Everyday an investing 101 book hits the shelf of major books stores that further complicates a reader’s investing plan. The secret to an effective simple objective-investing plan does not lie in any of these books. The secret lies in our approach to the stock market.
Wall Street spends billions of dollars paying analyst, research departments and economists to over complicate the stock market. They create complex reports and use terms specifically to confuse the average investor in hopes to scare them to their services.
The fact is that not one of these complex reports or theories has produced sustained repeatable returns over the long term. For example; leading up to the financial collapse of the mortgage backed security market, their were plenty of bulls and bears chiming in on the way up, but we only credit the bear who happen to make the call at the top while faulting the bull at the same time. On any given day we can find a bull and a bear in any market.
So instead of approaching the stock market with these cloudy judgments we need to understand that there are only two possible outcomes, it can only either go up or go down over a period of time. The stock market is very similar to weather. When the weather is poor we can expect the environment to be less favorable. When the weather is good we can expect the environment to be more favorable. The most important factor in weather is the point where the weather can get no worse or better. It is at these points where we understand it is improving or starting to get worse. As with weather, the stock market has these same points of change.
These points lie in the market’s expectations. When the stock market has high expectations, this is the points where we understand that the market weather cannot get any better. The opposite holds true that when expectations are at their low, we can expect that the market weather can get any worse.
Creating a simple investing plan requires that we first must find a way to exercise self-control in the stock market. When the market is at a point of high expectations, it will be flying high and require we have self-control to take profits. When the market is at a point of low expectations it will feel like it is free falling and we will need to have the self-control to buy into it. Quite simply we must be willing to leave the party before it’s over and be willing to get to the party early before most everyone arrives. This is easier said then done, because it is human nature to “let it ride” and avoid confrontation.
I find the best way to exercise self-control it to have an objective trigger. When we have an objective method of making a decision our emotions are removed from the situation. We must have confidence in this method, otherwise when it triggers we will not follow through. The trigger must indicate to us whether the market over bought with high expectations or over sold with low expectations. We must identify an indicator that provides a signal, which we can confidently act on.
This indicator requires that we understand all its moving parts and truly believe in what its signal means. I cannot stress enough to not merely chose a stock chart indicator and blindly follow its signals. For our simple investing plan to work, we must understand what each signal means. Understanding the why makes following the program easier, since losing our self-control just once can destroy our assets. Before we enter any market we must have a defined exit point otherwise our plan is to “let it ride”.
So we understand that our first step is to identify our self-control signal. Our next step is to understand our risk tolerance. Risk is not “what we are willing to lose”, because we should not be willing to lose anything. Risk in my opinion is determined by the time frame we are planning to participate in the stock market. If we are not looking for access to these funds for 20 plus years then our risk tolerance is greater than if we only have a couple of years. Our risk tolerance determines our diversity in the investment vehicles we use in our simple investment plan. The best method to determine risk tolerance is to consult a financial professional to determine what our time horizon truly is.
Once we understand what our risk tolerance is, the next step is to determine the investment vehicles we will use in our simple plan. The vehicles we use also greatly depend on our risk tolerance. The marketplace today has so many different methods to approach the market. My only suggestions are to pick investment vehicles that we understand and over time have reliably moved with the overall market and do not have independent risk of the market.
Independent risk of the market would include individual stocks because an independent event can sway their performance from the overall market. The simple investing plan is to move with the market as a whole and to keep this objective we must remove those individual risks.
The final step in our plan is to commit to the method. Once we have chosen a reliable indicator that we understand, following the plan is the most important and hardest step in the process. We will fight our emotions every time it signals up to buy or sell, because if it is a reliable indicator, we will be asked to sell as the market is going up and buy when it is going down.