and some luck; the second takes all of those, plus something else: a plan.
Creating your road map to wealth
Having a plan allows you to use your money and investing skills most effectively, by defining a goal and the steps needed to get there. While you can't know in advance exactly how you'll reach your goal -- nobody can predict precisely what the stock market will do, though we can make some reasonably safe assumptions -- when you have a plan you know what to expect, you stay focused on your goal, and you are able to make best use of all of your resources.
So how do we create an investing plan? For starters, ask yourself these questions:
- What's your goal? Or, put another way, how much money will you need and when will you need it? If your goal is retirement, the answer might simply be "as much as possible before I'm 70." But you might choose to figure out how much you'll need to support the lifestyle you want -- or you might choose a goal that's shorter-term and more finite, like saving to buy a second home.
- How much can you commit to this goal? Starting from where you are right now, how much money can you put toward this goal, both today and over time? Or, put another way, of the money and investments you already have, how much of that will be allocated toward this goal? And how much will you be able to add to that over time?
If you're like most folks, you'll probably need to go back and forth between these several times to get to a real answer. For longer-term investing, assuming an annual stock market return of 8% to 10% -- the historical average range, over long periods -- can help you get a general idea of what to expect.
But once you have a time horizon and an idea of how much you'll be able to invest, it's time to come up with a plan for your portfolio.
The basics of asset allocation
Most folks are familiar with the basics of asset allocation and diversification, two related concepts that are really about spreading your eggs among multiple baskets in a well-thought-out way. Asset allocation allocates your assets (get it?) among different asset classes that, at least in theory, respond to different market conditions and events differently over time. The asset classes used in your plan could be different kinds of investments, like stocks and bonds, or different sub-types, like small-cap stocks and blue chips.
Your exact approach will depend on the asset allocation "map" you use -- more on that in a minute -- but typically, for a long-term plan, you'll have several different categories of stocks, like:
- Blue chips: Big, established companies, typically with a dividend. This includes firms like Coca-Cola (NYSE: KO ) , which has increased its dividend annually for decades, and 3M (NYSE: MMM ) , which fell recently on concerns about Europe but should be a solid long-term bet.
- Growth stocks: Typically smaller caps like Samuel Adams brewer Boston Beer (NYSE: SAM ) , which has risen sharply since its flash-crash low 18 months ago. But they also include stocks like Apple (Nasdaq: AAPL ) , which despite its already-massive size is just getting started in the world's largest growth market.
- International stocks: Like London-based Diageo (NYSE: DEO ) , maker of some of the world's most famous brands of booze (and a great dividend stock), or perhaps an ETF that holds a basket of emerging-markets stocks, like the well-regarded Vanguard Emerging Markets ETF (NYSE: VWO ) .
Spreading your investing dollars among categories like these will ensure that your portfolio is set to take advantage of opportunities (or diversified against risks) that come up in any one part of the economy or world.
Implementing your plan
Coming up with an asset allocation "map" is straightforward -- if you have a 401(k) or 403(b) plan at work, chances are that your employer has access to online tools that will create a customized plan for you. Alternatively, you can check out the excellent templates maintained by the Fool's Rule Your Retirement team -- it's a paid service, but a free trial will give you access for 30 days.
Either way, make sure your plan takes into account all of the assets you plan to devote to this goal. Do you own stock in your employer? Does your spouse have an IRA? Do you have other long-term investment accounts? If your goal is retirement, for instance, all of these count -- and to get the most out of your plan, it's best to think of them as one big portfolio and manage them accordingly.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.