How to Start Investing and Beat Wall Street (New Grad Money Series Part 3)
Set and forget. This guide will tell you exactly what to do in a TLDR format and get all your main bases covered out of undergrad so you can focus on your job and friends. You’ll have your retirement and investment accounts set up, insurance accounted for, housing planned, monthly fun coupon limits calculated and more. 3 to-dos per article and how. Learnings from 30 personal finance books and conversations with wealth managers.
TLDR To-Do:
— — — — — — — — — — — — — — — — — — — — — — — — — —
Series Preview Contents
Part 1: Introduction and First Steps
Part 2: Why the Rich Pay Less Taxes and How You Can Too
Part 3: How to Start Investing and Beat Wall Street
- Why saving isn’t good enough anymore
- Lazy method: Learnings from Warren Buffet
- Active method: Making money with what you know
- How much do I invest?
- Frequently Asked Questions (FAQ)
Part 4: FAQ
— — — — — — — — — — — — — — — — — — — — — — — — — —
Investing well is hard. It’s even harder coming out of college where you’re just getting started with work and settling into a new spot. Guidelines here are based on books, conferences, and interviews of investors like Warren Buffet, Peter Lynch, and Cathie Wood.
Why saving isn’t good enough anymore
TLDR: The price of everything doubles roughly every 22 years, so your earning power slowly erodes. Don’t let this happen — invest your money.
Inflation is why your grandparents whine about the price of everything. Inflation is why my McChicken isn’t always a dollar anymore. Inflation is what happens when you leave your money in the bank without investing it somewhere.
Since the US began tracking inflation in WW1, our good friends around the world have lost around 3.22% of their money to inflation every year. What it costs you to buy the same things today, will cost roughly double in 22 years. This is why most of the wealth owned by the upper-class isn’t sitting in cash. Don’t let your money sit and do nothing — make it work for you.
If you still don’t believe me, think about how banks make money:
Banks pay you interest when you store your money, and they lend out your money elsewhere to get a higher interest rate for themselves. The difference between what they pay you and what they earn is their profit. Granted, putting your money in a bank is very safe, but a long investing time horizon coming out of college mitigates a lot of those risks for you. Takeaway:
Cut out the middle-man — invest your money directly if you don’t immediately need that money for a near-term purchase (i.e. medical bills, a house downpayment etc.)
Lazy method: Learnings from Warren Buffet
TLDR: Stocks are unpredictable and even the pros often get it wrong. The market (i.e. S&P500) consistently outperforms active money managers over the long-term. Warren Buffet (a smart man) recommends buying ETFs for most investors. Be like Warren.
TLDR To-Do
From your IRA or your individual investing account, look for any of the funds investing in S&P500 (i.e. Vanguard 500 Index Investor Share Class (VFINX), or iShare Core S&P500 (IVV)). From your 401k you’ll likely have a target-date fund — the longer term the fund, the more aggressive it will be. It would not be irresponsible to put most (if not all) of your invested money in market-based index funds.
Below is a chart of the overall market from 1950 to 2019. If we hadn’t labeled Black Monday here in 1987, you would’ve barely noticed a dip. But at the time, it was a big big deal. I also didn’t label 1953 after the Korean War, the 1973–1975 oil crisis, or the 1980s Iranian revolution because they’re hardly visible. At the time, these were large-scale events that caused substantial economic loss for investors. The big takeaway here is, don’t worry if the market dips because over long periods of time, the market recovers. Buy at consistent intervals with money you don’t need within 10 years. Even the worst economic events are recovered over time.
Big takeaway 2: You don’t want to have to sell at one of the dips to pay your bills because it’ll cost you a lot on potential growth in the long run. If you need to sell your stocks in order to cover your bills, you’re investing too much of your paycheck, and you should likely be focusing on growing your income. Investments in classes for yourself to grow earning potential through technical (i.e. coding or modeling) or soft skill (i.e. sales and management) coaching will yield infinitely higher returns.
See here if you’re not sure how much to put into your investments.
Why
TLDR: Because active management rarely wins. Buffet made a $1M bet against professional active managers (hedge funds) that the market would out-perform over 10 years and he won $1M dollars for a little girls’ charity. The gander was a blowout.
