The Benefits of Rules-Based Investing
This post is Part 2 of a two-part investing post. Part 1 of this post was about how to find money in your budget so you can start investing.
Our own wisdom doesn’t work well when it comes to investing.
Our brain lights up like a pinball machine when it comes to spending or investing money. We get a dopamine rush because we sense rewards a-coming (researchers compare it to a drug high). Our sense of logic and reason goes out the door, our emotions take over and we don’t make our best decisions.
To be a good investor, it’s best to get your emotions out of the equation and onto the sidelines. Otherwise they will tell you to ‘sell, sell, sell!’ as stock prices drop or ‘buy, buy, buy!’ as stock prices rise instead of sticking with your plan. We also need to sideline our ego and our opinion. They don’t help us with investing either.
The best way to approach investing is with a strategy that you feel comfortable with. One popular strategy that can work well is rules–based investing. The idea is to follow a few simple rules that can keep the emotions, opinions and ego out.
For example, with rules-based investing, you create rules that you’ll stick to regardless of what the market does. Rules like:
- When to invest
- What specifically to invest in
- How often to rebalance your portfolio (that means if you chose to invest 60% in stocks and 40% in bonds, you want to periodically make sure that ratio is still intact. The market ups and downs can knock it out of whack).
- That you’ll stay the course even if the market drops or soars.
One way to follow rules-based investing simply and on your own is through dollar-cost averaging. This is where you invest the same amount each month on the same day every month (so you have a rule for when, where and how much you’ll be investing). For example, investing $100 a month on the 1st of every month to the same index fund every month.
So your $100 buys more shares when the price is low and fewer shares when it’s higher.
The benefits: Many people fear that they’ll invest and then the market will drop, so they end up not investing at all. With dollar-cost averaging, it doesn’t matter if you’re starting when the market is up or down. Instead, you’re buying at regular intervals, whether it’s up, down or in between.
Also, since your $100 buys more shares when the prices are lower and fewer shares when they’re higher, over time you may end up paying a lower average price per share than if you tried to time the market. That’s because most people would never invest when prices are low or visibly dropping. But it can also be seen as a sale because it allows you to snap up more shares.
What are the simplest ways to invest?
There are many investment vehicles. For example, real estate, your own business, other businesses, the stock market and commodities like gold and silver. But one of the simplest and most popular investment vehicles for both new and seasoned investors are index funds. They’re a type of mutual fund that tracks an entire stock market index.
What’s an index?
It’s a bunch of stocks from one section of the stock market, grouped together, averaged and valued as a whole. The most common index tracked is the Standard & Poor 500 (S&P 500). It consists of 500 of the most widely traded stocks in the U.S. (There’s also the Dow Jones Industrial Average, NASDAQ, Russell 2000 and Wilshire 5000).
So if you invest in a fund that tracks the S&P 500, your fund is tracking the 500 popular stocks it holds. You’re probably familiar with many of them (check them out here).
Investors like Warren Buffet like index funds for many reasons. There’s many low-cost options, they have built-in diversification, there’s no trading and trying to beat the market (which, again, is nearly impossible with an unpredictable market).
In fact, Buffet has said that “a low cost-index fund is the most sensible equity investment for the great majority of investors…by periodically investing in an index-fund, the know-nothing investor can actually outperform most investment professionals.”
ETFs are similar to index funds in that they also track indexes; the difference is that ETFs trade like stocks. Both already contain a large mix of diversified stocks so you don’t have to stock-pick, and they’re essentially set-it-and-forget-it.
They also typically have lower costs than other types of funds, which is key for your money’s growth. High fees can really eat away at your investment.
Low-cost ways to invest
Online brokerage houses (for example, Fidelity, Schwab, Vanguard) allow you to invest in low-cost index funds, often with no minimum balance to start if you sign up for automatic monthly contributions. Often you can start with $25 or $50 a month. Some offer free access to financial planners who help customers understand their options.
There are also low-cost, online, automated investing services, like Betterment or one geared toward women, called Ellevest. These, and maybe others as well, have no minimum balance so new clients can start investing with very little.
If you’re new to index funds or want to know more about them, definitely read this detailed but easy-to-follow primer on index funds by financial planner Matt Becker of MomandDadMoney.com.
What if you don’t feel comfortable investing?
You’re not alone. Many people don’t feel comfortable. Investing is risky. When you invest, there’s a chance you could lose all of your money.
At the same time, there’s a risk when you don’t invest that inflation will eat away at the money you’ve saved that isn’t earning more interest than inflation. For example, if you had $10,000 saved from 2010 that hadn’t earned a dollar of interest these past seven years, today it’s buying power would be $8,828.42 (here’s a calculator). In just seven years, it would have lost over $1,171.58 due to inflation. So that’s also a risk.
Deciding which direction to go is very personal, and something you would need to assess based on your own needs, comfort level and situation.
If you fear investing but would like to dip your toes in the water, consider starting with a tiny amount of money each month that won’t affect your necessities or future if you were to lose it. As consumers, we waste a lot of the money on junk and overpriced gadgets or clothes that end up in the garage sale pile that could instead go to saving and growing our nest egg.
(If saving is a hardship for you or you have a lot of debt, you should not be investing at all. Look at ways to get your financial house in order and re-think investing later).
If you like the idea of finding money to save (from Part 1 of this post) but don’t want to invest in stocks at all, focus on saving. Look into CD’s, Treasury Bonds, or even a high-interest savings account. You can usually find the best interest rates for CDs and savings accounts online, for example at online banks like Ally or CapitalOne 360.
The bottom line here is to save more. Start building your wealth. It helps to shift the way you think about it. Instead of seeing it as a chore, look at it as a game you can win. We typically view saving as a loss–that’s how our brain registers it–so we don’t like to do it. But once you start seeing it as a tool to create the life you want, and seeing your goals coming to fruition, it can be the start of a healthy new relationship with your money.
What one step are you willing to take to start saving more and growing your wealth? We’d love to hear from you in the comments below.
Did you find this post helpful? If so, please Like, Tweet and Share, as it can help inspire others. As always, thank you!