For many investors with a long-term focus, few strategies work as well as one of the simplest ones out there: dollar-cost averaging into a low-cost index fund. Kept up over the course of a career, that strategy can potentially make you a millionaire by the time you retire.
Still, for a select few investors, that strategy alone isn’t enough. Maybe it’s because you want to attempt to beat the market. Maybe it’s because you want more control over your investments. Maybe it’s because you enjoy the challenge of analyzing businesses and building a portfolio. Whatever your reason, here are three signs you’re ready to level up your investing.
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No. 1: You are ready to practice basic diversification
One of the biggest advantages that index funds have over individual stocks is that index funds offer some level of automatic diversification. If you own an index fund and one company in that fund completely collapses due to its own problems, you might not even notice the impact on your net worth. If, on the other hand, you only own one stock and the business behind that stock fails, your overall portfolio will be devastated by that loss.
As a general rule, you’ll want somewhere in the neighborhood of 20 approximately equally weighted stocks across multiple industries in order to be adequately diversified. From a kitchen-table logic perspective, that means any given stock would represent around 5% of your portfolio. If that company were to fail, you’d still notice the loss, but you’d have a decent chance of making it back in well under a year, based on the market’s long-run historic returns.
That makes a single company failure much more survivable for your portfolio. It also makes diversification a very key strategy that you should follow if you’re going to level up your investing and start picking your own stocks.
No. 2: You are willing to follow smart asset allocation rules
Although stocks can be incredibly strong wealth building tools over time, they’re terrible when it comes to protecting your ability to spend money right now. Market crashes happen, and your bills won’t wait for a strong stock market before they come due.
Because of that harsh reality, you need to have a three-to-six month emergency fund in cash and keep five years’ worth of costs you need your investments to cover in something less risky than stocks. Cash, savings account, or CDs, Treasuries, or investment grade bonds that mature just before you’ll need the money can be reasonable places for money you’ll need within that time window.
Those guidelines are important for all investors, but they’re especially important for those that are picking their own investments. After all, it’s likely that you’ll face more volatility than an investor who sticks only to broad indexes, so you’ll need to be prepared for the ups and downs that entails.