Over the last few months I have heard the same request at least 3 or 4 times. Can you recommend a good introductory guide to investing? The most recent request was a comment on this site. Based on this feedback I have decided to take a stab.
This piece will have some similarities to our page index on our career content. I again want to incorporate links as a sort of guide through our existing investing content. However, unlike that post, this one will also focus on content outside my own writings.
My Investing Experience, Plus Others
The reality is, I have experience with many aspects of investing. I have studied investments and written academic papers on financial instruments. I have been an investor with a proven track record for more than 17 years. But unlike career advancement, there are some areas in investing where I do not personally have practical examples. These other sources will supplement this piece.
One final note, this post is going to be way longer than normal. It will be broken into 2 posts, with the first post talking bout the stock market.
Introduction to Investing: The Need For Known Goals and a Plan
If there is one thing you should take away from this post, and only one thing, it’s that you need to invest in line with your goals. What is your goal? Is it to buy a house? Investing for retirement? Get out of debt? Your investment goal defines how you should invest. You can read more about the importance of goal setting here.
Your length of investment time horizon is one of the biggest drivers of your investment choices. In general, most of what I will write below will focus on long term investing. Much of what applies here is applicable to other goals as well, but I need to set a specific target.
From Goal to Plan
Once you have that goal you need to plan how you want to reach it. Without a goal and a plan success cannot be achieved. It doesn’t need to be a million line plan, but you need a framework. I hope this article will provide you the information you need to develop that framework. You can read more about the value of a plan here: Plan for Financial Success Just remember the hardest part is getting started. After a while the money will do the work for you.
Guiding Investing Principles
In general, there are some basic principles you should follow when investing. They are important to understand because every investment is a tradeoff. When you invest in one thing you forgo another investment or spending. So choosing the right option for you is critical. It can mean the difference between living like a king or losing everything.
I found these basic principles early on due to my own mistakes. In general, the key to long term investing is to keep it simple, easy to understand, ensure you have liquidity, have low expenses, and diversify.
Keeping Your Investing Simple
There are all kinds of reasons to keep your investments simple. It will avoid many of the psychological hurdles we will talk about later in this piece. It makes it easier for those of us with busy lives. We also avoid the laws in society setup to trip up those who forget their accounts.
Keeping it simple means limiting the number of accounts you have and the number of investment types. This series of posts will talk about many different investment types. But for those of us just starting out, the stock market is probably best option with the lowest hurdle to entry. Stocks can be easily understood, diversified, and simple to manage.
Liquidity and Investing
Liquidity refers to the goal to have enough funds to run your everyday life. This would include dealing with major events like emergencies. Before you do anything with investing you need to ensure you have liquidity handled. If you can’t pay for your expenses then there is no point in investing. Bonds and bond-like investments are probably the best choices for liquidity. You can find out more in the next post in this series on safe(r) investments.
Diversity and Investing
Diversify meanwhile is the concept of spreading your money around. The reality is stocks, like any other investment, have an unknown. Many people try to time the market by placing money in specific stocks when they think it would be advantageous. As you will see in the market psychology section of this post, few if any are successful as no one knows what happens next. You can diversify by owning a broader selection of stocks. Thus even if a few companies you have chosen are down it will be offset by a few being up. Diversifying means not putting all your eggs in a single company or investment. A mutual fund or ETF is your key to diversifying across many stocks.
The Importance of Expenses In Investing
Almost all mutual funds and ETFs have annual expenses. Meant to cover upkeep, some of them can be significant. They also take different forms, whether it be an upfront, backend, or yearly fee. Fees, especially annual ones, can have a massive impact on your long term outcomes. This drag can quickly overwhelm any potential, real or imagined, gains from investing in a more exotic fund with higher expense ratios. The funds with the lowest expense ratios tend to be index funds, or funds that simply file a subset of the overall market. Rarely do actively managed funds, those that select individual stocks, beat index funds once adjusting for expenses.