If you think you can manage money better than the hedge fund managers and investment managers of the world who pick stocks for a living, read on. In 2006, Warren Buffet issued an open challenge to the hedge fund industry. He stipulated that if any collection of hedge funds out-perform an S&P500 index fund, he would donate $1M to charity. Hedge funds are the epitome of active management and usually charge a steep fee for the management of money. The S&P500 is representative of the overall market and can be bought for almost no fees using Exchange Traded Funds (ETFs).
In 2007, Ted Seides of Protege Partners took him up on the challenge and selected a basket of hedge funds, confident that the hedge-funds would vastly outperform the market. The result?
The S&P500 vastly outperformed the hedge funds over the space of 10 years BEFORE FEES, and it wasn’t even close. Although the performance of actively managing your own money can vary widely (sometimes drastically in your favor), returns tend to regress to the market over time. Usually, due to the higher volume of trades that investors like us tend to feel is necessary, we also tend to make more mistakes. If you have been doing well over the last few years or you won big on a few Robinhood trades, and you think you have what it takes, notice that everyone around you also won, like a game of craps. All you did was be the riskiest chap or chappette and you got lucky. You can make the riskiest plays and win because people in the stock market are optimistic, but when the worst of the economy hits the fan, you’ll be the first to be wiped out. At this point, notice that earning 10% of $100 is far more than 10% of $50. Even if the market moves up at a healthy pace after you lose, you’ll still be left behind if you dip.
That’s not to say that actively managing your money is not a worthy venture. Active management tends to outperform in economic downturns. In the gander between Seides and Buffet in the 2008 recession, the hedge funds outperformed the S&P500 by quite a few percentage points. Even then, if you just wait a few more years, the S&P500 will likely eventually outperform.
Active method: Making money with what you already know
TLDR: Read as much as you can — very few blogs (if any) will give you enough information to beat the market. Invest in things you understand through work or your hobbies or your friends. You’ll hear of news before institutional investors will, and you will have a better gauge for the story and objectives of the company as well as its most recent developments. It would be very difficult to purely “out-analyze” the institutional money managers on the valuations of stocks and outperform financial analysts from simply Googling about stocks for a few hours.
Investing well is tough. Different styles of investing all intersect at an understanding of business, familiarity with numbers and probability, industry analysis, economics, psychology, and philosophy. The best we can do here is to learn from the best who have tried and true frameworks of investing to beat the market.
Book Recommendations
To get started with:
- Rich Dad Poor Dad by Robert Kiyosaki
Skippable if you’re already motivated to learn investing/wealth building but still a very fun read. Rich Dad Poor Dad is not 100% an investing book and discusses very little hands-on practical knowledge, but provides a very core understanding of what it takes to build wealth. His anecdotes help put investing into a very understandable perspective that has stuck with me since I picked it up.
TLDR Takeaways:
- A high salary ≠ wealth. Wealth is having assets (real estate, stock, bonds) that generate income passively to support your lifestyle in retirement.
- The middle-class and the poor work for their money. The rich have their money work for them.
- The poor buy liabilities and think they are assets (i.e. cars, TVs, new phones etc.). The rich know the difference.
2. The Intelligent Investor by Benjamin Graham
The bible of value investing written by Warren Buffet’s teacher Benjamin Graham. If you’re looking for a quick profit in speculative investments, this book is not for you. The principles here are focused on making long-term investments, minimizing losses through tested portfolio management, and improving returns through disciplined research and analysis into unpopular stocks and bonds. While the book itself is written in layman’s terms, I warn that the book is far drier than other reads. Its advice is highly practical and is a great first step to learning investing.
TLDR Takeaways:
- The main principles of investing are: analyze for the long-term, protect yourself from large losses, and don’t speculate in risky trades for profit.
- The Market is untrustworthy in the short and medium-term. Don’t trust that the market is right.
- Be disciplined in your investing framework. Stick to what you believe in and continue to test and improve.
3. One up on Wall Street by Peter Lynch
My personal favorite. Peter Lynch, a famous portfolio manager of the Magellan Fidelity Fund, details how to invest in small to medium-sized “story” companies by investing in spaces that you are already familiar with through work or your hobbies. Peter Lynch’s philosophy is the philosophy of investing that makes the most sense to me.
TLDR Takeaways:
- Invest in what you know: The more you understand the dynamics of a business, the more likely these success stories will come true. Keep a lookout for good investments, through work or your interests. (i.e. I like building PCs so I keep an eye out on the latest developments in GPUs and semiconductors).
