My friends and colleagues know me as someone who is on top of their investments. I often get the question “how do I invest?” The question really needs to be, what am I trying to achieve?
In my last post I talked about the reasons people don’t save. Most of the self help and personal finance gurus I believe only scratch the surface of why people really don’t save because it usually is too personal and gets into the realm of psychology rather than personal finance.
Let’s assume though, that you have mastered the ability to save and you can plan out a budget and put money aside in a bank account consistently and watch it grow. Let’s also assume you do the responsible thing and set aside cash for emergencies and have put 6 months living expenses aside (this is the time it takes on average to find a job so I like this rule of thumb). Now you have some more money coming in, what do you want to do achieve with this money and how should you go about doing that?
Many people don’t ask that question, stop here and just let the cash accumulate. Investing is too intimidating and someone always has a story of their aunt Sally that lost everything in the market crash of blah blah year. What these people fail to understand is that even if you save, if you don’t invest, over time your money will become less and less valuable due to inflation. The inflation target in the US and Europe is 2% annually. This means you need a 2% return on your savings on average every year just to have the money be worth the same as when you socked it away. Most savings accounts nowadays pay way below 2% and offer rates so low it’s to the point where it’s almost paying you nothing. So although you do need some cash for emergencies in the short term, for the savings you are looking to put away for a while you need a higher return than you can get with cash if you want to make this money grow. If growing your money for the future is your goal, the only way to do that is to invest. I tend to think people are scared to invest and stay stuck in the cash holding pattern for 3 main reasons which I will discuss below.
The Reasons Why People Don’t Invest
1. Loss Aversion – The fact of the matter is most people hate losing more than they like winning. Loss aversion is seeking to avoid the pain of experiencing a loss. I get it, you worked hard for that money, if you were to see an investment drop in value, it would feel like you did hours, days or weeks of work for nothing. Fear of this and fear of having nothing after taking a risk is what leads people to extreme measures to avoid losses. In the example I gave of the bank account above, you are actually taking a small loss by letting inflation eat away at cash savings over time. However, this is not explicit. Most people don’t keep track of inflation and it acts as an invisible tax on savings. Many people would rather stick their head in the sand about these things and convince themselves that having cash is better than losing it in the stock market, but the real losers over time are usually those savers. Studies have even quantified how much people hate losing. One study found that people would refuse to take a gamble that could result in losing money if the potential winnings weren’t worth 2.5 times the potential losses people would experience.
2. They Don’t Understand Probability – How do casino’s make money? The laws of probability and large numbers. There is no game in a casino that if played fair, has the odds in your favor. You are set up to lose. What keeps people coming back however is the chance that they could take away a win. Look at yourself as the casino. Each year invested is a day of business at the casino. Things may be going ok but on day 7 of the month, a customer hits a huge jackpot on the slots and you lose $5 million in a day. Does the casino just close up shop when this happens? No, they pay it out and keep the customers coming because they know over time, even if there are ups and downs in day to day income, the odds are in their favor. This is exactly how the bond market and stock markets work. You may take a loss in a year or even 2 years in a row, but the odds are in your favor if you stay invested. The long term average annual return of the S&P 500 is 10%. In any given year, you may receive that return or you may not. However this is the return you can expect if you play over time year in and year out. To demonstrate this point, look at stock, bond and a blended 50/50 portfolio returns on a rolling basis from 1950 to 2013.
Source: Barclays
What a rolling basis means is if you pick any year within that period and hold it for 1, 5, 10 or 20 years, these are the different returns you could see. Notice that once you get to 20 years, nothing takes a loss. This is the exact probability game the casino plays and you can play it too if you understand that staying invested is what will eventually have you win. I shake my head when I think back to the financial crisis and smart people that I knew, even some who worked in finance, pulled all of their money out of the market. They were smart people but didn’t understand how probability and the market worked so they missed out. The ups and downs bring me to the third point.
3. They Don’t Understand Volatility – The market is going to go up and down. There is nothing you can do to stop it, no one knows when it will happen and you will not be able to time it. Volatility is the reason that the stock market can consistently give positive returns over the long run like in the chart above. Volatility is the the price you pay for that consistent long term return. Taking the risk of short term volatility will be rewarded with higher positive returns in the long run. People that don’t understand this will pull there money out as soon as the market takes a dip and try to put it in cash again. When that happens though, how do you determine when to get back in? There will be no definitive date when you open an email that says “hey, time to invest in the market again!” It will remain murky and unsure and….volatile. That is why it pays: taking a risk means you have the chance to get a reward.
