It's safe to say that all investors share one goal: to make money -- preferably lots of it. Any investment strategy that doesn't achieve that goal is a failure. And while successful investment strategies come in a variety of forms, they all tend to share certain qualities. If you incorporate the four tactics below in your investing strategy, you'll be far more likely to turn the profit you're hoping for.
1. Minimize fees
When you buy an equity or a bond, you don't just pay the asking price. It takes some middlemen to match up buyers and sellers, process payments, and so on, which is why fees are inescapable. That said, you can keep fees to a minimum, potentially saving yourself huge sums of money over the long run. Fees may often look small, but they can take a big bite out of your portfolio. If you buy shares of a mutual fund that grows in value by 10% every year but charges a 2% annual management fee, then your actual return from that investment is 8%, not 10%. Thus, if you're comparing two similar investments, the one with the lower expected return might actually be a better choice if its fees are also lower than those of the other investment.
For example, let's say you have $10,000 to invest and are considering two options: an actively managed fund charging 2% in fees per year, or an index fund charging just 0.5% in fees per year. Assuming both funds average 8% returns per year, after five years you'd have $13,382 if you chose the actively managed fund versus $14,356 if you chose the index fund. That's almost a $1,000 difference over a very short time frame.
Fund managers aren't the only ones who levy fees, either. Banks and brokerages often charge accountholders monthly or annual fees, and most brokers charge commissions whenever you make trades. Before you open any account or buy any investment, make sure you understand the fees involved and choose the lowest-cost alternative that meets your other criteria. Discount brokers are usually significantly cheaper than full-service ones, and index ETFs usually charge lower fees than other ETFs or mutual funds.
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2. Buy and hold
Forget about day-trading. It may sound terrific in theory, but study after study has shown that even during superb bull markets, timing the market just doesn't pay as well as buying and holding investments for a long time. First of all, it's nearly impossible to time the market perfectly -- and one mistake can wipe out all the profit you made on your last several successes. And even if you got your hands on a crystal ball and managed to avoid any timing mistakes, the commissions, fees, and capital gains taxes you'd pay on all those trades would take a huge bite out of your profit margin. However you pick your investments, if you hold on to them for at least a year before selling them and try to minimize the amount of trading you do in general, you'll greatly increase your odds of achieving good returns.
3. Diversify
Diversification is a magical way to making two plus two equal five. One of the basic tenets of investing is that higher-risk investments produce higher returns on average. But remember that that's an average. Plenty of high-risk investments go bust, rather than boom -- otherwise, they'd be low-risk investments.
Buying a single high-risk investment is nearly as uncertain as flipping a coin and hoping it comes out heads. Meanwhile, if you buy a broad variety of high-risk investments, it's like flipping 10 or 20 coins; the odds are much higher that at least some of the coins will come out heads. And it may only take a few winners to more make up for the losers and then some. After all, there's some simple math working in your favor: You can't lose more than you invest, but your potential gains are theoretically limitless. Early investors in Amazon.com, for example, have seen their shares grow to 500 times their original value.
When diversifying, it's important to choose investments that react in different ways to different scenarios. For example, when interest rates go up, stocks tend to gain value, while bond prices drop. When interest rates go down, the opposite happens. Therefore if you own both stocks and bonds, you're covered no matter what happens to interest rates.
4. Minimize taxes
Whenever you make money on an investment, Uncle Sam demands a cut. Capital gains are subject to taxes, as are dividends and interest (with a few exceptions). However, you can protect yourself from those pesky taxes by taking advantage of legal tax shelters. The best tax shelter in existence today is a classic retirement savings account such as an IRA or 401(k). Investments in these accounts are totally protected from the aforementioned capital-gains and dividend taxes. And if you invest through a taxable brokerage account, you can lower your capital-gains taxes by holding on to investments for more than a year before selling (which you should be doing anyway). Then your profits will be subject to the long-term capital-gains tax, which is significantly lower.
Another tax-avoidance tactic is to pick investments that are automatically tax-free, such as municipal bonds issued in your own state. Most big brokers have mutual funds and ETFs that are specifically designed to minimize taxes; these investments can provide a simple way to cut your tax bill down to size.
Bringing it all together
If all of this sounds overly complicated to you, then here's a simple way to use all four of these tips at once: Set up a tax-deferred retirement account through a discount broker, use it to buy shares of an index fund or index-tracking ETF and hold those shares indefinitely. This setup checks all the boxes for a solid investing strategy while requiring minimal time and effort on your part. And while there are no guarantees in the world of investing, you'll be setting yourself for success.
