Investing can be intimidating. The talking heads on CNBC or other media outlets may make you think they have some secret sauce about what the market or a particular stock may do next. I’m going to let you in on a little secret though: they have no clue, and neither does anyone else.
What I am seeing happening with the dispersal of knowledge on the internet is amazing, there is a wealth of people that are going straight to the consumers, who need to be educated on investing, and they are trying to push the knowledge to you free of charge. This is great, and in the long run it is going to empower small investors for decades and maybe even generations to come more than they ever have been. We are also in the Wild West of internet advice right now too. Especially for those that are not well versed in investing, you can be given a lot of conflicting information. Should I invest in stocks, bonds, gold, real estate or none of these? What do I do if the market goes down? How can I protect myself? Does the trade war matter?
There are lot of questions you need to answer before you get to all those answers though, and these mainly have to do with yourself and what your goals are. Much of the hype around personal finance in the past decade has been rooted in the financial crisis and the consumer culture: changing people’s mentality in order to stop spending and start saving. However I have noticed once people save, they think that is it, but it isn’t enough. If you want to become wealthy, the next step is to take risk with that money you saved. It will take a new psychology, which is completely different from the budgeting and savings mentality that got you the money, to kick it up to the next level and become wealthy.
The Hook
One great marketing strategy that I have seen on social media to get people interested in investing is relating to what they already know: if you are buying from certain companies, why don’t you just own them on the back end as well? I think this is a great way to get people interested and starting to dip their toe in investing. This is not a long term strategy though. Becoming wealthy through investing involves a long term time horizon, understanding the power of compounding and the law of averages.
People may know Amazon, they may buy many things from there, it may be the hot investment right now but let me ask you this: are you willing to bet the rest of your financial life on how Amazon performs for the next 40-50 years? Who were the top companies in 1979? Are many of them still top companies now? Probably not. It’s not easy picking those winners when you are picking a winner for life. It’s actually pretty risky to bet your entire future on one stock or even a couple stocks. I wouldn’t do it and I’m an expert on valuing companies.
I get people that come to me all the time for advice on what to do with their money, smart people, even other people in the finance industry. They may be smart, they may be experts in something but it doesn’t mean they know how to invest. It’s also important to know it doesn’t take genius to get rich off of the market but like anything, it’s a learned habit over time and an acquired skill you need to master.
Simple Advice
My sister has a masters degree and came to me asking what stocks she should buy a few years ago, my answer: don’t buy a single stock, buy the index and just keep putting money in consistently. Why didn’t I have a hot tip on the next Amazon? Because no one knows, and neither do I. I don’t even know if Amazon will be around in 35-40 years when she retires, but I know the index will be. The index in this case being either the entire New York Stock Exchange or the S&P 500. Either of which are available through low cost ETFs.
There is another reason I told her this besides not knowing if a company will be around in 40 years: when you buy one stock, you buy ownership in that company. If you don’t know how to value an entire company, how do you know if the price you are paying is too high? Do you know if a stock is priced fairly or poorly? To know that you would likely need to know about long term pricing trends of the market and valuation measures. When you get into those even the experts disagree, so why would I expect a doctor or a lawyer to have answers that billion dollar portfolio managers don’t agree on?
If you don’t know when to buy, then you likely won’t know when to sell. What would you do if it’s priced too rich? Sell some off or prepare for the crash? What if you sold at a price you thought high and it kept going up still? What if the company fundamentally changes its strategy and the business is unrecognizable and run by completely different people? Would you still bet your financial future on it?
What Is Your Time Horizon?
So if your goal is the long term, and I mean the long long term, like 10 years or more, then an index fund or an ETF that tracks a broad index is the way to go. However, not all goals are more than 10 years away, what if your goal is shorter? These are questions you need to ask yourself before diving into stocks. What is the money going to be used for? Retirement? If so, have you exhausted all of your tax advantaged options like the 401k or Roth IRA? College for your kids? Have you checked out a 529 account? Saving for a down payment on a house?
All of these goals will change the way that you could best be saving for it. I like to use the rule of thumb that if the goal is more than 5 years out, then you can invest some in the stock market to achieve that goal. If it’s less than 5 years though, it’s best to have it in a balanced fund heavily weighted towards bonds and fixed rate notes. You can still do some stocks if it is in your risk appetite but definitely do not do a single stock, keep it to a broad index.
Your Benchmark
Once you know your goal the other thing people don’t do is establish their benchmark. This is where you start to see that single stocks can be a problem. A benchmark is an index that you compare your return to. If you own a bunch of tech stocks it could be the FAANG index. If you own large dividend paying stocks it could be the Dividend Achievers Index. The benchmark you compare yourself to is the one that is most closely associated to the risk you are taking.
Many individual investors and professional portfolio managers can beat their benchmark over the short term. For example, instead of buying the Nasdaq index you could just buy shares of Netflix. That would have worked out great the past few years and you would have beaten your benchmark.
Source; Google Finance
What if instead however, you bet on Tesla? Well guess what? Over the past 5 years, the Nasdaq index returned 105% on a price basis trouncing Tesla which returned 15.5%.
Source: Google Finance
In addition to getting a lackluster return on Tesla, holders over this period of time had to deal with much more volatility than if they helped the index. The day to day euphoria followed by dread may be too much for many people to handle.
Understand Return
So knowing your time horizon, your benchmark and knowing the risk you are willing to take are key but playing it too safe can be a problem as well and to understand this you have to understand compounding.
The price you pay for the safety of bonds is paid with the lower return you get over a long period of time. To give you an example, take a look at the difference in return on holding a $10,000 30 year bond that returns 3% annually (we assume we can reinvest here for simplicity’s sake) versus holding the S&P 500 index which returned on average 9.05% over the last 100 years:
- $10,000 at 3% annually = $24,272.62
- $10,000 at 9.05% annually = $134,514.81
The return leaves you with about 5.5 times more than if you took the safe route and invested in bonds.
When you throw in the inflation target the Fed currently has of 2% annually, you start to understand that the safe return isn’t much of a return at all because it makes that total bond return $13,402 in today’s dollars. The index though will give you $74,276. Seeing this in the figures is the reason why so many advisors plead with young people to invest when they are young. That 9.05% return can make $1 into $17.73 in today’s money.
Conclusion
I’ll end this paraphrasing an interview I saw with Warren Buffet the other day who pointed out the longer you hold stocks the less risky they get while the longer you hold a bond the more risky it gets in terms of inflation and missing out on returns. Just remember that volatility smooths out over time which I like to visualize in the chart below.
Source: Barclays Capital
So stop trying to think you will beat the market with the hot stock tip or the latest fad, if you want to get rich save and then get boring with an index fund.
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