Building A Smart Investment Mindset: A Practical Guide For Long-term Investors

Investing is not about having a finance degree, a trading station, or an innate ability to understand markets; it is about knowing precisely what you are doing, being able to wait once you begin, and understanding how money makes money. People who lose money investing rarely do so because they are ignorant; they do so because they have too many options, too many ideas, and too many promises echoing in their ears. To overcome this noise and find value, focus on a few simple truths.

Before deciding what to invest in, an investor should have a firm idea of why they are making the investment. Money is a tool to accomplish a particular goal and should be viewed in the context of that goal and what it means to the investor. Whether it is a home, an education, financial independence, or retirement, an investment goal will shape every decision made along the way.

How soon the investor needs the money dictates much of the rest. Cash that is needed in the near future has less risk and will provide more stable growth, while cash that is further away can take more risks to yield greater rewards. Risk is not a binary factor based on the type of investment; it is relative to how much an investor can stand to lose and how much they need to gain. An investment that looks good on paper but wreaks havoc on the investor emotionally is likely to be sold at the worst time. The closer an investment is to being needed, the more limited the ability to withstand volatile swings of fortune is.

With thousands of investment options, an investor should understand that everything boils down to two things: lending and owning. A lending investment is when the investor pays someone else money, and, in return, they receive a promise of repayment with interest. This kind of investment is straightforward, predictable, safe, and boring. The amount of money paid back to the lender is fixed in advance; a borrower doing exceptionally well beyond expectations will neither increase the interest rate nor pay extra to the lender.

An owning investment allows the investor to own part of something that makes money. The investor can buy shares in a company, land in the form of real estate, or shares in a fund that owns something else. The value of an owning investment is directly linked to the value of what is owned, which offers more short-term uncertainty but much more long-term security. Everything in the financial space boils down to these two types of investments in one way or another. Understanding the difference allows the investor to know much more than they would otherwise.

Lending investments are seen as the safest place to keep money, but, really, there is always at least one risk involved: the erosion of purchasing power due to inflation. In reality, cash, one of the most liquid lending investments available, has been one of the worst-performing investments one could make over the long run.

The evidence is overwhelming, with statistics going back to 1926 showing that the average total return, net of inflation, of the US stock market has been around 7%, and the return of Treasury bills, a short-term lending investment and proxy for holding cash, managed to eke out barely a return over inflation. Cash held in physical form declined sharply in value over the same period. Bonds, another type of lending investment, have had a slightly better performance, but not by much; the average inflation-adjusted return on 10-year Treasury bonds was just under 1% per year for the 2023 fiscal year, while inflation averaged nearly 2.8% over the same period. In other words, bonds were a terrible investment for anyone who invested in them over the past decade, one that wiped out much of their purchasing power.

This does not make bonds a bad investment; they are an essential addition to a diversified portfolio and can help immensely in keeping money safe when the stock market takes a dive. It does, however, highlight the critical difference between bonds and cash as “safe” investments and one that has kept many investors from realizing that their money was not safe at all. Inflation has consistently eaten away at the value of money, decreasing it by several orders of magnitude over a century. That is why, when the choice exists between a lending and owning investment, the latter is significantly more valuable over time.

An owning investment is connected to growth and productivity; both are critical factors in long-term wealth creation. An investor should understand the difference between an investment in an owning asset and gambling; both are highly speculative activities, but the odds of long-term success are stacked in favor of the former and sharply against the latter. The connection between productivity and investment explains why owning investments beat lending ones over the long run. The market has rewarded persistence and patience, generating roughly a 7% real return for investors who purchased stocks at the end of 1925, which grew their initial investment to 1,000 times its size.

