While reviewing comments and suggestions from readers, I found several excellent ideas in one of our recent surveys. I am always looking for new topics to write about, and several of your suggestions not only piqued my interest, but also offer lessons for all investors. One reader remarked: I am interested in step-by-step stock investing instructions. I think that request goes well with this question: How should I develop my portfolio for retirement?
Rather than give you my own opinions, I decided to consult expert advice, and no one is better than the American Association of Individual Investors. AAII, as it is called, is an independent nonprofit organization founded in 1978. AAII’s goal is to assist individuals in becoming “effective managers of their own assets through programs of education, information and research.”
AAII offers a lot of unbiased educational material online and in a monthly magazine. The organization offers a lot of free information, and a host of additional instruction is available for just $49 per year.
AAII divides the investment life of an individual investor into four phases, and we’ll offer a stock investing instruction for each phase:
Phase 1 begins as soon as you become employed for the first time. (My first job was long, long ago in Boston as a stockbroker trainee at Paine, Webber, Jackson & Curtis.) As soon as your income begins to exceed expenses, establish a cushion for emergencies. Your cushion will need to grow to the equivalent of six months of your income. You can fund your cushion by investing in no-risk investments such as savings accounts at your bank or money market funds at a brokerage firm.
One of the cornerstones of wealth building is being frugal. You should set reasonable savings goals and live below your means. Individuals gain financial independence by budgeting, controlling expenses, and saving a reasonable portion of their income.
When you have accumulated the equivalent of six months of your income and if you haven’t piled up a lot of debt, you are ready to move on to Phase 2. If your debts from college loans, car loans, credit cards, etc., are excessive, you will need to reduce your debt before moving on to Phase 2.
Stock Investing Instruction #1: Build a strong financial foundation by controlling debt and living within your means
Phase 2 gets exciting. Any savings above your cushion can now be invested in mutual funds, exchange-traded funds (ETFs), stocks or bonds. Some advisors encourage investors to invest in mutual funds and ETFs first, and then stocks when your portfolio reaches certain levels. I recommend investing in whatever interests you the most, because you will probably be more motivated to learn about what appeals to you.
Phase 2 is the most important step in your investment career. You need to establish a solid foundation of investments that you can build on in future years. I do not study mutual funds, so I am not qualified to offer advice on a mutual fund strategy. Rather, I believe investing in a combination of ETFs and common stocks is a prudent approach for many new investors.
Your initial investments should be growth oriented, but conservative. I recommend low-risk companies with reasonably good growth prospects for the next five years. Each and every month, I recommend undervalued, high-quality companies in my Cabot Benjamin Graham Value Letter. Recommending high-quality value stocks is my specialty. I scan thousands of companies every month and pick stocks selling at modest prices with expected earnings growth of at least 10% per year. I want companies that pay dividends, although I will recommend non-dividend paying companies if I think the company will start paying dividends within the next couple of years.
The best route to financial independence is slowly accumulating wealth. Don’t expect to double your money every year. According to AAII, the average annual return for common stocks is 10% to 12% per year during the past 85 years. Nevertheless, an individual who invests $10,000 at the age of 27, adds $2,000 every year to his or her account for 35 years, and can average 11% annual returns including dividends, will end up with a cool $1,069,000 at age 62.
When investing start with a list of 10-12 investments, with comparable amounts invested in each, which is a diversified cross section of industry leaders. This is important because you will want to keep your risk low while you build for the future. Buying stocks in many different industries will reduce your risk.
Stock Investing Instruction #2: Invest in what you’re interested in and diversify.
Phase 3 begins after your initial investments start to show noticeable profits. Your initial stocks should be held for the long haul, unless the industry or the company falters badly. Sell a stock if it has risen to its Minimum Sell Price or the long-term outlook has deteriorated and replace the stock with a better one. An advisory which offers a buy recommendation will notify subscribers when to sell a previously recommended stock.
Assuming you haven’t accumulated a lot of debt, you are ready to start adding investments to your core portfolio. Stocks and ETFs are a good way to go, but mutual funds are also appropriate. Rather than staying conservative, now is the time to start investing according to your personal preferences. If you are a gambler, invest aggressively, but not foolishly. If you are conservative, then stay with low-risk stocks and mutual funds.
I advise adding stocks that are grossly undervalued and stocks with exceptional growth prospects. In addition, you might want to add to some of your smallest core holdings, but be sure that each company’s outlook remains robust. I also recommend offsetting your aggressive investments with bonds or defensive ETFs. You should be prepared to jettison risky stocks that underperform and sell stocks that become overvalued.
As your investment funds grow and you invest in more stocks, you will need to decide how many stocks, mutual funds and ETFs are reasonable to follow. When you reach your limit, add to stocks that you already own.
Stock Investing Instruction #3: Increase exposure outside your core holdings with investments that match your risk tolerance.
Phase 4 begins about five years before your retirement. At this point in your life, you should start to reverse your investment strategy. Initially, start selling some of those risky stocks. Invest the proceeds in ultra-conservative investments such as certificates of deposits (CDs), money market funds, bonds or bond ETFs.
Your goal in Phase 4 is to get back to owning very conservative stocks (your core holdings). I advise selling stocks that aren’t paying dividends. If you need to be ultra-conservative, sell almost all of your stocks and invest in shorter-term bonds, CDs and money market funds. When you are retired, your main goal should be to not lose money, and to invest conservatively.
One of the most important attributes that an investor must acquire is patience. The stock market can be a very frustrating place because of its unpredictability. Expect to lose money from time to time. Have confidence in your investment decisions. “If a business does well, the stock eventually follows. Our favorite holding period is forever,” states Warren Buffett, one of the greatest investors of all time.
Stock Investing Instruction #4: Move towards more conservative investments as you approach retirement.