Don't fear the bubble – three reasons why strategy matters more
Emotions do not belong to investing. They're so harmful in fact that it doesn't matter how intelligent you are if you get your emotions mixed up in your finances: The smartest man in the world, Isaac Newton, father of the laws of gravity and inventor of calculus, was an avid investor himself. In the fall of 1720, he made a massive blunder. Being a cautious investor he owned a diversified portfolio that delivered a stable stream of income.
However, the developments of the London stock market got the best of him, and seeing the South Sea Company share price increase eight-fold within months he wanted a share of the cake – he converted most of his safe investments to South Shea shares and within three weeks the market had turned upside down: His losses amounted to millions in modern dollars, never to be seen again.
Newton's example proves that your intelligence doesn't matter if you get sucked down the drain listening to your emotions and following the lead. There's constant talk of an economic bubble, and while its effects could be catastrophic you can't do much as an individual to prevent one from happening. This is why you should approach your personal finance and strategy in a way that mitigates the effects of a bubble when it happens.
An economic bubble is a financial situation where asset prices are considered overpriced compared to their underlying intrinsic value. This is often caused by overly optimistic projections and general hype often resulting in a sharp drop in prices called a "crash". It often leads to a big financial downturn increasing unemployment, suicide and other negative effects.
Get your financial security in check first
The first rule in investing is never to invest money that you are not willing to lose. Even though the risk of losing all of your money is always apparent, there is a more interesting mechanism underneath this warning: The actual reason to never invest everything is that when (and not if!) the next big financial crisis hits you have a rainy day fund that will save you from unemployment or something equally catastrophic.
If you don't have money saved up, you need to sell your investment at a time when its price has already dropped by as much as 50 %. You do not want to lose all of your capital gains just because you did not have the patience to save for a rainy day fund. You need to have enough money to cover 3 months of expenses – not just rent or food, but all costs. You can figure out that amount quite easily looking at your monthly bank account statements.
Big funds, ETFs and low-volatility stocks are your choice
The price drop during a crisis is never your biggest concern. If you money saved up for unemployment and other problems, the drop is only temporary. Markets will and have bounced back as governments do everything to prevent the global financial system from collapsing.
Your problem is when your investments hit the floor: If all of your investment is in small companies and they go bankrupt there is no getting your money back – you've lost everything just like Newton did in his carelessness. This is why massive funds, index-tracking funds and stable low-volatility stocks are so important in your portfolio: Big stock markets don't crash and neither do very valuable companies, so they offer a very safe option for times of crisis. This investment picking naturally requires some knowledge on the differences of investment instruments like ETFs and a common stocks.
Your portfolio does not need to be only these categories, but if all of your funds are invested in risky investments be wary of the effects of a crisis on your finances.
You cannot time the market – design your investing around it
The well-known American investor Peter Lynch has said that "far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves". No one has or will be able to predict the development of the market sustainably. You are free to try, but the odds are stacked against you from the get-go – I will briefly explain why.
According to this JP Morgan report, if you invested $10,000 in the S&P 500 index over almost 20 years and missed just 10 of the best days over that period, your overall gains would be 50 % smaller: Instead of $42,000, you would be looking at only $19,000 after 19 years for missing out on the 10 best days out of the total 7304 days. Even scarier is that had you missed 30 of the best days, you would be at a loss with $2,600 less than what you started with!
What does this mean, then? Don't try to time the market, just focus on consistency. If you see that market prices are clearly lower, then just buy more stocks that month. Time, not timing – that's what matters.
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