The Easiest Investment Option
The easiest option to match all 6 criteria is investing in the 3 to 5 index fund portfolio. You can read about that here: Simple Portfolios: 3 to 5 funds Basically a collection of 3-5 index funds covering various asset classes, the 3-5 allows all 5 of our goals to simplify, diversify, remain liquid, low expense, and be easy to understand.
The most common components of the 3 fund portfolio are Total US market, the world market, and bonds. From Vanguard that would mean in the following ETFs: VTI, VEU, and BND. Simply buy these in the right proportions and you will fit the needs of 90% of investors.
But honestly, there are more questions to answer here. How do you choose how much to allocate between each fund type? How do you stay invested when the market moves? Where should I buy these funds? We’ll explore those questions below.
How Do You Choose How Much To Allocate Between Each Fund Type?
In general investing is a function of risk. The more risk you take of having your assets wiped out the more return you are likely to receive. On the extreme end, you have speculation where you are just as likely to go to 0 as become a millionaire. On the less risky side, you have cash or bonds. These low risks investments only decline as a result of inflation or if you choose an unstable organization to invest. You can read up on what happens if you buy an investment from a unstable investment provider here: What is Counter Party Risk?
In the middle you have stocks. Mathematically, you want to invest as much as you can in stocks for the highest possible return.
Why You Do Should Not Invest Entirely In Stocks
But as we will learn about in the section below about market psychology, no one can invest by math alone. When the market drops 50% most people panic and sell everything. They lock in their losses from a decline, instead of waiting to see if things rebounded. That’s absolutely the worst possible thing you can do. The odds are high the market will eventually recover and you will make back your funds. But it’s very hard to remember that in the moment.
Conversely, some risks are more obvious to us than others, but there is no such thing as a risk-free investment. So you need to determine what risks you are capable of taking. Only by determining how much risk you can tolerate can you decide how you want to allocate your funds across multiple asset types.
Determining Your Risk Tolerance
Unfortunately, the only full-proof way to understand your risk tolerance is to experience a massive stock market decline. In absence of that, the best you can do is to imagine your portfolio of riskier investments dropping by 50% and your lower-risk investments dropping by 10%. How much combined drop would you be able to stomach before you lost it and sold? That’s the starting point for any allocation of riskier assets to lower risk assets you want to maintain.
Also playing into your allocation decision should be your goal for when you need your money, which we talked about at the top of this post. If you want to invest for a financial need in the next year to 4 it’s better to invest in low-risk investments instead of the stock market. After all the market has an average time from decline to recovery of 5 years. Anything less than 5 years and you risk needing the money when the market is in decline. On average longer than 5 years is statically likely to mean you have more money not less. A reminder, though, nothing in life is guaranteed.
Changing Risk Tolerance
There is one more thing to be aware of related to risk tolerance and investment timeline. They change over time. As you get older you will get closer to retirement. The older you get the less time you have until you will need the money for retirement. Also the less time you will have to recover any money you lose in a downturn.
Those facts will likely mean you have less tolerance for risk over time. Also hopefully your nest egg will be large enough that you will have less need for larger returns of a riskier portfolio. As such you should reevaluate your portfolio every few years and adjust your allocation appropriately.
Asset Allocation with Multiple Accounts
Now to return to asset allocation. It is likely over time you will end up with multiple investment accounts. Any asset allocation you manage should be carried across all your accounts. This doesn’t mean if you want to invest say 80% in stocks that account A has 80% stocks. Some accounts are better places to hold certain investments than others. No this means you should ensure you have 80% in stocks when averaged across all accounts.
The last thing to tell you about asset allocation is rebalancing. Inevitably your investment types will not grow in proportion. This means you will end up with a higher allocation of certain classes then you desire over time. This is when you do something called rebalancing, or bringing the allocation back into its original proportions.
Most advisors would recommend setting a threshold of how off your account will need to be from your allocation to make an adjustment. Say your allocation now holds 50% stocks instead of 80%. If the limit you set is 50% then you would now rebalance by selling bonds and buying stocks. You’ll want to set these limits based on your investment plan (see below).
