Most people believe they have a choice when it comes to whether or not they decide to invest. The truth is, you don’t. At some point, you need to start investing your money and saving for the future. You could be reading this as a 20 year old (lucky you) or someone who put this off until their 40s or 50s. Regardless of your age and financial situation, you need to be participating in some kind of investment to allow your money to grow into even more money.
“The best time to plant a tree was 20 years ago. The second best time is now.” – Chinese Proverb
Now, does this have to be a stock market investment? Absolutely not. Here at Investing Simple, we discuss all kinds of investments such as passive real estate investments, peer to peer lending and more. However, for the purpose of this article we are going to assume that you are interested in investing in the stock market.
At a time when consumer debt is at all time highs and stock market participation is at all time lows, I applaud you for reading this and considering entering the realm of investing. You might think the first step is to figure out what brokerage account to use and to start picking stocks. This is actually not the best way to do it. Some of you that are reading this might be ready to invest, but I am guessing most of you have a little personal finance clean-up work to do.
Phase 1: Pay Off Debt
Let me ask you a question. Let’s say you have $100 in the bank, but you also owe your friend $100. Your friend Bill is charging you $1.50 each month until that $100 is paid back. Now, your friend Jack calls you up and asks you if he can borrow $100. He agrees to pay you $0.50 a month until he is able to pay you back that $100.
Should you…
A. Keep that $100 in the bank
B. Pay back your debts with Bill
C. Loan your money to Jack
If you picked Choice A, this is actually the worst move you could make. Your money is sitting in the bank earning a very small rate of return. For most people, this is a rate that does not outpace inflation. Your first goal when it comes to investing is to protect the buying power of your money by outpacing inflation. If you didn’t take economics class in high school, inflation is an increase in prices over a period of time. As prices increase, the buying power of each dollar decreases. To explain this simply, bread is more expensive now than it was back in 1930.
In recent years, inflation has been at a rate of around 2 to 3% per year. The average interest rate on a US savings or checking account is around 0.05% per year. Assuming these figures remain the same, let’s take a look at how this plays out. Let’s assume you have $100,000 sitting in a US checking account.
$100,000 Now = $102,000 1 Year From Now (2% Inflation)
Thanks to our friend inflation, the purchasing power of $100,000 today is likely to be equal to the purchasing power of $102,000 one year from now.
$100,000 Saved = $100,050 1 Year From Now (0.05% Interest Earned)
Thanks to the “generous” interest rate paid by your bank, your $100,000 grew in value by $50!
One of the best comparisons I have heard is that inflation is like having termites in your house. Day by day, it goes unnoticed. The real damage is done over a long period of time.
So what exactly happened here? You earned a return of $50, but you lost $2,000 worth of buying power. Your net loss was $1,950!
Keep this in mind when your friends or family members tell you they keep their money in the bank because it is safe. Termites!
If you picked Choice B, you chose the best option! It does not make any sense to loan your money to Jack when you owe Bill money. Now, you might argue that this could make sense if you could get a higher rate of return than you are paying in interest. This is something people try to do with the stock market. They borrow money against the shares they already own and they invest that borrowed money. This is known as buying on margin, a key contributor to the stock market crash in 1929.
On average, the stock market has averaged a return of 8 to 10% per year. This is the average, meaning you will not experience this every single year! In a bull market (a time when the price of stocks is rising), you could see returns of 15% per year or more. In a bear market (a time when the price of stocks is falling), you could see a 20% loss or more.
Buying on margin and investing borrowed money is a result of two things. First of all, it is a result of impatience. You are trying to accelerate your wealth and possibly make up for lost time. While I am not a financial advisor, I have yet to meet a single one that recommends that its clients invest borrowed money. Second of all, it is a result of not understanding compound interest. Einstein called this the 8th wonder of the world for a reason. Warren Buffett attributes a lot of his success to it. It is imperative that you understand the power.
In this video, Ryan Scribner explains how you could become a millionaire with just $5 a day thanks to compound interest.
I encourage you to play around with a compound interest calculator if you haven’t yet.
If you picked Choice C, you made a very common mistake. Most people are so excited about investing in the stock market that they do not consider their personal finances and whether or not it actually makes sense to invest at this point in time. As we mentioned above, the average return from the stock market is around 8 to 10% per year. Just to restate this, you will not experience this kind of return every year!
The most common debt people have is credit card debt. Since this is unsecured debt, it typically has the highest interest rate. It is not uncommon for people to have a 20% or higher interest rate on a credit card. If you have credit card debt, you need to pay it off before investing in the stock market. It is no different than loaning $100 to Jack when you owe Bill $100. The best return you can get at this point in time will be from paying off your high interest debt.
As a general rule of thumb, you want to pay off all debt that exceeds your anticipated rate of return from your investment. If that is 8%, you want to pay off all debt near, at or above 8% interest.