- Invest in stories: What is the company going to do, how well is it positioned among its competitors, and can the stock be purchased at a reasonable price?
Building an Investing Framework
For the last four years, I’ve only invested in equities, long-only. I’ve outperformed the market by a few percentage points as of September 2020, but I can’t say that the method is refined and proven, or that I know anything about investing because everyone won over the last few years. My rationale for my investing framework is built off of general wisdom from Buffet, Graham, Lynch, and Cathie Wood through conferences, podcasts, readings, and articles. I also try to incorporate learnings from my work in finance. Please take this framework as an example to follow with many grains of salt and buckets of MSG. Screen all companies until you eventually reach a few companies for the last few criteria.
- Is it a business I’m interested in?: Investing in companies I don’t find interesting is a tough task. I find that I have no willpower to read about the latest developments or to read about trends that affect the business. Even if the business has a cheap price tag, I still find myself hesitant because I’m not an expert in the industry and never will be. In 2017, when I earned my first few dollars, I was very interested in building computers and saw that Nvidia had one of the most loyal enthusiast pc-building customers in the world. I myself loved Nvidia’s graphics cards and, in tandem with my view that eSports and data processing were growing too rapidly to ignore some sort of investment, I put every dollar I had into Nvidia stock. Every dollar there has since grown over 360%. Whether that was pure luck or proof of some sort of methodology, only time will tell.
- Industry trends: I like to focus on companies in industries that are growing very quickly, or on companies that have a small portion of a stable total market they are catering to with a very distinct advantage to grow revenues. For example, I would stray away from car manufacturers because industry revenues have been declining by an estimated 37% per year. Any investment in this space is likely an uphill battle. I also like investing in attractive industries because there is more room for error and less heat from competitors who are looking to grow the pie rather than divvy up a zero-sum game.
- Competitive Advantage: When Coca-Cola first came out with their soda in 1886, people loved it. As the drink picked up and continued to grow, imitators quickly tried to capitalize on Coca-Cola’s success by imitating Coke’s recipe. Because Coke had a reputation for creating the original Coca-Cola and holds a recipe very few people have access to, Coca-Cola has remained one of the most dominant soft-drink producers in the world. A competitive advantage can be anything from a strong brand, to intellectual property, to a trade-secret, to production advantages, to cultural advantages, and finally, to defined operational advantages. The VRIO framework or porter’s 5 forces are excellent for this section of the analysis.
- Strong Management: Even if I had a golden horse with massive Schwarzenegger style muscles and a rocket booster behind me, I doubt I would be able to win the Derby. At the end of the day, I just don’t know how to ride horses. The same goes for management. It’s not easy to run a company. Your investment is as much a bet on the rider as it is on the horse. Make sure your management is:
- Experienced: Dell was a struggling public PC-Centric business up to 2013, before Michael Dell, the original Founder, chose to buy back the company and invest in long-term growth. Investing over $4B dollars of his own stock and an additional $750M in cash, he has since grown his position in the business to roughly $30B. His intimate knowledge of the business, successful precise acquisitions, and an understanding of the business’s value drivers in the long-term ultimately transformed the company from a fallen-angel to a hail-mary success.
- Innovative: In August of 2013, JC Penney’s board replaced Mike Ullman with Ron Johnson, the executive behind Apple’s tidy Genius bars and sleek retail stores, in an effort to modernize the business and replace coupon clippings with all-time discounts. While the executive choice initially drove stock prices up, the business ultimately failed under Ron Johnson’s leadership, and Johnson was quickly replaced by the same executive he initially replaced. What went wrong? Many factors outside of Ron’s control were responsible, but also, there were many factors that were direct results of his decisions. Ron Johnson was not familiar with the perception customers had for JC Penney, and as a result of coupons disappearing, customers no longer felt they could shop at JC Penney and therefore, never returned. Ron Johnson has a full suite of innovative skills and experience but was lacking in other areas that were necessary for growth at JC Penney. I look for management executives that are well rounded and that have experience in similar turnarounds or growth stories.
- Integrous: Has executive compensation increased during times of economic contraction? If so, management likely does not have shareholders’ interests at heart. Are management compensation packages aligned with performance? I look at the annual filings released by the company each year (10-K). Paypal is an excellent example of a company with great alignment of executive compensation because A) Stock options are vested over multiple years, B) Restricted stock is awarded when the company achieves target revenue and free cash flow goals, and C) Stock compensation is awarded to the CEO when the price of Paypal shares reach a certain level over a 5 year period. You can bet that management is going to try their best to get some coin.