In general, rebalancing should be done no more than 2-4 times a year. ). Any more then a few times a year and the transactions and over movement will cause you to lose out on investment returns.
For those earlier in the acquisition phase or with larger savings, an alternate approach may be to adjust what asset classes you purchase with new money. The steady adjustment of these contributions can replicate regular rebalancing with even less drag. This is the approach we use.
How to Keep Yourself Invested
I am here to tell you that having the right asset allocation is not enough to keep you from touching your investments during a decline. We’ll talk a bit more about their impact in our section about market psychology, but in general, once every news source imaginable is talking about the collapse of the market very few people can resist. There is really only one other thing you can do if you are managing your money yourself. That is make a plan ahead of time on what you will do when things get rough. Then follow that when it does rather than letting your emotions make the decisions in the moment. Only planning ahead allows you to make decisions before emotions cloud your judgement. Use that to your advantage. You can learn about things to include in your plan here: How to Setup an Investment Plan
Financial Advisors, Target Date Investments, and Robo-Advisors
If you do not think you can follow your plan in the face of such a decline, it might be time to call in a professional.
The most basic form of professional help is a target date investment ETFs. These plans handle the asset allocation for you based on some assumptions about your investing time frame. You choose a fund with your expected retirement date and the provider adjusts the assets accordingly. I do not personally like the lack of control and personalization these provide, but I can see the value to some. Unfortunately, you won’t know if the allocation matches your risk tolerance or timeline until a downturn.
On the more extreme side of professional help is a financial planner. The best case is that these professional advisors protect you from yourself. But really they provide value beyond that in analyzing your goals and developing a plan that fits your situation. Don’t be too ashamed to ask for help, especially to nudge you towards a starting point.
The final type of professional help somewhere in between the two are Robo-advisors. I generally don’t recommend robo-advisers as their help is too generic. If you truly need help then you probably should consider calling a real person. If not a target date fund is probably sufficient.
So Now I Know My Allocation, Where Should I Invest?
So you’ve determined your chosen asset allocation, where do you choose to invest? Well, first you have to choose a brokerage. Basically an organization that can be a middleman in your purchase of stocks or bonds. I review the three biggest brokerage options in this post Where Should I Invest? In general, you can’t go wrong with any of Vanguard, Fidelity, or Schwab.
The second thing to determine is how you are purchasing your index funds. Do you want them in ETF or Mutual fund form? You can find the answer here: Which should you choose, Mutual Funds or ETFs? In general smaller investors would probably do best to invest in ETFs, at least until they pass the appropriate dollar thresholds to invest in lower expense funds.
Most of the big mutual funds have versions with different amounts in expenses. These versions are limited by an investment threshold. Say you need to invest at least 100K to get into the fund with only .05 expense. ETFs have no such limitations, which means you can jump right to the low expense ratio. As we discussed earlier a higher expense ratio can be a major drag on your portfolio. Shooting for something under 0.1 percent annual expense ratio is usually considered small enough. Granularity in the 0.01 to 0.03 expense percent range is not considered significant. Index funds, as discussed earlier, generally fit this bill.
Introduction to Tax Efficient Investing
Finally, you need to decide if you will be investing this money in any way that can potentially be tax beneficial. Generally any investment you make will be taxed as capital gains (15% for moderate income and 20% on higher income). You can get around paying these taxes, either permanently or delaying them, by using a tax-efficient investing vehicle. I ranked and reviewed each of these options here: A Guide to Tax Efficient Investing.
Some comments on tax efficient investing before we move on. Managed correctly, along with proper liquidity, it is not possible to put too much in a tax advantaged account. Note the caveats here though. Provided you maintain liquidity for your near term expenditures. A tax advantaged account is meant for long term investments. They even have rules in place that make it harder to get at these funds sooner.
We have written a bunch on tax advantaged accounts. Each one is situation specific, so I will leave these links in case they apply to you:
- Which should I invest in Roth IRA or 401K? – Deciding between investing in a Roth IRA or a 401K? Or Need to know what these are? This is the post for you.