Now, what about a car loan or a mortgage? These are secured loans, so the interest rates are typically much lower. For example, if you are paying 4% interest, it would make sense to invest.
Let me give you an example. Let’s say you have a car loan of $20,000 but you also have $20,000 in the bank. You have good borrowing history, so your interest rate on this car loan is 4% per year. Rather than pay off your car loan, you decide to invest that money. Your anticipated rate of return is 8% over the next year.
Interest Paid = $800
Investment Return = $1,600
Net Gain = $800 or 4%
You were able to earn a return that exceeded what you paid in interest. On top of that, you were able to build your credit in the process.
In this video, Ryan Scribner talks about whether or not you should invest while being in debt. The same concepts are explained!
Summary: The point is, you do not need to be debt free to start investing. You just need to use common sense and pay off any high interest debt first. It does not make sense for most people to borrow money to invest. Buying on margin was a key contributor to the stock market crash of 1929, and I have yet to meet a financial advisor that recommends their clients invest borrowed money. Some debt is okay, as this will help you build your credit score. While the stock market historically returns 8 to 10% per year, this should not be expected every single year.
Phase 2: Eliminate The Need For Debt
Why do people go into debt? Sure, it could be compulsive spending or keeping up with the Joneses. However for a lot of people, debt is a result of an expense that was not anticipated or planned for. This could be something like a car repair or a medical bill. Once you have committed to being a participant in the stock market, you have hopefully followed the steps outlined in Phase 1. Unfortunately, the next step is not to go on a stock shopping spree. The next step is to eliminate the future need for debt.
Most people don’t plan on going into debt. You don’t wake up on a Saturday morning and say “I want a $3,000 credit card balance.” However, most people do not plan for unexpected expenses. Here is a tip: Don’t be like most people.
I am a big fan of Dave Ramsey. If you are still in the phase of paying off debt, I would highly recommend watching some of his videos.
The next step is to build up an emergency fund. This is going to eliminate the need for debt in the future. A general rule of thumb for this is that this should be enough to cover all of your expenses for the next 6 months. Pretend you lost your job or main source of income tomorrow. How long would you be able to sustain yourself before you needed to grab your credit card? If the answer is anything less than 6 months, you need to build up your cash cushion.
Let me give you an example. John has the following monthly expenses.
Car Payment = $300
Mortgage = $1,200
Utility Bill = $150
Food = $500
Entertainment = $200
Other = $200
Total = $2,550
John should have an emergency fund that covers all of his expenses for the next 6 months, or around $15,000. This money should be sitting in a liquid account like a checking account or a money market account. This money should not be invested. You might be saying that $15,000 is a lot of money. You are right! It would take most people at least one year to save up that amount of money. What you could do instead is invest half of your money and save the other half for your emergency fund. This would allow you to participate in the stock market while improving your financial situation.
“Wait a second, you just told us above that inflation is like termites and it is eating our money! Shouldn’t we invest our emergency fund?”
Here is another Dave Ramsey classic on the emergency fund.
Let me show you exactly why you should not do this. Let’s assume you buy shares of a red hot technology stock. You picked up 10 shares at a cost of $250 per share. In doing this, you drained your checking account and left yourself with $500 until payday. You picked up your shares the day before this company is reporting earnings because you anticipate that this stock will beat expectations. When this happens, the share price can go soaring!
The next day, they report earnings that fall short of expectations. The stock drops 15% on the news. Your initial investment of $2,500 (10 shares at $250) is now worth $2,125 (10 shares at $212.50). You “lost” $375. To tell you the truth, you didn’t lose a penny. You do not recognize a loss until you sell those shares to someone else at a price that is lower than what you paid for them. Often times, people will say that the stock market is a scam or that the stock market took money from them. As if the stock market reached into your brokerage account and plucked the money out! The stock market never took a penny from anyone. If you lost money, you handed it over.
Back on topic here, you are now down 15% on your shares of this red hot technology stock and you have $500 in checking. After listening in on the earnings call, you decide to go grab breakfast. You walk out to your car, turn the key and hear clicks. After punching the steering wheel a few times, you call a tow truck. Your car repair and tow bill ends up costing you $2,000! This was clearly an unexpected expense and like most people, you did not plan for it. Here is a tip: Don’t be like most people.
At this point, you have two lousy options.
Your first option is to sell your shares of the red hot technology stock and recognize the loss. You will use this money to pay for your car repair bill. On top of that, it will take 3 business days for the funds to settle before you can transfer the funds back to your bank account.
Your second option is to pull out that shiny credit card and slap on a $2,000 repair bill and tow at a 20% interest rate.
Both of these options are bad. If you end up in this situation, flip a coin.
