Last Friday concluded one of the worst weeks for the stock market in recent memory. The Nasdaq took the largest hit, losing 3.1% for the week (its biggest single week loss since 2001). The S&P 500 finished down 2.6%, while the Dow Jones Industrial Average slumped 2.3%. Inspired by this sharp turn in the market, panicked investors went on a selling spree, specifically towards the end of the week. Interestingly, this sell-off took place one week after the S&P 500 hit an all-time high. Now, investors await insight into the reasons behind 2014’s volatile start and are left wondering whether markets will stabilize, or continue to fall. Regardless of what you may hear from the media, the truth is that economies are so incredibly intricate that we can never truly know every detail regarding market fluctuations. Which raises the question, how should investors react to turbulent markets? My answer: do nothing. Why, you may ask? Because most investments provide decent returns over the long-term. Provided below are three basic principles of long-term investing, and why they are especially important for young investors.
*The focus of this article is on long-term positions; Economix101 understands that there are many ways to monetize short-term investments (i.e. options trading, shorting, etc.). However, the main focus of this article is to emphasize the importance of basic investment fundamentals.
1. Go With What You Know
The renowned investor Warren Buffett is notorious for advising investors to only place money in companies they understand. If you do not know the revenue drivers of a biotechnology company, for example, you have no reason to invest in it (no matter how “hot” the sector may be). One of the biggest mistakes that investors make is positioning themselves in companies that they hear will be “big.” However, in order to be a successful long-term investor, you must understand the importance of familiarizing yourself with your investments. In doing so, you provide yourself with the ability to analyze and understand why parts of your portfolio may be struggling, while others parts perform exceptionally well. It is this knowledge that allows investors to avoid impulsive, emotional decisions driven by fear, or greed (as we have seen recently). This is especially important for young investors who lack experience and are often left susceptible to impulse decisions.
2. Set An Investment Timeline Based On The Future
When a long-term investor forms an investment strategy, it is based on how he believes the market will perform over the next five to ten years, not the next five to ten days. If you want to purchase stock in a company, you must first decide whether or not you see yourself owning the company for a year, five years, or even ten years from the date of purchase. If the answer is “no,” you should not invest in said company. If the answer is a resounding “yes,” it means you are confident in the long-term direction of the company and that, even though there may be volatile price spikes in the short run, the company will reward you with a decent return on investment over the long-term. Investing while young also provides many advantages; one such advantage is an extension of the investment time horizon. We have far more time to research companies, make sound investment decisions, and hold onto our investments. For young investors, this timeline can be based upon milestones in one’s life. Ask yourself questions like, “will I still want to own shares of this company after I graduate college?” or “will this company still exist on my 30th birthday?” If so, what condition will it be in? In doing this, you legitimize your investment decisions.
3. Be An Investor, Not A Speculator
This is especially relevant given current market behavior. From the S&P 500 hitting its all-time high, to the Nasdaq having its worst week in three years, the past two weeks have truly demonstrated market volatility. However, even though investing can feel like a roller coaster ride at times, it doesn’t necessarily mean we must predict whether or not the next part of the ride is a climb or a drop. As a long-term investor, your role is to choose companies based on whether or not they are fundamentally solid businesses, not based on whether or not you think their stock prices will increase within a week (there are short-term investment strategies for this, and they are much more complex). For the most part, short-term price changes do little to accurately reflect company performance. Constantly monitoring the market is stressful enough. Add this to the stress associated with classes, work, and extra curricular activities, and young adults simply do not have the capacity for additional speculative anxiety. So, invest! Don't speculate!