- SEP IRA or Solo 401k – When you are an entrepreneur or Freelancer you have a choice on whether to invest in one of these. Which should you choose based on your situation?
- The Value and Rules of a Solo 401K – More in-depth into how a Solo 401k works and whether it might be a good fit for you.
- Roth 401K Strategy and Tax Laws – Have an Option to Utilize a Roth 401K? This post talks about strategy’s involving this instrument in light of recent Tax Law Changes.
- Odds And Ends: Pro Rata Rule and 401K Discrimination Tests – Filled up all your existing tax advantaged space and want a way to shove in more. This talks about one of the lesser known ways, the Mega Back Door Roth. Note, utilizing this one is not for the neophyte.
- Tax Strategy Changes: QBI, 401K, and Withholding – How to understand what tax law changes mean to your investing strategy through the eyes of the 2017 Tax law changes
- RMD and Choosing between a 401K and a Roth – A more in-depth look at why you can’t have too much in a tax advantaged account and the importance of tax diversification.
- HSA Investment Strategies – Did you know you can leverage a Health Savings plan to invest for retirement?
If You Decide to Go Beyond the 3 funds: Introduction to Asset Classes
So you’ve decided you want to venture beyond the simple 3 fund. Well once you step beyond the 3-5 portfolio that basically covers every major stock out there, you need to start to understand how you can categorize stocks. In general stocks are divided into asset classes. You can read more about the types of classes here: Stock Categories, Understanding Asset Classes. Each asset class is grouped by some overarching characteristic of the underlying stocks. Then based on some expectations about that characteristic you can invest in an index fund representing multiple stocks in that class. Sounds easy enough.
When you buy a total stock market index fund all of these asset classes are included. The reason to venture outside of that overall fund to individual classes is to buy a higher concentration in a class than contained in the total market fund. The total market fund probably contains your asset class of interest in proportion to its value as a part of the whole market. But if you believe a specific sector or asset class will perform better than other areas, then you want to do what is called tilt. That is buy more of that asset class so it has a larger impact on your portfolio than it otherwise would in the total fund. You can read more about tilt here: Tilt: Playing Long Term Market Expectations
Specific Asset Classes
Over the years I’ve explored whether it is a good idea to invest via a tilt towards several of these asset classes. You can find some links about specific classes here:
- Should I Invest in International Stocks? – Should you invest in stocks outside your country? It is part of the 3 fund portfolio but let’s look at it here more in detail.
- Should I Invest in Emerging Markets? – Emerging markets are investments in up and coming countries. Is investing there a good idea?
- The Fallacy of Cause Based Investing – Say you have strong moral or political leanings. Should you let those leanings drive your stock market purchases instead of buying a broad market index fund?
- The Rise and Fall of Conglomerate Investing – There are large companies out there that do business in many different industries. For example General Electric. Are these companies as good as a fund?
- Internet, Technology, and Investing – Tech stocks seem to be the hot thing. But is investing in technology companies the right path forward?
- The Downside of Dividends – One hot area of investing is in companies that provide dividends. What are dividends? Is it a good thing when companies provide dividends or buy back stock?
So What About Investing In Individual Stocks?
Once you go along investing for a while your perception of your own investing abilities will be influenced by your track record. If you routinely get high returns eventually you will begin to believe your own press. At that point, you’ll probably start to experiment with investing in individual stocks. After all, if you can pick individual classes why can’t you pick individual stocks? Why go through the trouble of investing in a market that will get you rich over the course of years when you can buy the next home run stock and win tomorrow.
The problem is people who invest in individual stocks rarely if ever keep up with the overall market. The tendency is to either buy related to the news which is a losing battle, Or worse hang onto the positions as it declines because you’ve sunk a bunch of money into it. You may think you can pick the next Unicorn stock, but these are likely just your own biases speaking.
To score on an individual stock you have to have your timing right twice. Once when you decide to buy and once when you sell. The number of choices in that respect is nearly infinite. But the key to successfully making a decision is a human is limiting decisions. So we know that individual stocks are not the way to get rich.