This also highlights why investments are not gambling, even though both venture into unpredictable territory. When done right, an investment is not a single decision but a process that takes advantage of time and patience, which are essential elements in increasing an investor’s odds of success. Gambling puts the odds firmly in the house’s favor, with few opportunities for the gambler to improve their situation. A similar comparison can be drawn between short-term speculation in volatile markets and investing, where the former keeps the odds stacked against the speculator and the latter gives the investor a helping hand. People get rich quickly in short-term speculative trading, but it is more the exception than the rule, and it tends to happen right before markets turn. In contrast, most investors who get rich do so slowly and steadily, taking advantage of small, consistent returns over a long period of time.

Time makes small differences in investment returns add up to large ones, and small differences in risk take away from large potential losses. These concepts are the reason why diversification and patience are so critically important to investing.

Diversification is one of those investing maxims that have been proven over and over again with mathematics. In 1952, an unknown 24-year-old economics grad named Harry Markowitz published a paper outlining the basics of modern portfolio theory, which demonstrated that a portfolio could reduce its risk significantly by combining different kinds of assets that did not always move in the same direction. Markowitz would go on to receive a Nobel Prize in 1990 for his work, which underpinned decades of research into diversification and its effects. At its most basic, diversification means not putting all of one’s money into a single instrument, company, or anything else that exposes the investor to significant risk. It is much easier said than done, but few things in investing have as much impact on a portfolio as the simple act of reducing risk by spreading it out among several assets.

Similarly, time is the reason why any investment of any size grows significantly over the long run. One of the easiest ways to see how time affects returns is to look at the differences between owning and lending investments. An owning investment grows exponentially over time due to compounding, while a lending one only grows linearly. The difference between the two can be enormous, especially for large sums of money. It is this discrepancy that allows small, consistent contributions from an investor to grow into significant sums of money over time.

An allocation is a distribution of money between different types of investments, and, for most investors, it is the most important part of any portfolio. The type of allocation reflects the risk tolerance and time horizons of the investor, who should hold more owning investments and less lending ones as their personal financial situation stabilizes and they get closer to a financial goal. Time horizons are a part of every portfolio, shaping it according to the needs of the investor. Someone saving for retirement or another long-term financial goal will typically have a much broader range of allocations available to them compared to someone with more immediate needs, who must have more lending and cash-type investments in their portfolio to keep the money stable and preserve value.

A large chunk of money to be invested can be overwhelming, and dollar-cost averaging helps the investor get around that by allowing them to spread out their purchases at regular intervals instead of investing the entire sum at once. It is unlikely to offer the best possible return, but it does reduce the risk significantly by taking away the pressure of one large purchase right away. The version of the investment plan and execution that an investor sticks to is much more important than the theoretical best, which may require an unrealistic risk tolerance to achieve.

Two other matters should capture the attention of any investor: fees and who to listen to. Both are essential considerations due to the significant impact they can have on an investment.

Fees, which come in many forms, are one of those seemingly innocuous aspects of investing that can cripple an investor over time. A 0.25% cut at the end of every year may seem insignificant, but it compounds just like any other return, only in the wrong direction. Over a 30-year span, a $100,000 investment with a 7% annual return and 0.25% or 1% in fees would be nearly $135,000 worse off for the investor who chose the pricier option, a significant loss for either investor.

Firms and individuals who deal with money and who give financial advice tend to have different incentives, and those differences should be kept in mind at all times. Any company, individual, or institution that makes money by managing the money of others should be carefully selected with an eye on their ability to limit fees and cut costs. It will be much easier for the investor to choose the best person for the job when they understand how these incentives work.

It is also important for the investor to understand what to make of Wall Street and the people who work for it. Much is made of financial experts being able to accurately forecast market conditions, but, in reality, these proclamations tend to be largely incorrect. The most recent example is the market’s expectation of what the year-end value of the S&P 500 would be, which, over the last four years, has been, on average, 16% lower than where the index actually closed. Other studies of market analysts on television tend to show roughly 47% accuracy on average, which is barely better than chance. None of this is meant to dismiss these people; it is entirely possible for any one of them to have made accurate predictions. It is simply a matter of probability, and probability favors no one when it comes to predicting a fickle market.