Learning How To Invest (Part 1)

Hi,

I’d like to start with an idea: fear is essential for protection, but fear also makes one irrational. This goes for anything, but especially for money. According to Behavioral Economists studying investing mindsets, “losses loom larger than gains” — a loss is felt approximately twice as powerfully as a gain (Kahneman & Tversky, 1979).

I think that’s why investing used to seem so foreign, so beastly to me before. It meant volatility, loss, and uncertainty more so than anything. This project is my attempt at combatting the fear: by wading into uncertainty and learning how to swim.

This is the first installment of my mini investing journey. I am not an investment expert, so please do not consider me one. I am just here to learn and document my journey. These notes are written for those who’d like to understand basic concepts around investing, informed by books that helped consolidate my knowledge (Investing Reading List).

1. The Advice I’ve Been Given

When I had a conversation with my dad about investing, he candidly told me: “Nicole, I have lost a lot of money on stocks.” Encouraging. “They’re risky,” he continued: “I’d rather you think more about safer streams of income rather than individual picks.” He cited the forms that he’d like me to use: REITs, index funds, and ETFs (I will comment on these later).

My dad had a great point that investing should not be entirely individual stocks and he was the one who introduced me to the idea of ‘diversification’. However, I disagreed that I should avoid investing in stocks entirely. Being young and having a limited amount to invest in the first place means that I have a longer investment horizon, and can, therefore, afford more risk than someone closer to retirement age.

Who was right? Was stock-picking too ‘risky’? Should I avoid it completely? Would I be wasting time and money? With competing perspectives, I turned to books to get a better sense of the investing world and how to proceed. I decided to keep digging and record the insights on this blog so I have clear documentation of my rationale behind my investing ideas. First, I started learning about the theory of diversification, and the different investment vehicles I could invest through.

2. Diversification: The Whole is More than the Sum of its Parts

Winner of the Nobel Memorial Prize in Economics (1990), Harry Markowitz, came up with ‘Modern Portfolio Theory’. It supposes that every investor wants to achieve the highest possible long-term returns without taking extreme levels of short-term market risk. However, this is impossible to do without diversifying a portfolio. If you have a portfolio filled with only stocks they might reap a higher return, but also come with higher risk. If it was only filled with bonds, the return would likely be lower but the risk would also be lower. If you combine both, however, you reduce risk while increasing potential returns. Bonds and Stocks also tend to be negatively correlated. Investing in both effectively reduces the risk of your entire portfolio declining drastically. These offsetting results can limit the volatility in your portfolio while improving its performance. The risk is spread among different types of securities that act in different ways (Source: TD Ameritrade).

Key takeaways from multiple books I read also emphasized the importance of diversifying. In Unshakeable, Tony Robbins argues that an investor should:

1. Diversify between assets across classes (real estate, stocks, bonds, commodities, private equity)
2. Diversify your holdings within asset classes (avoid concentrating putting all of your money into one stock or bond; you must diversify even within your asset classes)
3. Diversify globally (different markets, countries, currencies)
4. Diversify timelines (dollar-cost averaging, maturity date)

3. Descriptions, Pros, and Cons of:

Index Funds

Description: A fund replicating the performance of a benchmark market index.

Essentially, index funds are a collection of securities (think of it as a basket of securities) that mimic the market.

Example: an index fund that tracks the S&P 500 (top 500 companies in the United States). By investing in that index fund would mean you own a tiny fraction of each company within those top 500 companies.

Websites and Reading: ‘Unshakeable’ by Tony Robbins, and this youtube video provides a really easy definition for audio learners!

Index Fund Pros:

• You can have a diversified set of companies and avoid completely correlated assets (not all of your eggs are in one basket).
• Despite market crashes, the overall market has generally gone up over time — so it makes sense to invest in the stock market as a whole.
• They are mostly automated, with no sales commissions and fewer trading fees. This makes them lower in cost compared to other mutual funds. This makes it easier if you have limited investing funds to get access to investing.
• Tip: Expense ratios vary for different brokerages, so choose the lowest expense ratio for the index fund in question, because the different brokerage index funds are essentially tracking the market index passively — there is no advantage in paying more for the same product.

