4 Simple Ways to Invest for The Long Term

Most people do not want investing to take up too much of their time and effort. This is due to us having many other things in life to focus on, such as our careers, families, housing etc. And so, trading, timing the market and stock picking is not suitable for 90% of retail investors.

So how can you grow your money without taking up too much time and effort? Here are 4 simple ways to do so and if you stick to this, there will be a high chance for you to retire comfortably after 20 to 30 years.

1) Start Early & Stay Invested

Inexperienced investors looking to grow their money without active monitoring can first look to compound interest to pursue gains over time. The key ingredients here are starting early, and staying invested. By doing so, you will have more time to grow your money. The table below shows how even saving and investing a small amount every month when you are young benefits you, simply because of the power of compound interest.

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2) Diversify Your Portfolio Among Various Assets and Geographical Regions

Market timing and stock picking are not suitable strategies when you want to invest passively. What you can do is to construct a well-diversified portfolio.

Diversification involves another important concept – Asset Allocation. This means mixing you portfolio among various asset classes to spread your risk. The most common asset classes for retail investors are: equities, bonds and cash. A lack of diversity means less liquidity in times of need.

A simple two-asset portfolio, comprising bonds and equities, helps to enhance returns and reduce risk. The proportion of a person’s investment portfolio to be allocated in bonds should be equal to the person’s age (or age minus 10 if he/she is more risk tolerant).

The reason behind this formula is because as we age, we are closer to retirement and should safeguard out nest egg by having less exposure to risky assets such as equities. For young people who mostly have higher risk tolerance, they can allocate more of their investments in equities which can potentially yield higher returns. I have written a separate article on why we should invest in equities if we have a long investment horizon to prepare for retirement.

Besides the classes of assets, having a basket of stocks spread across different geographical regions can reduce your long-term portfolio risk.

Interestingly, we should note that much research have shown that more than 90% of investment returns are determined by asset allocation. Only 10% is influenced by stock picking and market timing. The pie chart below illustrates the recommended asset allocation for a person with a moderately aggressive risk profile.

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3) Invest Regularly – Effect of Dollar Cost Averaging

Every stock investor may fall into the trap of emotional or irrational investing. This stems from our 2 strongest emotional forces – fear and greed, which leads to failure to grow our money.

1. Fear – When the price of our stock holdings fall, a common response stemming from fear is to sell our shares and cut our losses. Subsequently, when the stock price rises, we may be afraid to invest in the stock again. If the stock price continues to rise, we may enter the market too late to see any substantial return.

2. Greed – When we see the price of a stock going up, greed drives us to invest our money in it, with irrational optimism that the price will continue to rise. Quite often, the stock price drops instead.

Emotional/irrational investing often yields little returns for retail investors. Instead of speculating on a stock price, we should do quite the exact opposite – We should set aside a fixed amount of money to invest regularly, regardless of how the stock market is performing. The graph below illustrates what happens if we invest a fixed sum of money on a monthly basis for a certain stock, X:

DCA graph

This enables us to take advantage of Dollar Cost Averaging, a passive mechanism which helps you to buy less of an investment when the price rises, and more when the price falls. This lowers your overall purchase price for investments in the long term.

4) Review and Rebalance Your Portfolio

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Given the dynamic global economy, investors should review their investment portfolio regularly and change the mix of assets, a process called rebalancing. Rebalancing safeguards your portfolio from being exposed to undesirable risks and maintains your original desired asset allocation. This would ensure you are on track to meeting your financial goals.

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Compound Interest & the Rule of 72

“Compound interest is the Eighth Wonder of the World. He who understands it, earns it … he who doesn’t … pays it.”

– Albert Einstein

 

Compound interest is paid on the initial principal and also any interest that is accumulated for previous periods of a deposit or loan. When Albert Einstein discovered the rule of 72 which applies to compound interest, he was instantly awed at the wonder of it. He believed that anybody can make use of compound interest to grow their wealth. So, what is the rule of 72?

To put it simply, the rule of 72 helps us to calculate the required time to double our wealth. The formula below explains:

72 / Rate of Investment Return = No. of Years to DOUBLE your Money

If you have $20,000 and this amount of money reaps you an investment return of 3%, you will required 24 years for it to grow to $40,000, twice the size of your initial investment. So, if you can achieve a higher rate of return of say 7%, you will only require 10 years for the same $20,000 to double.

The difference between an investment that yields 3% and an investment that yields 6% may seem small in a one-year period. But compound this for 40 years and the difference will be immense. The table below illustrates this (assuming an initial capital of $20,000):

Number of Years

3% Investment Yield

6% Investment Yield

5

$23,200

$26,800

10

$26,900

$35,800

20

$36,100

$64,100

30

$48,500

$114,900

40

$65,200

$205,700

 

Therefore, if you wish to achieve financial freedom and retire as early as possible, it is crucial to understand how compound interest works to help you grow your money. By keeping your money invested, your returns compound. The longer you stay invested, the greater the compound effect.