The last 18 months have been little more than a big boost for many long-term investors. But for those arriving for the first time, especially those in their twenties and thirties, the opportunity to generate high returns by taking advantage of extreme volatility has proven very appealing.
In fact, last year’s research found that “Gen Z” and “Millennial” consumers were 66% more likely to invest over the next twelve months than their “Baby Boomer” counterparts.
Anything that makes the younger generation interested in investing is very positive. The earlier you start, the more ability you have to recover from the inevitable setbacks. This allows them to climb the risk ladder and potentially be rewarded for it in the long run. Larger investors do not enjoy this flexibility.
But young investors still need to be careful when escaping their highly earned savings.
New investors can fall into various costly traps when they submerge their feet in the markets. Even passing the management process to an expert carries its own set of avoidable risks. Thanks to composting, the cost of many of these setbacks is amplified over time.
Alternatively, evidence-based investing offers young investors the opportunity to maximize market returns by investing them longer in the market, minimizing commissions, and completely eliminating unnecessary risk.
Bad weather and behavioral bias
A natural starting point for a novice investor is to allocate their cash to a few shares. This can be extremely profitable (we’ve all seen the headlines tell us how much our € 1,000 would be worth if we had invested in a hot stock at the right time), but it’s also very risky.
For example, imagine if a twenty-five-year-old investor had to read about three shares online and put £ 1,000 in them. Imagine then that, instead of firing, the value of one of those stakes dropped to zero in a matter of days.
One-third of the total investor portfolio would be wiped out almost overnight. In addition, a full recovery would require a significant increase in the value of the remaining holdings.
One way to reduce this stock-specific risk is to buy a fund. This can offer first-time attendees a great way to experience the benefits of the stock market under expert guidance, while at the same time spreading the risk considerably.
In addition to being able to analyze the underlying stocks in detail, fund managers are also smart with the benefits of diversification, reducing the risk of the portfolio by investing in many stocks in many sectors to ensure that the performance of a it does not overwhelmingly influence overall performance.
But there are drawbacks as well. A growing research bank suggests that humans (including fund managers) are prone to letting their emotions guide their investment decisions rather than thinking only rationally.
Our innate fear of loss can see even the most skilled investors panic and sell investments with a bad return too soon, crystallizing losses at the bottom of the market before a subsequent recovery. Along the same lines, our overconfidence can lead us to add to a high-yielding stock at the top of the market, just before the tide transforms drastically.
These behavioral biases apply to everyone. Studies on the persistence of fund performance overwhelmingly conclude that the historical overcoming of fund managers tends not to persist in later periods.
Now, keep in mind that the most actively managed funds charge significant commissions, eroding a considerable portion of the profits they make …
The combination may leave fund investors for the first time sitting on disappointing long-term returns.
None of these options fully optimizes the market opportunity offered to young investors. A solution that is a model portfolio solution managed according to evidence-based principles.
Evidence-based solutions focus on risk as a driver of returns. The financial capacity and psychological composition of the investor report on risk tolerance.
From here, instead of building a portfolio around selected stocks using subjective human assumptions, evidence-based investors rely on robust, peer-reviewed academic studies, based on decades of historical data, to establish an optimal portfolio asset allocation for your client’s particular risk profile.
So why is evidence-based investing particularly ideal for younger investors?
Like an investment fund, the approach offers benefits and oversight of full diversification (in this case, drafts of historical data) to divert the usual investment traps for the first time.
The evidence-based investor maintains its risk allocation through systematic rebalancing throughout the market cycle. This means that human excitement, tactical allocation, and market time that inevitably eat up portfolio returns, especially over a very long investment horizon, are completely removed from the equation.
Because this is broad market access, evidence-based investment strategies typically include high-efficiency passive vehicles, such as index funds and ETFs. Avoiding individual stock selection and associated research costs means these vehicles incur extremely low rates. Erosion of young investors’ yields is minimized, a benefit that worsens over time.
Stock baskets easily allow evidence-based investors to tilt portfolios toward a specific topic, such as sustainability, which has proven especially popular among younger investors.
Golden egg opportunity?
Investing young people is a smart move, either way.
But to make the most of the golden egg that comes with a long investment horizon, new investors in their twenties and thirties must avoid and minimize unnecessary risks and unpaid costs wherever they can. The impact of these only amplifies over time.
Evidence-based investment can offer those who have many years on the market ahead of them the opportunity to reap steady profits through diversification, cost efficiency, and the deliberate avoidance of human bias.
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