How People End Up Making Poor Investment Choices
Sometimes people have tried investing in the past but were burned and they never want to get back into it. This is understandable but it also may be due to one of the following pitfalls that many people succumb to when starting to invest.
1. Trying to Get Rich Quick – The media and gossipers will try to tell you about some guy who bought a ton of stock XYZ and got rich in a short amount of time. The reality is this almost never happens, which is why they are being singled out. Trying to get rich quick also makes people fall prone to scammers, they take advantage of your hopes and dreams to sell you a course or product that they swear will make you rich. If it makes you rich, why would they tell anyone about it? They should just keep making it work for them and become billionaires. Forget getting rich quick, start to develop habits that make you rich over time and you will win.
2. Watching Too Much News – There is a show called Fast Money on CNBC that totally typifies what I consider the Wall St. bro-hustler culture which pressures you to buy and sell stocks constantly. The format is even set up to speak to the demographic that tends to engage in this type of trading: young men. The commentator’s rapid fire questions and answers about a myriad of stocks has a flow very similar to an NFL pregame show. Even the graphics look like they could be from a sports network.
Source: CNBC
I’m here to tell you everything on this show is garbage. In fact, most of what you watch on CNBC is garbage. It’s a staple in the background of trading floors at banks but those are traders and they have different objectives than long term investors. They care whether the 10 year treasury note dropped 3bps this morning on news of Iran because they are buying or selling right now on behalf of clients, this has nothing to do with you and I on a day to day basis. So for the rest of us, turn off the talking heads and let your strategy run it’s course.
3. Taking Advice from Non-Professionals – Uncle Jimmy has a sure fire winning stock tip. He must know something you don’t and he’ll let you in on his little secret. Uncle Jimmy doesn’t have the answers and he may even lose you money. Just like in the case of the news above, you have to filter out the noise and the people who want you to think they know something. The secret is: there are no secrets. Be the casino, not the guy playing the slots hoping to be a millionaire while he flushes his money down the toilet.
Remember the Basics
So to get back to the original question: how do I invest? Number one is educating yourself and establishing objectives, maybe with the guidance of a professional or one of the many online resources. Separate the money you may need for emergencies from that which you may need in a year and that which you don’t need to touch for 5 years or more. For this medium and long term money, establish that you want to grow it for some future expense or simply to build your money.
Two is to take appropriate risk. Cash for short term needs, CDs and money markets for 6-12 month money, bonds for 1-3 years, a mix of stocks and bonds for 3-5 years and beyond. Stocks for over 5 and beyond. Don’t dump your money in a few good companies, you will likely lag the market. Choose index funds, Vanguard is cheap, Fidelity has zero cost funds now. Get funds that track the US Bond Index, buy funds that track the S&P 500 or the MSCI World Index. Stay invested and don’t trade. Some people tend to be surprised I have a Vanguard target date fund for most of my retirement savings even though I spend a lot of time researching markets and investments. It’s because I don’t want to touch it and run the risk of being tempted to trade it or invest in a fad (I see you tech stocks). The law of large numbers will take over long term, so why bother?
Three is to let compounding take effect. It’s a great thing if you just stop looking at your investments and just let it happen. Trading does not produce reliable income for most people. There have been studies done which found that traders tended to lag in terms of returns, even when they have no brokerage fees as is becoming more common now. Take a look at how your money starts to compound over 20 years if you invested $1,000 at an annual rate of return of 10%.
Source: Invest Made Easy
The green is compound interest or interest upon interest. Notice how it takes 6 years to start to even become noticeable but takes off like a rocket between 10 and 20 years. This is what most people don’t account for and what makes people wealthy long term.
Conclusion
I asked the question at the beginning, what are you trying to achieve? If your goal is to take your long term savings and grow them to become wealthy, the answer is simple: invest in a diversified holding of stocks and bonds and don’t touch it. Just put it on auto pilot and add to it continuously. That’s all there is, there are no tricks and no secrets, it’s just discipline and patience.
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