Summary: Most people do not plan on going into debt. Usually, debt is a result of a lack of planning. An emergency fund will eliminate the future need for debt. A general rule of thumb is that you should have enough money in a liquid account like a checking account to cover all of your expenses for the next 6 months. You can contribute to your investing account as well as your emergency fund at the same time. Your emergency fund should not be invested.
Phase 3: Your First Investment
Have you ever seen a horse race before? Don’t worry, this will make sense shortly. People spend hours upon hours analyzing the horses and the different variables involved. Then, the horses go off and the fastest horse is the winner. No matter how much research is conducted by the handicapper, they are frequently wrong about what horse will come in first. Is this due to a lack of intelligence or research? In most cases, no. It is because horses are horses and sometimes they just don’t feel like running. But what if instead of picking the winner of this race, you were able to make a different bet on all of the horses? That’s right, you are betting on the outcome of the entire race and not just one horse.
This is exactly how stock picking works. Everyone has their own strategy when it comes down to the analysis of the investments, but at the end of the day nobody knows how the market will perform and what stocks will come in the lead. While you can’t bet on the entire horse race, you can bet on the entire stock market with an investment known as an index fund.
An index fund is a pool or collection of different stocks designed to replicate an underlying benchmark. This benchmark could be the S&P 500, foreign telecommunication companies or even the entire global stock market. This fund is designed to replicate the performance of the underlying benchmark as closely as possible.
It is important that you understand the difference between the index fund and the distant relative known as the mutual fund. A mutual fund is actively managed, and the expenses associated with this type of investment are often significantly higher. The truth is, most actively managed mutual funds do not beat the market. Mutual funds are often benchmarked against the S&P 500, an index that tracks the performance of the 500 largest publicly traded companies in the US. What most people do not realize is that you can simply invest in the S&P 500 through a low fee index fund instead of trying to pick stocks or pick a mutual fund that will hopefully outperform.
In fact, Warren Buffett recommends that people simply invest in a low fee S&P 500 index fund! One example of this is the Vanguard 500 Index Fund. You can invest directly into this fund through Vanguard, or you can purchase shares on the market through a financial instrument known as an ETF. This is simply an exchange traded fund. Shares of this fund trade openly on the market under the symbol VOO.
Most people should just buy low fee index funds. Now, am I telling you this to deter you from going out and picking stocks on your own? Absolutely not. It is possible to beat the market and you can learn a lot by investing in individual stocks. However, if you are brand new to investing you should start with an index fund. It is in your best interest to build your tolerance for risk and your understanding of the stock market before you begin to hold individual stocks. By holding ETFs, you get to experience what it is like to be a stock market investor without holding individual stocks that can be volatile.
In this video, Ryan Scribner talks more about index funds and ETFs.
Volatility is the degree of variation seen in the price of a stock. Individual stocks are far more volatile than the overall market, meaning you will see more drastic price fluctuations. One of the easiest ways to determine the volatility of a stock that you are looking at is to look at the beta. If a stock has a beta above 1, that means this stock is more volatile than the overall market. If the beta is below 1, that means this stock is less volatile than the overall market. If you are investing in individual stocks as a complete beginner, you should consider investing in stocks with a beta below 1.
Some stocks are inherently more volatile than others. For example, a technology stock like Advanced Micro Devices is going to see more variation in the share price than a blue chip stock like Coca Cola. These durable, time tested investments are named blue chip stocks after the blue chip in poker. The blue chip is the poker chip with the highest value. If you are looking to invest in an individual stock as a beginner, you should familiarize yourself with these blue chip stocks. A great place to start is the Dow Jones or DJIA. This is a list of 30 well established, financially responsible industry leaders. This includes companies like Apple, 3M and UnitedHealth.
Summary: For most investors, especially beginners, your best option is to invest in low fee index funds. This will give you diversified exposure to the stock market. Warren Buffett recommends this too! If you do decide to invest in individual stocks, you should consider the beta or volatility of these investments. As a beginner, you should avoid stocks that have high volatility.
Phase 4: How To Make Money
When it comes to investing in the stock market, there are two different ways you can make money. The first way you can make money is through asset appreciation. You purchase a stock and hopefully sell it at a higher price in the future. It is important to remember that share prices can be completely erratic, and you should always invest in a company you fully understand. Consider the investing style of Warren Buffett. He invests in simple businesses like Kraft Heinz, American Express and Coca Cola. There is a lot of temptation out there to invest in complicated industries like biotechnology. At the end of the day, you need to ask yourself one question. Do I understand what I am buying?
The second way that you can make money in the stock market is through dividends. Companies can decide to share a portion of their earnings with shareholders through dividends. These dividends are typically paid on quarterly basis, but in some instances companies pay annual, semiannual or quarterly dividends. It is important to understand that these dividend payments are never guaranteed. A company that pays a dividend can cut or cancel this dividend payment at any time. Generally speaking, companies like to increase dividend payments over time and avoid a dividend cut at all costs. A dividend cut almost always results in a decline of the share price, which hurts the reputation of the company.