Index Funds Cons:

• You have to buy the entire set of companies within that index (even if you don’t support their mission). Lack of ability to pick and choose stocks within the fund that are over or undervalued.

ETFs: Exchange Traded Fund

Description: Fund tracking indexes of a specific exchange.

ETFs are listed on an exchange (as the name implies), and you use a brokerage account to buy/sell. ETFs are categorized by the types of investments held. So, you could buy a sector-specific ETF like healthcare, or you could buy a commodity ETF like gold, oil, or natural gas ETFs. ETFs trade intraday like stocks.

ETFs Pros:

• Niche Sectors: If you believe in the potential of the sector to outperform the whole stock market, many US ETFs are more narrowly focused on a niche.
• For example, in this coronavirus situation, there may be hypotheses you’d like to test out if you feel certain sectors will continue to thrive despite uncertainty (like now!) A basic example is one I’ve been tracking: VPU (Vanguard Utilities ETF) — people need utilities whether they are staying at home or not.
• Low Cost (compared to mutual funds)

ETF Cons:

• Trading Costs: Some ETFs generate a commission per trade
• Market-Timing Anxiety: One large difference between ETFs and index funds is that ETFs can be traded in the day whereas index funds are priced on the close. ETFs prices, therefore, fluctuate greatly, causing one to potentially try to time the market and feel anxiety if the price goes down after it is bought.

Bonds

Definition: A fixed income instrument in which the bond issuer borrows money from the investor. The investor gets payments with interest. They have maturity dates by which the principal will be paid back to the investor. They are correlated with interest rates.

Bonds Pros:

• Bond owners issue payments on coupon dates, giving more certainty to the cash flow timing.
• Less Risky: bond owners are obligated to pay the coupon, while stock issuers are not bound to issue dividends.
• Clear Credit Quality: Bonds are rated on the financial strength of the company issuing the bond and its ability to make interest payments and repay the principal of the bond.

Bonds Cons:

• Inflation may reduce the purchasing power your bond earnings have in the future.
• Interest Rate Risk: Bond prices tend to decrease in value when interest rates rise.
• Less potential return than Stocks.

Stocks

Definition: Stocks are equity investments that represent legal ownership in a company. You own a little piece of the company you invest in.

Investing in stocks requires you to do research on a particular company and have a strong belief that this individual stock has a durable moat (competitive advantage) and you believe that it has strong management and principles that will keep it relevant and growing in the future. Stock prices fluctuate a ton due to information given to investors because it is like an auction. When more people bid the price up, the price can increase, and when people don’t want to buy into the stock, the price decreases.

One example I have been following is Luckin Coffee, a public company in China that was predicted to beat Starbucks in China. Within the past 6 months, the price of Luckin shares fell from a high of 50 USD on January 17 to 2.82 USD as of May 21, 2020.

Source: Yahoo Finance (Luckin Coffee)

Why would this happen? The answer is that there was new information that discouraged investors that previously supported and believed in the company, leading to investors selling their shares and dropping Luckin. The information in question was that the company faked $310M worth of transactions! This just goes to show that stock picking can be risky, if you had invested all your savings into Luckin, you would be in a very bad position about now.

Websites and Reading: ‘One Up on Wall Street’ by Peter Lynch, ‘A Random Walk Down Wall Street’ by Burton Malkiel.

Stocks Pros:

• Regular Dividend Payments: dividend payments are quarterly payments that companies send out to shareholders. This means you get a steady stream over the years without selling your shares off. However, dividends may be used to falsely signal health in a company because dividends could also be used to reinvest in the company’s future growth.
• Potential to Outperform the Market: If you believe a company will grow and prosper and that the market has mispriced it, there is a chance to buy stocks for ‘pennies on the dollar’ — investor speak for ‘at a bargain’.
• Read Peter Lynch’s One Up on Wall Street: an encouragement for the individual amateur investor that independent information (Eg: if you know about certain industries through everyday life that is hard to discover through research) can be used to beat even professional investors. (However, this requires in-depth research as a lot of a company’s potential and information has already been reflected in prices. This is known as the ‘Efficient Markets Hypothesis’.)
• Liquidity: You can sell stocks for cash quickly through brokerage accounts, so if you need the money quickly you can cash out.

