Stock market investing for dummies — 1
I’ve been meaning to write this for couple years now. During the last week I’ve been approached on three different occasions by my friends with the same question:“How do I invest my money, especially in a 401K plan?” So, I decided it’s time to finally do it… besides, it’s a good time killer for a long plane ride ☺
Stock market investing for dummies — 1
This is my attempt at trying to write a very simple and hopefully short guide for stock market investing. So from now on when somebody asks me about investing, I can ask them to read this first ☺
However, I’m not going to be able to go into depth in everything, so Google is your friend. My idea is to give you some pointers which you can then use to learn more by yourself. I’m also surely not the most knowledgeable guy on this topic, so don’t take anything I say as a final truth.
First, it’s actually not that hard to get average market returns on a stock market, but it’s way harder to get returns above the market. This post is about how to get market returns, which would be good enough and useful for most of the people. This is not about how to beat the market.
Disclaimer: this is written for people who don’t know much about investing and not professional investors, if you already know about investing, you’ll probably be really bored. And, of course, I’m not responsible for anything, so proceed at your own risk.
Basic premise of stock market investments
The basic premise of investing money in a stock market is that you can grow your money better than other alternatives. If you look at stock market returns long term, you will see somewhere close to 10% over many years. That is better returns than your bank account, although it’s riskier too.
It is important to understand; you need to be ready to wait. The stock market fluctuate, there are some downturns during which you can lose some of your money and the worst thing to do is to take money out of the market during a downturn. So, if you are thinking about putting money into the stock market, do it only with the money you are not planning to touch for at least 5–7 years, preferably more.
First step, take your time and learn at least a little bit about investments.
The analogy related to this, which I usually like giving to people is: if you are be able to take a week long course after which you are guaranteed to increase your salary by $10K a year, for all following years, would you take a week of vacation and take such a class? Yes, of course! Then, why, wouldn’t you take such a class about investments??? If you are mid-career successful professional, you probably have in your investment accounts (retirement, 401K etc.) more than enough money to make a difference bigger than $10K a year depending if you invest smart and not so smart.
As another illustration, I have a friend, whom I helped to re-balance his 401K recently. The performance of his previous selection was such, that in about 6 years, on on $100K investment he earned about $30K+. It sounds not that bad, but if he would do from the beginning the same selection we created now, he would’ve earn about $70K, twice more, with the same amount of risk, by just better selections.
That is why, it’s really worth your time to invest in some education on this topic.
Financial advisers don’t work well
It sounds natural to outsource this to a professional, but the problem with many financial advisers is that their interests are not exactly aligned with yours. The ones which would “help” you for free are complete sham, because guess what? “if you’re not paying for the product, you are the product”. Such advisors do it for free because they are getting paid by the financial companies, who sell you their products. So their interest is to push you into some investments because they’ll pay most to adviser and, usually it’s not the investment, which will give you the best return.
The ones who just take a per-hour fee are better and their interests are more aligned with yours but still, as I’ll explain later, nowadays you can easily construct a decent market portfolio by yourself and be in control of it.
Diversification of Portfolio
Important thing to understand is that whatever portfolio you build has to be well diversified. What does “diversified portfolio” means? It means you have at least several different securities in it. These securities will behave a little bit differently. This from one side will soften the blow when things will go bad; From another will help you to get advantage from the upside of asset which is doing better than another. In short, you’ll get an average market return, which is what we are trying to achieve.
In theory, a really diversified portfolio needs to have stocks, bonds and other things, may be even real estate, but here, I’ll stick to what I know better, which is stocks.
How many things should you keep in your portfolio? You need to have several and they have to be different, but I’d suggest to keep it balanced, so you won’t have to oversee hundreds of different positions.
As example of what you couldhave as a basis of diversified portfolio, you should have in it different indexes, like (only a short description here, use internet to learn more about each one of whose names):
- DOW — DOW Industrial Average
- S&P 500 — Standard and Poor 500–500 biggest stocks on US market
- Some international stocks (as indexes)
- Some small caps, some mid-caps indexes — small cap stocks are smaller companies (but still traded on stock exchange — less than $100M valuation)
- Some different industries — if you have broad market indexes, you don’t need to have every single industry, but if you believe that some industry will grow better than others, e.g. High-Tech or Biotech, you may want to add this particular industry to your portfolio.
Single stocks, mutual funds or ETFs (Electronically Traded Funds)?
Should you buy a single company stocks? Well, first, whatever was said about diversification on a portfolio level is 100% applicable on a single industry or other category level. So, if you’d like to buy some stocks, you better have several of them for each category. But the bigger problem with single company stock is, that it requires you to really understand everything about this company, read a lot of material and continue studying it while you own this stock. All of this is a problem, you need to know how to read financial statements, analyze the company, you need to continue spending time on following this and you need to do it for every single stock you have in your portfolio. On top of all of that, there is an information asymmetry here, doesn’t matter how good you are at this, there are analysts, who cover the particular stock and they will always know more about it than you do, so professionals will always be ahead of you in this game. So, if you are not a professional, my suggestion is, don’t play with single stocks.
What about mutual funds? Mutual fund is basically a bunch of stocks, picked up by professional managers of this fund, so theoretically it should be better, right? Well, not so fast… two problems: not all the managers are actually that good and, second, they get paid for managing this fund, quite well actually, so from whatever money you put in the mutual fund, some portion is going towards these expenses (see expense ratio, front/back loads etc.). As a result, most of mutual funds are under-performing the indexes they try to beat.
The solution to this are ETFs, Exchange-Traded Funds. The way ETF works is like a mutual fund, but without any active management. In simple words, it automatically buys all the stocks in a single index according to their weight. Since it emulates the particular index, it gives you all the advantages of diversification within this index, but since it’s automatic, passively managed, it’s expenses are usually way lower those of an actively managed fund.
Note here, there are also Index Funds, which technically a different thing than ETF, but they behave very similar, so they are pretty much interchangeable.
So, to summarize, ETFs are the best option for most people who are trying to get market returns.
Dollar cost averaging
In theory, you should buy when the market is low and sell when it’s high, but in reality, could you really time the market? Probably not. Even professionals can’t do it and usually trying to time the market leaves you either sitting on sidelines or paying too much. So what you should do is use a simple technique called dollar cost averaging: let’s say you want to put $50K into the market, instead of buying whatever you plan to buy in one shot, you divide it by about five $10K blocks and buy every week for $10K whatever you were planning to buy. This way if the market goes down, you buy some at higher prices, some at lower, so, instead of risking to buy at the top price, you know, that you’ll always get an average.
- It’s not that hard to get an average financial returns from a stock market
- You don’t really need financial advisers, especially be aware of the ones which are “free”
- Create a diversified portfolio
- Use ETFs instead of stocks or mutual funds
- Don’t try to time the market, use dollar cost averaging
- Learn more about investing!
To be continued…