Time is On Your Side When Investing

Through the Carnival of Investing #13, I was pointed to an interesting chart and some comments by “Geek” at A Geek’s World. I have grabbed the corresponding chart and included it below (I hope you don’t mind Geek!!).

What Geek points out is that the periods of bull markets (green) are much more common than those of the bear markets (red). By thinking long term, diversifying, and using strategies such as dollar cost averaging an investor has a pretty good chance at succeeding at making some money in the market.

I would like to add a couple of my own points to this chart as additional items to think about when making your own investment decisions:

1. Diversification

If you are like me and enjoy the process of selecting dividend paying stocks for your portfolio, then diversification is even more important. By investing in individual stocks you are opening yourself up to company-specific risk. If that company messes up or cheats (a la Enron) then you have no where to go but down. If you hold an index fund, then that loss will not impact you as much as an Enron would in a portfolio of 8 individual equities. To help offset individual company risk an investor can do a couple of things:

1. Hold a higher number of stocks in your portfolio. This quote from A Financial Revolution sums up the effects this has on a portfolio:

The objective of diversification is to reduce the portion of a portfolio’s risk not attributable to the stock market’s overall movements. Examples of this type of risk include when a product line doesn’t sell well, a company cooks the books, or a company misses earnings. Based on statistics, owning two stocks reduces this risk by 46%. Four stocks reduces nonmarket risk by 72%. Eight stocks cut your risk by 81%. Sixteen gives you 93% protection, 32 provides 96%, and 500 cuts your risk by 99%.

The result: Once you own eight stocks in different industries (and that part is key!), the benefit of adding more stocks in an effort to reduce nonmarket risk is minimal.

2. Hold Not Correlating Assets. This means holding assets that don’t move in line with each other, such as bonds (historically at least) and real estate.

2. Comfort With Risk

Geek talks about having a long time horizon and not putting money in and out of the market. Il believe, as an extension to this, that an investor must have some natural ability to sit on their hands and not act when times get tough. For example, during that time period around 2000 when the market was dropping like a rock it would have been very difficult for any investor who could not stomach risk to not cut their losses and move on. This is not easy during a free fall but is important to be able to do, so that harsh, drastic decisions are not made.

In summary, from a historical perspective the market tends to go up but is interrupted for periods of bear markets that can last for a varied length of time. Having a solid diversification strategy as well as some natural comfort with risk is important to maximizing your benefit from this trend.