Stocks Cons:

• If you’re not careful, a monkey might perform better: In Burton Malkiel’s book ‘A Random Walk Down Wall Street’, the author argues that investing in index funds is safer and that stock investors find it difficult to recognize when a company is doing well versus patterns of randomness.
• Stock Price Volatility = Emotional Volatility
• Fear and greed can send a stock price soaring or falling in an instant. If you have a lot riding on a particular stock, this could mean a stock’s falling price may instill fear and panic selling.

REITs

Definition: Real Estate Investment Trust. A REIT includes a company’s properties that they manage and shareholders invest in. Whatever the company earns in rental income or in sales, you earn dividends. Yields from REITs tend to be high since they are required by law to redistribute their income through dividends.

Websites and Reading: Singapore REITs and REIT overview

REIT pros:

• Exposure to Real Estate, without the illiquidity of owning a home yourself.
• Sector-specific in the US: you can invest in sectors you think will grow significantly.
• For example, office REITs are highly cyclical whereas industrial REITs tend to be steady. Healthcare REITs in particular, tend to be somewhat resistant to recessions as compared to Hotel REITs — look at the recent coronavirus crisis for example Hotel REITs in Asia down 40% due to the virus.
• Inflation: Real Estate prices also tend to rise with inflation.
• Diversification: REITs tend to have a lower-than-average correlation with other areas of the market which can help diversify and hedge against other parts of your investment portfolio.

REIT cons:

• REITs are not immune to cycles, and there may be fluctuations in revenue (eg: apartment REITs)
• REITs can be sensitive to interest rates depending on debt
• Different global REIT structures behave differently, making it difficult to assess global REIT performance and invest globally. The US has a vibrant public REIT market, whereas Asia and European REITs only emerged more recently — therefore depending on country there may be less sophistication in REIT management. For example, China only launched its first REIT this year, though it had been experimenting with quasi-REITs beforehand.

Broad Takeaways from Books

• Search for Asymmetric Risk and Reward (Mohnish Pabrai): Buy when the market is down and full of fear — that is when great companies are discounted.
• Buy Companies Within your Circle of Competence (Danielle Town): The best investments are when you buy things you understand on personal experience rather than getting swayed into what is trendy. If it is trendy, the likelihood is that its trendiness is already priced in.

• “The three most important words in investing are margin of safety.” (Warren Buffett): Only buy at a good price for your expectations on how the company will fare based on intrinsic value, with a margin of safety built-in.
• “The two greatest enemies of the equity fund investor are expenses and emotions.” (John Bogle): Write down an investment checklist and thesis for every investment. Return to it whenever emotions run wild and the market is overreacting. Know why you make every investment and stick by it unless the companies’ competitive advantage disappears.

Next Post

Thank you for reading this far in. I have spent considerable time and energy reading a bunch of different investment books and sources to collate this (even though most of this information is available online in various formats). I also used Audible to listen to a few books and highly recommend it (you get two books free, but you can ‘exchange’ books once you’re done). I am slowly becoming familiar with investing jargon and recognize the patterns behind the different theories circulating within the investing community. I don’t swear by any particular investing methodology as I am too new to this, which is somewhat of an advantage so I am not bogged down trying to categorize myself within a school of thought.

In the next post, I will be discussing asset allocation and further dive into stocks. As you follow along on this journey, one of my goals is to apply the theories I am currently learning about. I will manage and invest (in the next year) my own savings thus far and document it. Hopefully this goal is reasonable. I am trying to take each piece slowly and fully learn the fundamentals before acting. If there is anything I learned from books and advice, it is that everything compounds (money, and knowledge).

I will end this post on this quote by psychologist Jonathan Haidt:

“More often than not, the emotional tail wags the rational dog”

Nicole