In this video, Ryan Scribner explains how money is made in the stock market.
Stocks that pay dividends are referred to as income stocks. Stocks that are growing at a faster rate than the overall market are referred to as growth stocks. You will also find that there are some stocks that are both growth and income investments. The company pays a dividend and it is also experiencing a faster rate of growth than the overall market.
You also have conservative growth stocks and aggressive growth stocks. As the name suggests, aggressive growth stocks are likely to experience a higher growth rate than conservative growth stocks.
When you begin investing in the stock market, it is important to consider what type of investor you want to be. Do you want to invest in aggressive growth stocks? Do you want to invest in durable blue chip stocks that pay dividends? Do you want to invest in stocks that pay dividends while also having growth potential? Like anything else out there, it is important to have a game plan and a strategy. A dividend investor would be focused on companies with a consistent operating history and a durable competitive advantage. A growth investor would be focused on what the most innovative companies are. Determining what type of investor you are is above and beyond the scope of this article, but you should begin to think about what type of investing seems most appealing to you.
Remember, if this seems too overwhelming you can always bet on the outcome of the entire race! This is why many investors simply invest in index funds rather than bother with picking individual stocks. If you are bullish on a particular sector or industry, like semiconductor technology, you can invest in a sector or industry specific ETF. You have no idea what the top performing semiconductor stocks will be, you just believe in that industry as a whole.
Summary: People make money in the stock market through asset appreciation or income from dividends. It is possible to invest in stocks that will offer both. Income investors buy shares of companies that pay dividends on a consistent basis. Growth investors buy shares of companies that are highly innovative and adaptive. It is important to understand what type of investor you want to be.
Phase 5: Core Investing Principles
There are a number of core investing principles that you should know before you begin investing in the stock market. You should also refresh your memory once in a while to ensure that you are following them. Here are the cardinal rules to sensible investing that will help you stay out of trouble.
Buy Low, Sell High
This is the most important investing principle, yet so few actually practice this. Let me give you an example. In 2017, Bitcoin went mainstream. Cryptocurrency was the topic of bar room conversations all over the world. By the time the average person learned about Bitcoin, it was trading at a price of over $10,000 per coin. Looking at the chart, you could see that Bitcoin had gone nowhere but up.
At this point, FOMO was triggered. Also known as the fear of missing out, masses of people entered the cryptocurrency market because they were afraid of missing out on the hottest investment. Do you know what all of these people did? They purchased Bitcoin at all time highs. To the untrained eye, Bitcoin had nowhere to go but up. Seasoned investors knew that the opposite was true. Whatever it is that you are buying, do not buy it at all time highs. People who are new to investing are often cautious about buying low. They see that the share price has fallen and they are afraid to buy. If you went to the grocery store and found out that Tide laundry detergent was on sale, you would stock up and buy extra. But when Procter & Gamble stock goes on sale, the maker of Tide laundry detergent, people are afraid to buy it. Stocks are the only thing that people do not buy on sale.
Ignore The Noise
When it comes to investing, noise is everywhere. There is always a line of people waiting to give you their opinion regardless of whether or not you wanted to hear it. To some extent, you can control the noise. Most of it is coming from the news outlets. Keep in mind that Wall Street makes money when you are active. Activity leads to trading and trading makes your broker money. Wall Street wants you to be active. They want you to invest in a stock on Monday and change your mind Thursday, sell it and buy something else only to sell that Friday. There is a difference between staying informed about your investments and being obsessed.
Check on your stocks once a day, maybe twice. Keep track of the major company announcements, quarterly earnings reports and annual reports. Beyond that, the rest is just noise. While investing in stocks can be a social activity, you should be careful about where you get your advice from. Hot stock tips are a dime a dozen. Beyond that, even if they are right about their hunch, what is your next move? Is your plan to wait for someone else to give you a stock tip at the bar? That is not an investment strategy. An investment strategy needs to be scale able and repeatable.
The Stock Market Is A Pendulum
A man by the name of Benjamin Graham once said that the market is a pendulum, forever swinging between optimism and pessimism. Warren Buffett learned a lot from Benjamin Graham. For example, Buffett has said that you should be greedy when others are fearful and fearful when others are greedy. Optimism leads to greed and pessimism leads to fear. Buying from the pessimist means that you are buying stocks when there is fear in the market, or buying low. Selling to optimists means that you are selling stocks when there is optimism or euphoria in the market, or selling high.
If you hear everyone talking about a hot stock, it is probably time to sell it. The underlying value of a stock does not change in the short term, only the price does. At some points, the price is high due to greed and feelings of euphoria. At other points, the price is low due to feelings of fear.
This article is a work in progress, bookmark and come back often!
Last updated August 20th, 2018.
