Been thinking about investing? Are you ready to dip your toes in the waters, and finally give this stuff a shot? I’m glad you’re reading, because investing is not easy, but it can be and is enjoyable if you know approach it responsibly. The market can be a scary place, but a lot of the fears and preconceptions you might hold are unfounded once you really take time to understand it. Every investor and trader has to face the fear of beginning at some point, but the awesome part about it is that you’ll only be new once. After that, it’s only uphill.
So if this describes you in any capacity, then I hope that this post can serve to both inform AND warn you of both myths and false expectations of potential investors, respectively. While we all would love to see double digit returns every year on our brokerage statements, it simply isn’t plausible, as you’ll soon see. It is very important to keep a sober attitude about investing, without getting carried away in the grips of an opportunity that “can’t be missed,” but somehow seems to come again every few months. A lot of the tips and advice out there can be misleading, so I’ll attempt to provide backup for any general statements that I can, both in this article as well as on this site in general. I don’t want to be seen as just another person spouting off an opinion, but rather as someone who can help guide your investment process and help you make your own decisions. [As a side note: that is what I really think is the responsibility of a financial adviser, but I understand that not everyone has time or chooses to make time to understand investing as much as I do.]
That said, the four things I would tell new investors to keep in mind are as follows:
- The average return per year of stock market indices is 7-8% a year
- You will lose money, and it will take a while to succeed
- There are opportunities everywhere you look (but don’t rush it!)
- If nothing else, mutual funds are a great place to start if you don’t have time (no excuses not to be investing right now!)
What do I mean by each of these? Let’s take a look at them individually.
1. The average return per year of stock market indices is 7-8% a year
This first thought should be reason enough to get curious about investing. Especially when compared with simply saving money in the bank or in a certificate of deposit (CD), the returns available to investors simply blows other opportunities away. An 8% annual return will double your money in a little over 9 years. This is pretty cool stuff. Moreover, the great thing is that investing is totally scalable. What I mean by this is that it requires the same amount of effort to invest $100 into the markets as it does to invest $1,000,000. And in the same manner, an 8% return is exponentially larger on a per-dollar basis in a bigger investment pool.
I used the data from http://www.moneychimp.com/features/market_cagr.htm to find the compound annual growth rate of the S&P 500, including reinvesting dividends (which is something regular investors would do most of the time). The compound annual growth rate takes into account risk (in the form of the returns’ standard deviation) over time as well, because all markets fluctuate day-to-day.
To contrast the returns of the stock market, consider the interest you’d make by simply putting money in a savings account. A quick search on Google produced the following results:
Wow, 1.30% a year! That’s some serious money. If you invested $1,000 of your hard earned money on January 1, 2011, by the end of 2011, you would have made a whopping $13!
In case you can’t tell, I think that is totally pitiful. The S&P 500 in 2009 returned 23.66%. That would have produced a gain of $236 over the course of the year. As you can see, using a savings account as a long term money-making strategy is not really an option. When you adjust for inflation, a savings account at 1.30% per year would, most of the time, make you worse off! Your money is worth less when you take it out than when you put it in. A table of inflation data from the past ten years shows average rates to be between 2-4%. In short: if your money is compounding at a rate less than inflation, you are losing money.
InflationStats Ready to Invest? Some thoughts to keep in mind.
However, I am not in any way saying that investments in the stock market make money every year. Most people are familiar with the idea of risk—after all, weren’t we supposed to have learnt at least that from the most recent financial crisis? Sure, OK Brett, I know all investments involve risk. In general, the only reason investors can expect returns on their money is because they take on the risk of loss. That is the core tenet of risk and reward.
Well, that being said, an investment in the stock market still might not be appropriate for all investors. A two-second overview of asset allocation (another area of investing) is that the older you get, the equities (fancy name for stocks) should make up a smaller percentage of your portfolio, and fixed income (fancy name for bonds) should make up a larger percent. Every financial adviser you’ll ever talk to will have a rule of thumb for the right percentages of each, but it’s best not to get tied up in the details. Just realize that in order to expect a return over time, you have to risk the chance of loss by investing in equities.
2. You will lose money, and it will take a while to succeed
The second thought picks up where the first left off, but it’s important enough to stand alone as well: you will lose money. It’s guaranteed. Over your lifetime, the markets will not always gain exactly 8% a year; some years they might gain 30%, other years, they might lose 50%. There is no easy way to predict it. If you invest in only a few individual companies, the chances are even greater for loss, since one might have a bad year while the rest of the market does well. But, the one truth that cuts through everything is that you will lose money. Every professional investor has lost money at some point in their career.
