In a healthy financial strategy, investments are one essential element for achieving financial success. When looking at where and how to invest, there are three essential elements that need to be considered. These are asset allocation, market timing, and time.
Asset allocation is simply how you have invested your funds. Here is where diversification comes into play. A well diversified portfolio enables you to avoid some risk, while taking advantage of economic growth on a large scale. To illustrate, let’s look at the portfolios of two friends, Bill and Katelyn. Bill invests in the S&P 500, as a diversified portfolio that tracks the movement of the 500 largest companies traded in America. Katelyn however has invested her money in a company she is betting on for the future, Tesla.
By allocating your assets in an undiversified portfolio, you can expose yourself to massive risk. In Katelyn’s case, having $10,000 in Tesla on March 1st led her to see an unrealized loss of $ 3,044.88 by May 21st, 2019. This could be devastating to any portfolio, especially if life circumstances required her to sell at the low point. Bill on the other hand saw moderate gains in the same period. His more diversified portfolio wasn’t exposed to massive gains, but also was protected from the huge losses his undiversified friend.
As this rather extreme but not unheard of example illustrates, the volatility of investments makes it very risky to keep all your eggs in one basket. For those without immense knowledge of the market, that risk is usually not worth the potential reward.
The above example also works well when looking at the second element to growing your investments, market timing. Timing the market means buying low, and selling high. Knowing precisely when to buy and sell is impossible for even the most talented stock trader. Taking a look at the S&P 500 again as our benchmark, we can look at the price on the first of every month for the last 9 months.
No investor has ever accurately predicted the right time to buy and sell on a consistent basis to be able to beat the market regularly. By looking at the graph above with only 9 data points, we can see that it would be hard to time exactly. If we looked at the daily market prices, the graph is even more sporadic.
The final element to growing your investments is time. In the long run, historically investments have increased in value. This can be seen when looking at the market price of the S&P 500 since its inception. For our example purposes, we are only looking at the last 5 years.
Even in the last 5 years, despite economic fluctuations, the price of the S&P 500 has increased 43%, or 8.6% annually.
The three elements that are essential to growing your investments are asset allocation, market timing, and time. Diversification of your investment portfolio helps mitigate risk, while combined with the final element, time, leads to consistent growth. Market timing is risky, as knowing when to buy and sell is impossible. And by staying out of the market thinking you will buy at the lows, and sell at the highs, leaves you missing out on the one main element you can control, and that is time.
Investing part of your monies for the future is the only way to reliably achieve financial freedom, and that is something not worth gambling over. Investing in a diversified portfolio regularly, automatically, will help you stay in the market. This capitalizes on the time element you can control, and takes the gambling out of market timing.
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