3 Signs You’re Ready to Level Up Your Investing

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.

No. 3: You recognize your edge over Wall Street

Index investing typically beats professional active fund management. There are three major reasons for this.

First, active investment managers have to cover their costs from the returns they earn. That makes it an uphill battle for the average active investment manager to win due to those structural costs

Second, the more trading you do the more friction costs you face. Although commissions don’t take nearly as large a bite as they used to, bid/ask spreads still exist, and the more any investor churns a portfolio, the more of those friction costs that investor will see.

Third, professional money managers are in charge of other people’s money. Those other people tend to pull their money out of the professionals’ control if they significantly underperform the market for any period of time. As a result, those professionals tend to be focused on the short term and are often unable to buy companies they believe will be long-term winners if they’re not performing well right now.

It’s that last issue that gives you your edge over Wall Street: patience. As an individual investor managing your own money, you can afford to wait out the short term ups-and-downs in the market. If a company’s long-term prospects remain strong and its valuation looks decent compared to those prospects, you can buy and wait for the market to realize that fact.

You don’t have the pressure of managing other people’s money, and you can use that to your advantage as you seek out a potential edge over the market. Add to it the fact that that following a good asset allocation strategy means that you don’t need to rely on the stock market to cover your immediate costs, and you have a strong foundation for success.

Are you ready to level up your investing?

If all three of these signs apply to you, then you’re more than likely ready to begin leveling up your investing. As you move forward, recognize that we all make mistakes. That’s part of why recognizing the benefits of diversification is a key sign that you’re ready for the next stage of investing. What matters is that you learn from those mistakes and not let them get big enough to destroy your overall portfolio.

If you’re not quite there yet, that’s OK, too. Dollar cost averaging into a low-cost, broad-based index fund remains a viable long term strategy and one that is worthy of your consideration as well. When you are ready, you’ll know by those signs, and you can take that next step into the world of buying individual stocks.

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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.