Introducing the Play Portfolio
But that does not mean you should avoid individual stocks. That drive to tweak your investments will not go away. You need a way to manage that innate need. The best approach I have found is to set a small amount of money aside as a play portfolio. If tweaking this small portfolio in line with your perceptions of the future market keeps you from playing with your overall portfolio it is well worth it.
In the same way you should not just ignore reading financial news. You can learn things that might be beneficial in managing your non-investing life from others. But it’s a fine line from gleaning tidbits about how to start a business to trying to learn the latest stock tip. A good point to remember is once a stock tip is published, you only have a few seconds to act before all available profit from that tip disappears. A note, this instruction to follow the news and have a play portfolio is null and void if you don’t have enough control to keep these actions from spreading to your overall portfolio.
So What Decides Stock Market Return?
The above probably makes you wonder what drives the return from stocks? In general stocks price are defined by the underlying value of the individual companies. But the problem is, the valuation is not based on today’s value. No, it is based on the value of the underlying company going forward. What are the expectations of revenue, profit, and growth going forward? These are the drivers of stock return.
The problem, of course, is different people have different expectations of future company performance. The market prices stocks based on the aggregate of everyone’s opinion on the future of companies. The group most well known for analyzing companies and releasing prediction of future company performance are market analysts. These folks first analyze a company’s books. They use data analysis techniques that are prone to potential errors.
They take these data analysis concepts and approach the future price expectations in one of two ways. The first is to analyze the underlying company performance. The second is to analyze the prior price trends of the stock to predict the future base on prior price moves. Both methods are fraught with error.
If there is one takeaway you should get from this section, it is that there is no single perception of the future movements of any given stock. Because they are using processes fraught with error and not even using the same processes their results will all be different. This is another reason following the frequent market news screams of Sell! or Buy! is a losing battle.
But What About a Stock Market Bubble?
If I apply the above to index funds do we find the same thing? Do we have no clue where the index fund is going as well? Then why invest in stocks at all?
Well, in the short term, the reality is the same as individual stocks. We have no idea where the market is going tomorrow, next week or next year. It could be up, down or sideways. Your guess is as good as anyone’s, including those that do this for a living.
But… If you look at statistics or analyze stock theory long enough you realize something. Eventually, in the absence of major collapse of a country, stock markets go up. It could be 10, 20, or even 30 years from now, but eventually the overall market and economy will be worth more than it is today. This is even the case if the market is overpriced today, and some people believe it is (A note there are also people out there that believe the market is underpriced. I make no effort to validate or invalidate either belief here).
This is where that goal thing comes into play again. The longer you have until you need the money the more likely it is that the market will be up when you sell. The average market recovery over the last 130 years is about 5. But the longest time to recovery in the US was nearly 20 years. In Japan they are still waiting at nearly 30. So for those with longer time horizons, the scale is tipped towards investing in a higher proportion of risky assets. For those who have a nearer-term need the odds are such that you should have more in less volatile lower risk investment like bonds. (Which again the next post in this series will address.)
What About Buying At the Next Crash?
But, given no one has a clue what happens next, it’s fairly foolish to just sit your money on the sidelines waiting for the next market decline or crash. The reality is there is always someone calling for an upcoming crash. It will come eventually. But the low point may even be higher than today. And you have no idea when it will happen.
The example I always use is 1996. Alan Greenspan, the then head of the US Federal Reserve, predicted that stock markets were overpriced. He entitled the concept “Irrational Exuberance” after a piece by the Economics Professor Robert Shiller. For those who know their history he was right. The overheated market collapsed in 2002 leading to the Dotcom Crash and recession.
But he was also wrong. You see the depths of that Dotcom Crash were still higher than the price in 1996. 1996 was and still is the best time to buy the stock market in the years since then. If the man with the most knowledge about the economy at the time got the timing of the call wrong, what makes you think you will get it right?
This series will continue on Wednesday with a discussion on Safer Investments and Real Estate. Do you have any questions so far?