I've been promoting the tried-and-true principles of smart money management for so many years, it can be hard to come up with fresh ways to share their important message. Spend less, save more and diversify your portfolio as you invest for your long-term goals. As old-fashioned as this advice may sound, it remains the foundation for your future financial success.
But if you still need convincing, I invite you to listen to the wisdom of prominent behavioral economist and Nobel Laureate Richard Thaler. One of my colleagues had the opportunity to sit down with Professor Thaler early this year and asked him the following question: "As individuals, what lessons can we take from 2020 as we strive to build a strong future?"
We all need an emergency fund
Professor Thaler's advice was two-fold. First, if you were lucky enough to reduce your spending over the course of the last several months and now have extra cash, this is a unique opportunity to build a financial cushion. Take enough of that money to cover a minimum of three-to-six months' worth of your essential expenses, and stash it in a safe and liquid account. It won't earn much, but you can be confident it will be there when you need it.
Don't be blinded by the stock market stars
If you're one of the millions of people who jumped into the stock market for the first time last year, Richard Thaler has a word of caution: Beware of false confidence. For months on end in 2020, several leading tech companies in particular were burning bright. But these shooting stars may soon flame out. Making money on Zoom, Amazon or Tesla in 2020 made investing seem deceptively easy and seductive. To quote Professor Thaler, "If you were a new investor who started in May, you may think you're a genius. It is very hard to distinguish between luck and skill."
This is a crucial distinction. As I've pointed out in a recent column, investing is serious business that requires time, knowledge and discipline. Slick trading platforms can resemble video games, eliciting the same rapid-fire moves. But as Professor Thaler points out, "if you want to entertain yourself, don't play with stocks, go find a poker game." That get-rich-quick mentality is the complete opposite of the mindset you need to be a successful long-term investor.
Spread out your risk with funds
At the core of this advice are the crucial principles of asset allocation and diversification. By spreading out your money not only between different companies, but also between different types of companies and categories of investments, you decrease your risk and increase your odds for long-term success.
What does this mean for individual investors? According to Thaler, the message is clear: Stick with mutual funds and exchange-traded funds. He notes that last year saw an alarming increase in the number of amateur investors buying shares of individual companies. Yes, the high-flying companies are alluring, but the reality is that they can fade as quickly and easily as they can soar. At some point, many may come back to earth.
Backing up just a little, it's important to set realistic goals and have a plan whenever you invest. Only after you've built a solid foundation of broad-based funds should you even think about adding a few individual securities—and then only if you have the skill and time that it takes to research a company's financials, management team and strategies.
It's not impossible to do well by buying and selling individual securities—and it can be fun. But it's far more likely that rapid trading–especially in 'meme stocks'–will wind up being hazardous to your long-term wealth. It's a rather bold assertion to think you know something that millions of other investors including institutional and professional money managers haven't already priced in.
Make what's good for you easy, and what's bad for you hard
Part of the brilliance of Professor Thaler's work in behavioral economics is the understanding that you can’t fight human nature. We don't always, or even mostly, behave in a rational way. So given that, it makes more sense to work with our nature rather than work against it.
I think of this in terms of making the things that are good for you easy, and the things that aren't good for you hard. It’s not unlike how you might approach a diet. You purge your kitchen of candy and other sweets, and you stock the fridge with veggies and fruit.
When it comes to investing, you can think of funds as your fruit: healthy and easy to access. You can then apply the same principle by setting up automatic deposits from your paycheck to your 401(k). This not only takes the day-to-day decision-making out of your hands, but it's also your ticket to a strategy known as dollar-cost averaging that will help you navigate the stock market year in and year out, through market surges like the one we experienced recently, but also through market declines.
This is because as risky as it can be to pour a huge amount of money into the stock market at any particular moment, it's equally dangerous to pull it out and find yourself on the sidelines for the next upswing. Multiple studies have shown that 'market timing'—or the attempt to get in and out of the market at exactly the right time—is extremely difficult to achieve. And if professional money managers can’t do it with any consistency, you won’t be able to either. Successful investors often continue to invest through good times and bad, and automatic deposits can help you do just that.
A path to a brighter future
When you think about how complicated the financial world has become, it's easy to feel overwhelmed. Every time you turn around, you have to make another choice—between banks, brokerage houses, insurance companies and investments. So my strong advice is to simplify.
As Richard Thaler recommends, stick to the fundamentals. Use that money you didn't spend in 2020 to build up your emergency reserves. Use mutual funds and exchange-traded funds to diversify your investments. Keep yourself on the right path by putting your contributions on auto-pilot. The road to a brighter future doesn’t have to be complicated. It just requires having the confidence to set yourself up to succeed.
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