This second part will focus on the things that you can control when it comes to investing. Yesterday I posted the things you cannot control. Here is what you can control:
- Reducing expenses
- Diversifying portfolios
- Minimize taxes
This is actually easier than it sounds. All mutual funds have to tell you what their annual expense ratio is. You should be investing in funds that charge less than 1%. The lower the expenses, the better. Why does this matter? Because these are fees that you pay. You pay them indirectly. You don’t get a bill, but rather you pay them through your investment. Look at a quick example of what a fee costs you:
You have $10,000 that you can invest. You choose Fund A, which has 1.14% expense ratio. In 10 years, you paid $2,774 in fees. Now, your friend has the same amount, $10,000 and chose to invest in Fund B, which charges 0.26% in expenses. In 10 years, he paid $658 in fees. That is a difference of $2,116. So, if both of your funds returned the same amount, in 10 years, his account would be worth $2,116 more than yours. Fees make a difference. You can control them. Pay attention to what you are being charged. (See this post on how to pick a mutual fund.)
Making sure you have a diversified portfolio is a big deal. When I talk about diversifying, I mean that you should have your money spread out between large and small cap stocks, domestic and international, and include a mix of bonds. Case in point, in the past 10 years, had you only invested in the S&P 500 Index, you would have returned almost nothing. This means if you invested $10,000 in 2000, in 2010, you still have roughly $10,000. However, had you diversified your portfolio, you could have returned just over 6% during this period. The old saying is true: don’t put all of your eggs in one basket.
Just like expenses, taxes are your enemy. You pay taxes on any dividends you receive and any capital gains. There are funds out there that focus on tax efficiency. This means they will do their best to keep your tax expense low. Seek out these funds. Additionally, you can choose to hold bonds in your retirement accounts and equities in your taxable accounts. The reason for this is because bond funds pay out monthly distributions that are taxed at your ordinary income rate. Capital gains from equity funds on the other hand, assuming the holding period is long enough, get tax at a lower, capital gain rate. Take advantage of this and structure your portfolio so that you minimize taxes.
This is easier said than done. You cannot control what happens in the market over the short term. But over the long term, you can earn 8% on your money. Stay focused, stay disciplined. Stay in the market. Don’t let the media or others try to talk you out of it. You need to focus on the long term and you will meet your goals be doing this. Do whatever it takes to put blinders on when it comes to short term volatility.