Investing 101— Save, Invest, Repeat (Part 1/2)
Conventional wisdom states that to be “financially independent”, you must spend less than what you earn and purchase assets with your savings. These assets over time generate income, which can be used to buy more assets and generate even more income. Sounds simple enough, but where do you start?
Most people assume that investing is a complex art only a certain number of “qualified experts” can carry out. However, the only skill required is time and patience. Investing doesn’t have to be hard, as long as you manage your expenses and stick to the plan.
The first step in a successful investment plan is to save money. I recommend saving at least 20% of your income each month. To start, make a list of your monthly expenses. Identify costs you can live without or substitute for cheaper alternatives. Be honest with yourself. Stop eating out every day; instead, buy groceries and cook. Make coffee at home instead of spending $4 at Starbucks. Take the subway or the bus, instead of an Uber. Limit a trip to the nail salon twice a month instead of every week. I’m not saying cut every expense, just be more cogniscent of living within your means.
Think of savings as if you are “paying yourself first”, a pseudo-tax you are withholding and growing for a future self. Therefore, move the 20% as soon as you receive your paycheck, so you don’t have to worry about “accidentally” chipping into your savings.
The next item is to PROPERLY invest what you save each month. But first, some background material on the different types of assets we will be dealing with throughout the article.
Stocks
Stocks represent actual ownership in a company. If you own 100 shares of a company with 1,000 total shares, you own 10% of the entire company (100/1,000).
Everyone is familiar with the stock market — thousands of companies with prices that change every few seconds. It is important to understand that a price change is simply a by-product of a successful trade — i.e a particular owner selling stock to another buyer.
As an example, say you want to buy stocks of “Company X” currently priced at $100. For you to buy, someone has to sell. Assume that someone is willing to sell for $101. As a result, the price will effectively jump to $101, at which point the transaction between you and the seller can take place. This is a rather simplified overview as there are millions of buyers and sellers at a given time, but the basic principle applies.
Over time, as companies grow, the price(s) at which such trades occur continue to rise. Using the example above, say 2 years down the road, “Company X” is priced at $150. At this point, if you chose to sell, you make $49 per share (since you bought it at $101).
Besides selling stocks for a profit, another way you as a shareholder can generate income is by receiving dividends. Some companies chose to distribute part of their income to shareholders. Therefore, you make additional income by merely holding the stock of a dividend-paying company. Do note that not all companies pay dividends.
In summary, stocks increase your wealth in one of two ways:
- You sell at a price higher than what you paid
- You accumulate dividends for the time you own the stock.
There is one final point to mention here — taxes. When you sell for a profit or receive a dividend, Uncle Sam taxes you. The key thing to note is if you sell a stock more than a year after you bought it, you pay substantially less in taxes than if you own it for less than a year. And less taxes means more money in your pocket.
S&P500 Index Fund
Remember, the stock market contains thousands of companies changing hands every second. If you are a super investor (only a handful of people can be classified as such), you know what companies to selectively buy and hold for a profit. You are not in this category; a several caveats if you think you are:
- The stock price is different from what’s going on inside the company. Exciting companies (for example, Amazon or Netflix) are overly expensive compared to their true value, due to people’s inflated expectations for the future. If you buy, you will overpay. The stock may keep rising; however, even a small hiccup will cause a massive drop, which will lose you money.
- It is pretty common to get lucky and show great returns with the first few bets over a year or two. However, it is completely different to show superior returns over a period of 20+ years. Human psychology — especially over-confidence — makes you over-exaggerate your abilities. Your results will revert back to the mean, usually in the form of consecutive losses.
- Buying and selling individual stocks is stressful. You will be checking the stock price every day. When you see red for a consecutive number of days, you will lose a general peace of mind, most likely resulting in you selling your positions at a loss.
Fortunately, there is a better and less stressful way to own stocks, but not have to worry about picking the right companies. This is by buying an index fund that tracks the S&P500. Let’s break down the 2 components:
“Index fund”
Everyone has heard of mutual funds . You give money to managers who invest it for you. An index fund is essentially a mutual fund, but the managers have an easier task— instead of picking individual stocks, they simply match a particular market index.
