If you're investing, your focus should be on the long term. There are no guarantees in investing, and there's always risk involved, but there are strategies savvy investors use that reduce risk and increase the chance for financial success. Here are four essential tips for becoming a savvy investor.
1. Understanding the power of compounding
Very few forces in finance are as powerful as compounding. When dealing with debt, it can add insult to injury, but in investing, compounding can be credited with a lot of wealth creation. It's great to earn a return on your investments, but it's even better when that reinvested money earns a return itself. When you begin to understand the power of compounding, you begin to understand why starting to invest early and letting time work its magic is one of the best things you can do.
Imagine that you made a one-time $10,000 investment that returns 8% annually. Without investing another penny, your investment would have accumulated to over $68,000 in 25 years. Even if you made $500 monthly contributions to the same investment for 25 years, you would have accumulated over $438,000 while only personally contributing $150,000. Compounding rewards investors for being patient.
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2. Use index funds to achieve diversification
One sign of a good investment portfolio is diversification. Having too few companies in your portfolio increases your risk because it's heavily swayed by the performance of those companies. Ideally, you want companies spanning many different industries and market caps. Instead of having to research and invest in a ton of different companies to achieve diversification, you can invest in index funds and instantly become exposed to many different companies across many different industries.
Even if you don't invest in a fund that covers all sectors -- such as the S&P 500, for example -- there are many sector-specific index funds that you can invest in to ensure you cover all your bases. There are also many different index funds containing only companies of a specific size, so you can gain exposure to larger, more established companies, as well as smaller companies that may have room for hypergrowth.
3. Accumulate dividend-paying stocks
In addition to index funds and other investments, you should aim to have some stocks in your portfolio that pay dividends. Dividends are a way for companies to reward shareholders for holding onto their stocks, and if you're intentional enough with your investing, they can be a great source of retirement income. Imagine you're able to rack up $100,000 in a company or index fund that pays out a 2.5% dividend yield. In that scenario, you can count on receiving $2,500 in annual payouts from just that investment alone.
With enough time (and compound interest), it's very possible to get to the point where you accumulate upper-six figures or more and can receive thousands in monthly retirement income. This can be a perfect supplement to other retirement income sources, such as a 401(k) or Social Security.
4. Use dollar-cost averaging
It's easy to get your emotions involved when dealing with money; it happens to the best of us. However, making investment decisions based on emotions can prove costly. One way to remove some emotions from investing is by using dollar-cost averaging. With dollar-cost averaging, you put yourself on a schedule, investing specific amounts at regular intervals with no regard for stock prices at the time.
Not only does dollar-cost averaging get you in the habit of making consistent investments, it also helps you avoid trying to time the market, which is all but impossible to do consistently long-term. When dollar-cost averaging, you may find that sometimes you make investments before prices drop, and other times, you may find yourself investing before prices rise. In either case, what's important is that you stick to your schedule and trust that it'll even out over time and be less stressful along the way.