5. Clean balance sheet: Companies not burdened with debt. Interest on borrowed money can get expensive quickly, so be on the lookout for companies that may not generate enough cash flow to pay off their debt balance. I would look at these numbers as a multiple (i.e. total debt / free cash flow or total debt / EBITDA) relative to the multiples of your company’s competitors. As with a price to earnings multiple, a debt number alone does not tell you the full picture.
While this analysis may seem broad, I wanted to keep my framework as transparent and universal as possible. These traits allow you to compare different companies across industries and will act as a bulwark against emotional decisions to buy or sell.
Additional Important Notes
- Financial analysts are rarely correct: If you google any particular stock and why you should buy it, you would likely be able to find a similar recommendation to sell it. Analysts are paid to predict performance for the next twelve months and can rarely accurately predict good long-term price targets for buy-and-hold investments. If they could truly accurately predict the price of stocks with high certainty, they would not be working at a financial firm writing research reports for other people to buy or sell.
- Create a framework to test: Without a framework to transparently and universally evaluate each part of a stock purchase, there is no baseline which we can continuously iterate upon and improve. Without a framework, all we can do is invest off a gut feeling which is often affected irrationally by impulse and emotion. The simpler your framework for investing is, the easier it will be to apply the same framework to various industries and companies. There is a lot of helpful information on the direction and strategy with which management would like to take the company in the “Management Discussion and Analysis Section” of a 10-K annual report and within the “Business Summary Section”.
- Keep your framework simple: Warren Buffet has one of the simplest frameworks for investing. At its core, he chooses to buy companies that will make money for long periods of time and that perform better than peers producing similar products or services.
This is a very abbreviated view of investing but there are plenty of other resources online and in-paper that approach each facet that I didn’t address. All I can show here is what has worked for me and what I find to be most reasonable through my readings, current understanding of finance, and conversations with investing professionals. Consult an advising financial professional when making major financial decisions.
How much do I invest?
TLDR: For a new college graduate with few near-term financial obligations, I try to maximize my savings in my Roth 401(k) and my Roth IRA first whenever possible, followed by my other investments, and finally my fun-coupon checking account. Example for my friend below:
I based this graph off a close friend who asked me to help set up their bank accounts and savings. In summary:
- Emergencies first — you never know when you’ll need it
- Pay yourself before you pay anyone else — you work for you
- The bills
- Remaining Cash minus monthly spending needs = additional savings in taxed advantaged accounts — extra goes into regular investing accounts
Hope this helped friends. Feel free to message me with any questions or comments below.
FAQ
- If stocks usually go up in the long term, why not just buy a levered index fund (amplified returns or losses) or buy long-term stock options?
There is certainly potential for extra upside. However, what usually happens is that losses and fees compound. Here’s what your returns look like on a $100 investment if each month you alternate between gaining 5% and losing 5% for 20 years. This effect worsens when movement is compounded daily (which it is in real life).
On top of that, fees for operating a levered ETF will further eat away at your returns. Unless you have a specific reason for a short-term play, I would stay clear of levered ETFs.
2. What types of companies return the best money?
Historically, small companies can be bought for value. But that’s not the whole picture.
Small-cap stocks perform the best after economic downturns. They grow fast and are the first out of the dirt. But for the rest of the time, small-cap stocks usually get crushed by large-cap stocks, especially in industries where a few large companies control the large majority of the market (i.e. cereals and semis). If you want to invest large sums of money in smaller companies, be prepared to last long periods of time without being in the green.
3. When should I buy gold or oil?
In general, I would not consider purchases of commodities as investments because the commodity itself does not generate income. While there are certainly times where buying commodities could be worthwhile, they are complex speculations that do not always correlate with general wisdom regarding their purpose. For example, gold does not always retain value best in an inflationary environment. Low oil prices do not always stimulate the economy.
4. I think the market is going to fall. Should I short it?
I would think long and hard before shorting anything. The issue with shorting is that there is no limit to how high an asset price can go. That means that your potential losses on a short are infinite as well. On the other hand, if you just buy assets, your losses will be limited to the amount you put in.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
