A Goal and a Strategy
The first thing is to have a clear goal in mind and define your strategy accordingly.
The goal shall not be, realistically, “to get rich” as this will not happen to most of you, this is not a lottery game.
Instead, a realistic, yet ambitious goal is to beat the inflation by, say, 5% margin on average.
The more aggressive you are the more shares and exotic assets your portfolio shall contain and be ready for lots of volatility. That is why I said “on average”, ‘cause there will be years where you will be well below that and even lose money. Remember: there will always be periods of expansion (boom) followed by recession, on any market. This is part of another chapter in macroeconomy, just take it for granted.
It can be mathematically demonstrated that in the long run you are better off spreading your investment into several types of assets and geographically, as opposed to bet everything on one horse. This is what the commonly known as Portfolio Theory teaches us.
Of course, the more you diversify the more expensive, in terms of transaction costs and investment evaluation time, the portfolio will become.
Exchange-Traded Funds
With the advent of ETFs it is possible to mimic the value of a particular asset (gold) or asset class (commodities, real estate) or the index of a Stock Exchange without you buying an ounce of gold or a flat or a single share. They are relatively inexpensive because there is not much brain required to run them: the caveat is they will not beat the market, but follow it instead. Some of those ETF will be riskier (more volatile) than others, which is due to the nature of what they intend to track, which allows you to chose which profile of risk you want to get.
Therefore, if you want to take higher risks and like technology stocks you can allocate parts of your money to an ETF tracking the Nasdaq. Fund-of-funds may be used to dilute the risks and add stability. Of course, remember to season your portfolio with the right balance of currencies.
This strategy provides you with a big advantage: you do not need to follow the markets every day and keep buying and selling; on the opposite, you should not, even in times of crises. You can further improve your position, by following the key strategy for self-made investors outlined below.
Managing your Strategic Reserve
You are in a battle with the market and you have to make sure you have and manage a strategic reserve, represented by about 30% of your portfolio. This reserve is liquid, on a money market account, for instance. Use it during market crisis or serious adjustments. You hear the market going down on a few consecutive bad days? You have an opportunity to buy assets at a cheaper level. Take about 30% of your reserve and invest it. Market keeps going down? Wait for a week or a month and see what happens: further down? New opportunities to buy. Even if after several months prospects look gloomy and you have exhausted your strategic reserve you are still better off and prepared for the upward trends.
If instead the market recovers and goes high again rebuild your strategic reserve by selling. Do not wait too long to sell, otherwise you risk being taken without defence when bad times arrive, ‘cause they have the bad habit not to announce themselves.
In essence the role of strategic reserve is to enable you buy low and sell high by exploiting the opportunities of volatile markets.
[It may be contrary to the spirit of this site to promote self-service portfolio management, but one has to admit that in many cases the only ones to gain are the portfolio managers and not their clients who commit their money. As pointed out, among many others, by The Economist (March 2008), this has to change and follow more accurately the arbitration laws.]