“S&P500”
The S&P500 is a market index that tracks the aggregate price of the top 500 companies in the US.
In essence, when you buy an index fund tracking the S&P500, you are buying a piece of 500 of the top companies in the US. This way you are betting on the U.S economy as a whole, instead of individual stocks that can go up or down for too many reasons to outline.
There are a number of additional benefits to index funds:
Buying index funds is simple. When buying individual stocks, you have to specify the number of stocks you wish to purchase. The problem is obvious: if you have $100 to spend, you may not be able to buy even a single stock of the company you want. With mutual funds, you don’t have to worry about the quantity. You can invest $100, and if the price of the fund is $200, you just end up owning 0.5 shares of the fund.
Take advantage of compound interest + dividend re-investments. Say you invest $100 in an index fund at the beginning of the year (Year 1). During the year, the price of the fund increases 10%. At the end of Year 1, your initial $100 investment is now valued at $110 ($100 + 10% growth = $110).
You also receive a 2% dividend payment at the end of the year — remember, you own a piece of the top 500 companies, some of which pay dividends. You can re-invest the dividend payment to buy even more shares of the fund. Therefore, at the end of Year 1, the same $100 is now worth $112, a monetary gain of $12.
Summary of Year 1
- Initial Investment → $100
- Fund Growth → 10% of $100 = $10
- Dividend Payment → 2% of $100 = $2
- End of Year 1 Value → $100 + $10 +$2 = $112
Fast forward to the end of Year 2. Assuming that the fund grows at the same 10% rate AND you earn/reinvest the 2% dividend return, the $112 will now be worth $125.44, a gain of $13.44.
Summary of Year 2
- Beginning of Year 2 Value → $112
- Fund Growth → 10% of $112 = $11.20
- Dividend Payment → 2% of $112 = $2.24
- End of Year 2 Value = $112 + $11.20 + $2.24 = $125.44
Notice your fund’s growth each year — $12 during Year 1 and $13.44 during Year 2. Not only is your asset growing, but the rate at which it is growing is also increasing. This is the power of “compound interest”.
If the investment followed something called a “simple interest” pattern, you would earn 10% each year on the initial $100 investment. At the end of year 2, your asset would be worth $120.
Initial Investment → $100
Year 1 Return → 10% of $100 = $10
Year 2 Return → 10% of $100 = $10
Comparing the two models, notice the additional $5.44 in the “compound interest” example ($125.44 instead of $120). This additional growth might not seem like much, but over the years, it really adds up. So much so that the great Albert Einstein has been quoted to say that “compound interest is the most powerful force in the universe.”
See the image below, where the red line represents compound interest over time, compared to the counterpart.
Index funds offer better returns than “active funds”. The results of the S&P500 has beaten 92% of active money managers over the past 15 years. (SPIVA). By active money managers, I mean individuals who pick individual stocks, as compared to the index funds’ “passive” nature of simply replicating an index.
10 years ago, the legendary investor Warren Buffett issued a $1 million bet to the hedge fund industry that they could not put together a portfolio that would outperform an S&P 500 Index fund over a 10-year period. One company, Protégé Partners LLC, accepted the challenge and selected five funds, while Buffett selected the S&P500 Index Fund offered by Vanguard.
The result? Over a 9 year period, the hedge fund portfolio gained 22 percent; the S&P500 gained 85.4% — more than 4X the hedge fund’s return! Furthermore, not even one of the five funds that Protégé selected beat the S&P500 return. The bet was so one sided in the S&P500’s favor that it was actually settled a year ahead of schedule.
Index funds charge less in fees than “active funds”. When you have money invested in a fund, you have to worry about the yearly fees. Index Funds, compared to actively traded funds, are 5–10 times cheaper to won.
Not only do index funds generally perform better than “active funds” in the long term, they are more cost effective. Don’t believe me that fees matter? Check out the image below:
That wraps up what you need to know about stocks and why low-cost S&P500 index funds should get your focus.
Part 2 will dive into other important investment options. I will also provide a step-by-step breakdown of exactly how you should be investing.
