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April 27, 2010

Financial Literacy 101: Making the 'right' investing decisions

Eighth in a series for
Financial Literacy Month

At Sound Mind Investing, we're doing our part for National Financial Literacy Month by featuring a series of posts on basic principles of investing and personal finance.

Here's post eight — on how to make investing decisions with confidence.

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Having seen a horrendous bear market in 2008 (and early '09) and now a sharp run up over the past 14 months, many people are finding it difficult to know the "right" steps to take going forward. They wonder:
"Is this a bad time to buy stocks, since the market has already risen so strongly?"
"If I move from one kind of investment to another, will I actually be better off?"

"How much of my retirement money should I put in stocks versus bonds?"

It's important to keep in mind that since you can't know the future with certainty, your investment portfolio will never be perfectly positioned to profit from upcoming events. In retrospect, it is always possible to think of ways you could have made more money (or lost less) than you did.

The human inability to make fully accurate predictions means it's pointless to think of the "right" investment portfolio simply in terms of making the highest possible profit. If that's your approach, you will always be second-guessing your decisions, and you'll end up frustrated and disappointed.

Instead, the "right" portfolio is one that realistically faces where you are right now, looks years ahead to where you want to go, and has a very high probability of getting you there on time.

Let me describe a few characteristics of the "right" steps to take:

The right investing decision is one consistent with a specific, biblically sound long-term strategy you've adopted. I have discovered a common trait among many people I counsel: their current portfolio is simply a random collection of "good deals" and assorted savings accounts. Each investment appears to have been made on its own merits, without much thought of how it fit into the whole.

Their portfolios tend to be an incongruous collection of savings accounts (because the bank was offering a "good deal" on money market accounts), a savings bond for the kids' education (because they read an article that said they were a "good deal" for college), a universal life policy (because their insurance agent said it was a "good deal" for someone their age), and 100 shares of XYZ stock (because their best friend let them in on this really "good deal").

Those who hold this kind of random assortment of "good deal" investments are what I call responders (i.e., reacting to sales calls, making decisions on a case-by-case basis). I urge you instead to become an initiator (i.e., one who develops an individual investing strategy tailored to your personal temperament and goals).

The right step is the purchase of an investment that you seek out purposefully, knowing where it fits into the overall scheme of things.

The right investing decision is one you have taken time to pray over, and about which you have sought experienced Christian counsel. Because your decisions have long-term implications, you should take all the time you need to become informed. Don't be in a hurry; there's no deadline.

You need time to pray, ask for the counsel of others, and reflect. You should consider the alternatives, examine your motives, and continue praying until you have peace in the matter. If you're married, you should pray with your spouse and talk it out until you reach mutual agreement. Remember, you're in this together.

The right investing decision is one you understand. It's not likely that your situation requires exotic or complicated strategies.

In fact, the single investment decision of greatest importance is actually quite easy to understand. It is simply deciding what percentage of your investments to put in stocks (where your return is uncertain) as opposed to bonds and other fixed-income investments (where your return is relatively certain). This one decision has more influence on your investment results than any other.

Another aspect of understanding your investments is to educate yourself on the basics. The right investment step is the one where you understand what you're doing, why you're doing it, and how you expect it to improve matters.

The right investing decision is one that is prudent under the circumstances. Does it pass the "common sense" test? How much of your investing capital can you afford to lose and still have a realistic chance of meeting your financial goals? Investments that offer higher potential returns also carry greater risks of loss.

The right investment step is the one that protects you in the event of life's occasional worst-case scenarios. Generally, this moves you in the direction of increased diversification.

I realize many people find investing to be a nerve-racking, if not downright scary, experience — and the turmoil of 2008 certainly didn't calm any nerves. Unfortunately, anxiety and the fear of doing the "wrong" thing cause many people to "freeze up." They become frightened into inaction. In mail from readers, we get many variations of these three comments:
"There's so much at stake. I'm afraid I'll make the wrong decision."
"I don't have much experience. I'm afraid I'll make the wrong decision."

"My savings aren't making enough now, but if I make a change I'm afraid I'll make the wrong decision."

What is the "wrong" decision, anyway? If you think a wrong investing decision is like saying 2+2=5, then you're off track; such thinking implies that investing decisions can be made with mathematical certainty. They can't.

It's not that the economy and investment markets are completely random — they aren't. But investing deals with probabilities, not with certainties and predictable events. We can know some things but not others.

All of this is actually good news. It means anybody can play. It's like learning to drive a car. After a couple of lessons, you know enough to travel around town if you follow a few basic safety guidelines. After all, you're not trying to qualify for the Indy 500 — you just want to reach your destination.

In the same way, once you understand certain core concepts (such as those taught in our Sound Mind Investing Handbook and monthly newsletter), you're fairly well equipped to make basic investing decisions — and to do the thing that's "right" for you.