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4 lessons every long-term investor must learn

(MoneyWatch) Investors with long investment horizons have significant advantages over those with shorter horizons:

  • They can stay the course and wait out bear markets.
  • They can ignore short-term "noise" and focus on potential long-term results.
  • They can earn the risk premium that comes from investing in less liquid investments.

To take advantage of these benefits, there are several lessons you must learn and incorporate into your investment plan. The following are four of the most important lessons for long-term investors to learn.

Know when you'll need to access your assets. Your portfolio should be appropriately tailored to your ability, willingness or need to take risk. This includes making sure you are planning for any future emergencies. For example, as the authors of the paper "Investing for the Long Run" state, it's important that investors in illiquid assets don't underestimate their need for liquidity. If they do, as did such "sophisticated" investors as Yale and CalPERS, they'll be forced to sell equities at exactly the wrong time, when valuations are low and expected returns are high. Both of these institutions had to sell stocks to raise funds to meet unexpected calls on their capital.

Know your risk tolerance. It's also important that you not take on more risk than your stomach can tolerate. Otherwise, you'll be susceptible to panicked selling when crises occur. CalPERS provides a great example of this as well. On June 30, 2008, its stock allocation was 52 percent. In response to the bear market, CalPERS deliberately sold stock, bringing the equity weight down to 44 percent on June 30, 2009.

Understand how your job relates to your portfolio. The risk of your portfolio should also incorporate the stability of your human (labor) capital. For example, all else equal, a construction worker has less ability to take on the risk of stocks than, say, a tenured professor because the former's labor capital likely correlates more highly with the economic risks of stocks. If a crisis arises and puts his work in jeopardy, it's likely that his stock allocation would be suffering as well.

Buy when others are selling. Finally, it's important to understand that investing for the long term requires you to be a countercyclical investor. You have to buy assets that have done relatively poorly (when others are avoiding them) and sell assets that have done relatively well (when the crowd has fallen in love with them). That's what rules-based rebalancing requires you to do. Having rules helps you to be a contrarian, countercyclical investor.

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