The Two Components of Investing

 The Two Components of Investing

Investing is comprised of two parts:

1. MATH.
   Do your research. Learn about the market. Learn what the overall market does, and when. Try to find out why—not necessarily why it went up or down on a given date, but what powers the market to begin with.
    
   
   
   
   
2. PSYCHOLOGY.
   You'll never stick with investing in the long-term if you don't feel comfortable with your strategy.
   
   Your strategy should be based on two things: one, on your research about investing; two, on your personal situation. What works for me may not work for you, because we may be at different stages in our lives.
   
   And your stage in life is probably the biggest factor in determining your risk tolerance. If you're about to retire, you won't be thinking about the long term. And if you're young and single, you'll probably ask yourself why anybody would buy bonds at a 3-4% average annual yield when the long-term average annual yield of the total stock market is in the neighborhood of 10%.
   
   Why would anybody accept lower yields?
   
   The answer is that, in the long-term, stocks provide a lot more growth. But not everybody is concerned about growth, or about the long term.
   
   For instance, if you're two years away from retiring, you'll be willing to trade some growth in exchange for the superior stability of bonds. If you're interested in comparing the annual returns, Yahoo Finance lists the annual return for Vanguard's total stock market fund here (for years 2001-2019) and Vanguard's total bond fund here (for years 1987-2019).
          *Note: for the purposes of this exercise, we're worried about the worst years for each.
           Bonds: -4.70% in 2008 for the whole category; Vanguard's fund actually made +5.05% that year. Vanguard's fund posted its worst year in 1994: a loss of -2.66%.
           Stocks: in 2008, the category yielded -37.79%; Vanguard's fund lost -36.99% that year. There are a couple other years with sizable losses as well, although I'd also point out that the gains more than make up for those losses.
   
   Imagine that you've been working for a middle-class sum for your whole life. You've saved up a million dollars by age 63. Yay! You're planning to retire at 65. Now, chasing better yields, you've left that million dollars in the stock market. And now, due to a subprime mortgage crisis or an economic shutdown to slow the spread of a pandemic, the stock market plunges by 25%.
   
   Imagine losing $250,000 in the span of a week! To make up for that loss, you'd have to work an extra five years or so!!! And you've been looking forward to retiring and spending time with the grandkids while they're still toddlers—well, now you can kiss that dream goodbye!
   
   But now, imagine you're 27 and have $1000 invested. That same 25% loss is now no big deal: $250 equates to only a couple days' worth of labor. Not years. Days.
   
   When you're young and poor, the growth potential outweighs the possible loss. When you're older and (hopefully) wealthier, the possible loss is weightier than the extra gains.
   
   See why a 60-year-old would probably prefer bonds while a 20-something wants stocks? The difference in strategy is entirely logical for each person. The older person wants to preserve her existing wealth; the younger person has little to lose and much to gain. Bonds are better for capital preservation and dividend income. But long-term, stocks win.
   
   And make no mistake: the only way for investing to pay off—to really pay off—is to be in it for the long haul. Think in terms of an entire decade, not just what the evening news is talking about. That's not investing; it's too short a timeframe.

Notice how much more time I've spent on the psychology than on the math? That's because the math is easy: the math says 100% stocks. Over long spans of time, that will pay off much more handsomely than bonds.

Of course, you can have some of both. In fact, I've already postulated allocations that include a mix of stocks, bonds, growth funds, and real estate investment trusts.

Or, if you want to automate the procedure, your company's 401(k) almost certainly offers target-date retirement portfolios. These automatically reduce their stock holdings and increase their bond holdings as time passes. They're really not bad options.

Math, of course, says you'd do a lot better by going 100% stocks until you're 5 years from the target date, and then instantly flipping to something like 80% bonds. But in the world of numbers, you're working from a spreadsheet. Nothing slips your mind; if something does, you can go back and adjust it. Reality is never quite that easy.

Right now, in practice, I'm using an even simpler approach: in one account, I've got 62.5% in stocks and 37.5% in bonds, and am currently moving to make that a nice 70/30 split. In another, smaller account, I've got 90% stocks/10% bonds.

I've got plans to invest in real estate using REITs, but I'm still doing some research to make sure I understand what's going on. I do like the idea of exposure to another asset class with similar yields to stocks, but I want to make sure it's not just an asset that does the same thing stocks do at the same time—in which case I might as well just get more stocks. The research I've done shows that they're not unusually correlated, but I still want to dig deeper. Hey, I'm an academic. And being slow-to-act has served me well at times in the past, so I plan to continue plugging along.

Once I'm fully comfortable with my understanding, then I'll proceed. I'd recommend similar caution in your case. Make sure you know what you're doing before you do it.

And that begins, of course, with a thorough understanding of both components of investing.

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