August 08, 2012

Good Idea, Bad Idea

It kills me how complicated people try to make finances and investing. Spend less than you make, save and invest what you don’t spend, and if you want a higher standard of living, work more and have a little good luck. Sometimes, I feel that about covers it. Sure, there are conundrums like credit default swaps (there’s no link because trust me, you don’t want to know!), thoughtful considerations like how you are going to put your children through school, and big decisions like whether to take a lump sum payment or choose an annuity at retirement, but financial planning and investment strategies do not always have to be on the same playing field as nuclear physics!

Today, we are going back to the basics, as I’ll share with you a number of simple, yet not always obvious, financial truths. I’m going to borrow the always-funny, segment-filler “Good Idea Bad Idea” from Steven Spielberg’s animated series, Animaniacs, to talk about some prudent investment principles that everyone should at least consider. Here goes:

GOOD IDEA: Have 6 months to a year’s worth of living expenses in cash.
WHY: Having an adequate rainy day fund can be a lifesaver when something unexpected comes up, and can even give you an added sense of peace when the stock market is being unusually volatile.
POSSIBLY A BAD IDEA: Have 6 years’ worth of living expenses in cash.
WHY: Have you seen interest rates? Your rate of return on your CD or checking account is not going to keep up with inflation over time. If you don’t increase your returns by investing in some stocks and bonds, you will eventually lose spending power compared to others who did invest in stocks and bonds.

GOOD IDEA: Invest in Apple in January 2009 (around $100/share).
WHY: In hindsight, the stock was about to begin a 3-year climb to around $600/share.
POSSIBLY A BAD IDEA: Invest in Apple in August 2012 (around $600/share).
WHY: The stock might go up some more, but it might not. Either way, you’ve already missed most of the ride. Does investing in anything that has increased 6 times in value already really seem like a good idea? Ask some people who bought highly-appreciated real estate in 2006 and 2007 for their thoughts if you don’t believe my warning.

GOOD IDEA: Have a well-diversified portfolio with no individual stock holding greater than around 10%.
WHY: Enron, Worldcom, and Lehman Brothers. They went bust; your diversified portfolio would not have.
POSSIBLY A BAD IDEA: Invest heavily in one or only a few stock holdings, particularly if you have an emotional tie to the stock.
WHY: Enron, Worldcom, and Lehman Brothers. They went bust; your undiversified portfolio could as well, and I don’t care what company you’re talking about! Enron’s own employees couldn’t believe what did happen could have happened either.

GOOD IDEA: Fight the urge to make your investment portfolio more conservative (more bonds, less stocks) after a market downturn or sell-off.
WHY: You rode the elevator down, you might as well ride the elevator back up. After you recoup most of your losses, reevaluate your strategy if you can’t stomach the thought of living through another sell-off.
POSSIBLY A BAD IDEA: Panic at the bottom of a market downturn and exit the market or make your investment portfolio ultra-conservative.
WHY: You just got hammered. Why do you want to get hammered again by making fewer returns than everyone else when the market bounces back and gains positive momentum? Over the long term, it will bounce back.

Look, I could very well be wrong about holding a ton of cash, buying Apple, diversifying your portfolio, and changing strategies after a market downturn being bad ideas in your particular situation. However, to effectively invest over the long run, I really believe you need to focus on the tried and true rules, not the exceptions - even if they’re popular!

I hope you found some of my financial truths meaningful and will remember them in the future. In the epic cartoon-ending words of Porky Pig, “That’s all Folks!”


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