One of the greatest wealth building engines in the history of humankind is the stock market which provides greater access to financial markets and the profitability of small and large companies than ever before. There are many advantages to investing in the stock market in terms of the inflation protection, profit growth, and the liquidity of the investment itself.
Having said that, there are also many risks associated with investing in the stock market as well and this is true for individuals who are looking to invest over the short and long term. Investing in the stock market over the short-term is riskier than over the long-term as any stock position can move in a specific direction for a short duration for logical and illogical reasons, while fundamentals and inflation tend to have a bigger impact over stock positions over a long-term period.
Building out a portfolio that can reduce the risks can help you to minimize the risk and magnify your total return over short and long periods of times. Here are some tips for building a stock portfolio for any economic climate that you are facing.
Diversification within Stocks
It is important to not get too saturated in any one stock position over the short or long-term. Any individual stock position can go up or down at any moment. There are plenty of horror stories of individuals who invested significant amounts in a seemingly safe stock such as Enron, Lehman Brothers, or General Electric only to see their investment dissipate. While it is fine to invest in risky positions, be sure to spread out your investments into varying companies and industries in order to avoid being too levered to any specific stock or industry.
Index funds are a common tool that can provide quick and easy access to a large number of stocks and industries. Some index funds will track an index such as the Dow Jones, S&P 500 or Nasdaq and these can be a great tool for getting broad exposure to the market with a reduced entry price. Investors in the stock market will be charged a commission for each stock they buy or sell with the amount of the commission charged dependent on the stock broker you use. It can be burdensome to buy the 500 stock positions that make up the S&P 500 but this problem is solved by the one time purchase of an index fund.
Diversification Outside of Equities
The stock market, and in particular equities, are a great way to make money over the long-term but you should diversify into other asset classes that can provide diversification and growth to your portfolio. Examples of asset classes that you can diversify into are real estate, bonds, gold and other precious metals, and natural resources. The stock market can provide access to these investments through real estate investment trusts (REITs), Electronically traded funds (ETFs) that hold precious metals or bonds, and Master Limited Partnerships that extract natural resources. These investments are an often-overlooked portion of the stock market but one that can offer true diversification from equity investments as gold and precious metals typically have a negative correlation to equities.
Dollar Cost Averaging in the Stock Market
One strategy that helps investors is dollar cost averaging. This simply means timing the investments into the stock market over a period of time. In other words, regardless of how attractive or overpriced a stock position or index seems, you buy amounts of stocks in fixed or variable amounts regularly. In this situation, you buy stocks when they are low in price, when they are high, and at every point in-between. Many people who practice dollar cost averaging will buy positions after they receive every paycheck.
By utilizing dollar cost averaging, investors are able to avoid the problems of buying high and selling low and instead benefit from the rising tide that all stocks tend to experience over time. By avoiding timing the stock market purchases that you make, you can benefit from investing regardless of the stage of the stock market and have a more measured method into entering stocks and equities that can help you in any economic climate.
Dividend Investments and Reinvesting Dividends
Stocks that pay dividends reward shareholders with regular cash flow at different intervals throughout a year. In the United States, dividends are most commonly paid on a quarterly basis, while in Europe, the cadence tends to be bi-annually. While it can be tempting to use these dividends to cover your expenses or make purchases, reinvesting dividends provides a multiplier effect on your investments that can yield you an advantage in any economic climate. Theoretically, buying stocks that pay dividends and reinvesting these dividends is conceptually similar to dollar cost averaging and provides stability and avoidance of buying high and selling low.
Further, companies that pay regular dividends tend to have more regular cash flows and are more stable business models that can protect investors over the long-term better than riskier assets. During downturns you buy shares at depressed prices when you reinvest dividends, and when the market is high you can transfer the dividends to other assets that are lower in price.
Investors need to have exposure to investments that can climb significantly when the market increases in value. Buying some speculation plays can benefit an investor greatly in that they can provide more upside than more stable investments. When an investor becomes exposed to a large gain in a speculation play they can sell and convert it to an New speculation play and quickly benefit from these wins and their role in growing your investment portfolio. The point is that investors need to be exposed to speculative plays as well as conservative ones in a balanced portfolio.
No two investors have the same exact stock market strategies and risk tolerance. Understand what allows you to rest at night and build out a portfolio of investments that comfort you and provide long term success and short term protection from the variances in the market.