However, the good thing about losing money is that it teaches you. For one, it teaches you about risk management. Knowing when to sell a stock is an incredible difficult skill and one that I’ll cover at the end of this series. However, experiencing losses will encourage you to put controls in place (like stop loss orders, which I’ll also cover in the future) so that you can automatically get out of a position if it drops below a certain level. Another thing it teaches you is to be unemotional about investments. Too often when someone starts investing, he gets upset when his portfolio is worth less than what he put in, and understandably so. But, to be successful, you need to remove emotion from the equation and look at a company from an intrinsic value point of view: put another way, if you know how much you think a company is worth, you are more patient and willing to put up with temporary losses. [side note: I covered eliminating emotion as one of the top ten rules of value investing]
3. There are opportunities everywhere you look (but don’t rush it!)
The third thought is that there truly are opportunities everywhere you look. While this site right now is limited mainly to covering equity investing, there are thousands of different ways to invest in public markets, and you really can make a directional bet on any view you have of anything. Even if you looked just at equities, there are more than 19,000 publicly traded companies in the US (see http://www.crmz.com/Directory/CountryUS.htm). Trying to analyze that many companies is enough to keep any investor busy for a few lifetimes. But not everyone wants to just invest in stocks. If you want to branch out, there are many, many different asset classes out there. The bond and fixed income markets are monstrous by themselves, but then there are derivative securities, which account for a growing segment of the market too. Options and futures contracts are considered derivatives since their intrinsic value derives from a multitude of factors, one being the underlying company or index they are based on.
If you were more of an economist and had views on how the country is going to perform relative to other countries around the world in the coming year, you could buy foreign currency contracts. In fact, the forex (foreign exchange) market is the largest by far with respect to daily trading volume; stocks pale in comparison. Even beyond forex, you could buy interest rate swaps, or foreign stocks, bonds, and derivatives, and literally anything you could ever possibly want to bet on. The markets (and companies who create financial products) have endless ideas of things you might want to invest it, so they will continue to produce them!
That is what is so amazing about the markets–there are hundreds of thousands of opportunities available to you, and all you need to do is look. That being said, if you are just starting out, I would stick with stocks for now. You can always be open to new opportunities, but in some cases the learning curve is a bit steeper, and all other investments require the same if not more research and due diligence than stocks, so it’s best to keep it simple for now.
4. If nothing else mutual funds and ETFs are a great place to start
The final thought, and perhaps the best starting point for a new investor, would be to consider an index mutual fund. An index fund is simply a fund that holds a basket of stocks seeking to mirror a stock market index, such as the S&P 500 or the Russell 3000. By investing in one, you can essentially mimic the performance of the index without actually having to buy all the companies in it. They are great for opening low-maintenance opportunities up to investors, but they still should be approached with the requisite due diligence. I started out investing only in index funds, and even today I still hold part of my portfolio in them. I use Vanguard for mine, because they have some of the lowest costs in the industry, and you can buy and sell shares of index funds for free (provided you don’t buy and sell too frequently).
Without getting too deep into the rationale for tax considerations of mutual funds, one thing to keep in mind is that unlike regular stocks where you incur taxes only when you sell a position for a profit, you can be taxed on mutual funds even when you don’t touch the investment at all over the course of the year. As a result, you can lose a bit of your investment over time due to taxes—this is bad for us as we saw previously how wonderful compound interest is.
Fortunately, there are such things as exchange-traded funds (ETFs), which can solve this tax problem for us. ETFs can include many different asset classes, but they are similar to mutual funds in that you can buy them to get exposure to indices such as the S&P500. However, with ETFs, you only really incur taxes when you sell them, similar to stocks. Another similarity is that you can trade ETFs intraday, whereas mutual funds are only required to credit your account for the closing price of the shares no matter at what point during the day you placed a sell order.
That said, there are advantages and disadvantages to both, but for now, mutual funds are simple and easy to get started with. If you have a little bit of money to invest, Vanguard is a great option to get an account with. Most Vanguard funds require a minimum initial investment to buy into a fund, but in some cases the amount is as low as $500. If that is too much for now, then stick with an ETF, as you can buy as small an amount as you want (and you can buy them from an account with any brokerage). If you just want exposure to the market, three S&P500 ETFs are: ticker symbols SPY, IVV, and VOO. The latter is Vanguard’s ETF.
All that being said, I really don’t see any reason why not to get started with investing. Sure, it involves risk, but if you are in your 20s or 30s, and have a little bit of money to spare, then starting small and learning the basics of investing can be a really fulfilling process. You will lose money at some point during the process, but the sooner you learn these lessons, the better off you’ll be! If you have a long time horizon (5-10+ years), then there really is no reason to wait. Just go for it. You’ll be glad you did.
Disclosure: I don’t hold positions in any of the ETFs mentioned: SPY, IVV, or VOO, although positions may change at any time.