All about investments, personal finance and well-being! But almost always based on academic research.
Investing in products such as stocks, bonds, ETFs, among others, can be very intimidating (and make no mistake, it’s done with that intention). The objective of this article is to detail what are the 4 basic pillars that any investment must have. These 4 pillars must be present at all times because if any of them does disappear, your capital, time, and investment will be severely in danger.
The 4 pillars of any investment are: Long term, compound interest, investments based on academic research and discipline. Let’s look at each of these in detail.
There is no such thing as a short-term investment. Let’s repeat, there is no such thing as a short-term investment, the only thing that exists in the short term is speculation, and there are a huge number of papers that have detailed how harmful this type of practice is for your capital (we will see these papers in detail in future articles).
Any investment should be thought of with a minimum horizon of 10 years. Any time less than that is extremely risky and the inclusion of bonds in our portfolio must be taken into account to reduce risk. It is in the long term that your greatest ally will come to light: Compound interest.
Compound interest basically consists of re-investing your profits. According to the internet, Albert Einstein said “compound interest is the most powerful force in the Universe.” Even though this phrase has dubious provenance, it is still absolutely true. Compounding interest over the long term is definitely the best way to generate a huge amount of wealth in the long run.
Check out the following compound interest calculator to theoretically calculate how an investment would grow over the years (I advise you to assume a 10% annual return). Try what would happen after 20, 30, or 40 years if you contributed US$200, US$300, or whatever amount you want every month. You will see that, over the years, your capital begins to grow exponentially. The sooner you start to grow this “snowball” of compound interest, the better results you will get.
So, is that enough? invest in something, maintain that investment, and constantly feed it. Does it make any difference what I invest in as long as I’m aiming for the long term and taking advantage of compound interest? Sadly not.
Investments based on academic research
It does matter what you invest in (and what you don’t invest in), it does matter what kind of portfolio and investment practices you have. You must ensure that all your investments, investment strategies, and financial products are based on a large amount of serious academic literature that supports their returns in the long term.
There are a huge number of papers that have described the impact that certain types of investment have on people’s capital. To give you an idea, some of the investment alternatives that exist are:
- Normal savings.
- Day Trading or Trading in general.
- Investment in gold.
- Get ahead of the market (“Timing The Market”).
- Portfolio of selected shares (“Stock Picking”).
- Mutual funds.
- Index Funds.
- Factor Investing.
In future articles, I will discuss each of these investment types in full detail (and with a great deal of academic evidence). We will evaluate if they are recommended or not and why, but for now, stick with the following idea: Your investments must be based on serious academic research.
Finally, we are left with the last pillar to describe.
Let’s take a look at what we have so far. We know that we should always aim for the long term since in the short term there is no investment, only speculation. We also know that we have to take advantage of compound interest in the long run by re-investing our profits finally, we also know that our investments must be based on serious academic research, leaving aside those practices or types of investment that have been proven harmful.
Now comes the hard part, all of the above is much easier said than done. In reality, it will happen that, even when you apply all of the above perfectly, sooner or later you will go through periods of economic crisis or terrible results that can last for years. All these situations will cause enormous stress and fear in you. You will put aside the statistics and you will feel that your strategy is wrong, you will feel that you made the wrong decision and if you do not get out of the market soon, you will lose a lot of capital. I can assure you, sooner or later we all go through feelings like this. So what can we do? There are 2 ways to fix this: Personal discipline to stay rational or hire a financial advisor.
If you choose the first option, then you must develop the personal discipline to be able to stay calm during situations of extreme stress, and thus avoid making decisions based on emotions. You should focus from the beginning on understanding your portfolio (stress testing past crises is a good idea), study previous crises to understand what has happened and how you should react (I will do articles on this in the future). You have to understand all the statistics of the economic crises and your portfolio to be able to have confidence in it. I know it sounds difficult, but it is possible to do it.
The other option is to hire a quality financial advisor to bring you rationality and calm in times of crisis (trust me, you will need it). If I’m absolutely honest, it’s totally worth paying a reasonable fee for a financial advisor to help you stick with your portfolio and avoid panic sales. The only important point is to make sure that this financial advisor is actually good (I will also write an article on this point).
Whichever option you choose, the conclusion is the same: You must find a way to control your emotions, as sooner or later they will try to greatly damage your profits.
So there you have it, those are the 4 pillars that must exist in any investment you want to make.
Don’t forget to always go for the long run, take advantage of compound interest (reinvest earnings and regularly contribute to your portfolio), choose academically backed investment alternatives, and develop the personal discipline to keep investing when everyone else is panicking (or hiring someone to do it for you).
As I wrote at the beginning, investing can seem intimidating, but it is, at its core, quite simple.
I hope you liked my first article, I plan to write many more about the world of investments and, of course, we will start to analyze everything using many academic papers.
© 2022 Nicolas Hidalgo