Ric Edelman: So you finally saved up some money and you're ready to begin investing. If you want to enjoy the profits that are produced by the stock market you need to invest with a long term view. Just consider the year 2007 for example, that year the S&P500 gained 5.
5%. Now considering at the stock market has average 10% a year since 1926 according to Ibbotson Associates, a 5.
5% gain doesn't sound great. But 2007 is even worst than you think, that's because from January 1st to November 21st of that year, the stock market gained nothing. That's right the S&P500 stood at 1418 on January 1 and it was virtually the same on November 21st. And then from November 21st to November 28th a single week the stock market jumped 5.
5% and after that the market remained flat for the rest of the year. We didn't have a good year in 2007, we have a good week.
And amazingly 2007 was not unusual, we had a similar experience in 2006 when the profit of 13 and half percent occurred in only 18 weeks. In 2005 the entire year's profit occurred in 8 weeks and 2004, 7 weeks. So if you're one of those investors who jump in and out of the market, you could easily miss out on those few weeks when the profits are really made. and you could loose an entire year's worth of gains.
Every investment has risks, bank CDs are subject to inflation risk and tax risk, bonds face interest rate risk and credit risk and stocks of course are sensitive to market risk. Every investment has risks, there's not way to avoid it. And that's why achieving your investment goals means limiting your exposure to each type of risk. And the best way to do that is to diversify your investments. Imagine that you have $25,000 to invest for 25 years, if you choose a 3% CD for the whole amount, your account will grow to about $52,000. On the other hand, let's say that you split your 25,000 evenly into 5 piles of 5 grand each. With that first pile you buy 5000 lottery tickets, like everyone else, you loose it all. With the second pile you bury it under your mattress you earn in no interest for 25 years.
The 3rd pile of 5 grand you open the back account at 1% interest and your 5 grand will grow to about $64,00 over 25 years. With the 4th pile you buy a U.
S. treasury bond, it earns the same 3% as the bank CD and that 5 grand grows to about 10 grand. And with your fifth and last pile you invest in the stock market, you earn 8% per year that's well below the 10% that the S&P500 stock index has earned on average since 1926 according to Ibbotson Associates. At that rate 10% year your 5 grand will grow over 25 years to more then $34,000. In total you have about $38,00 more then if you had invested the entire amount in CDs, even though you lost everything on the first pile earned nothing on the second pile invested in a bank account with the 3rd and super save government bonds with the fourth and you only gambled with the stock market with 1/5th of your money.
This result is possible banks to diversification, it allows you take calculated risk and even though some of your money might fall in value or earn just a small amount, you only need one part of your money to earn above average returns that can boost your overall portfolio, surprisingly simple yes. Of course rather then invest in lottery ticket or mattresses I recommend that you create a portfolio using up to 19 major asset classes in market sectors to help you achieve true diversification. When most people think of long term investing they think of buy and hold, but the real secret is buy and rebalance. Let me explain using a hypothetical example. Let's say you've got a portfolio divided evenly between stocks, bonds cash and government securities. Overtime one of these assets classes will inevitably out perform the others, let's assume that it's the that do that, as you can see the stocks now represent a larger portion of our portfolio then before. Our portfolio is no longer the balance the way it once was we must fix this problem other wise we will end with the portfolio that's mostly stocks and it won't be diversified based on the design we created based on our needs. So how do we rebalance we do it by selling some stock and buying some of the asset class that has fallen in value, in this case the case, wait a minute, you might say though. We're selling the asset class that made the most money; we're buying the asset class that made the least money? That sounds crazy but it's actually the right thing to do. All you're doing or buying assets that are low in price and selling assets that are high in price; buying low selling high, makes sense doesn't it.