The Top 6 Things Every New Investor Should Know

Man and woman taking reviewing new investments
••• Jose Luis Pelaez Inc / Getty Images

Starting on your path to successful investing might seem overwhelming, but there's no need to worry. Millions of people have traveled the same road as they made their way through booms and busts, war and peace, major life events, and every twist and turn life can throw at you. With patience, discipline, and a sense of calm, you can weather the storm and come out on top.

Here are a few things to keep in mind as you take your first steps toward investing and financial success.

Key Takeaways

  • Every new investor should first take an honest look at where they are in life and their financial priorities. And they should leave emotion out of it.
  • Brace yourself for the road ahead, which won't always be smooth. The market can swing over time—and it will, sometimes greatly.
  • Don't go it alone unless you're a seasoned financial advisor. Pay an expert for their guidance and advice.
  • Invest early in life so that your money will have plenty of time to grow. A 10-year difference can have a major effect on compounding returns.

Take Advantage of the Power of Compounding

You may have heard this a million times, but it's vital that you truly internalize it in a way that changes your behavior and reorders your priorities. You will end up far richer if you begin investing early. It's all due to compound returns, and the outcome differentials are staggering.

For example, an 18-year-old who jumps straight into the workforce and saves $5,000 per year in a tax shelter such as a Roth IRA, earning long-term average rates of return, could end up retiring with $4,359,874. For a 38-year-old to achieve the same thing, they would need to save more than $36,000 per year. A college grad could end up with $4,426,000 by saving $111 per paycheck throughout their lifetime. It all boils down to using the time value of money.

Tailor Your Portfolio to Your Unique Life Circumstances

People tend to get emotionally involved in their investments and are sometimes too attached to a certain legal structure, method, or company. They lose their objectivity and forget the adage "If it looks too good to be true, it probably is."

Be wary if you come across pitches like these:

  • "The only stock you'll ever need to buy."
  • "Buy these three index funds. And ignore everything else."
  • "International stocks are always better than domestic stocks."

You have a job to do as the "manager" of your portfolio. That job depends on many factors, including your personal goals, risk-tolerance level, objectives, resources, temperament, psychological profile, tax bracket, willingness to commit time, and even prejudices. Ultimately, your portfolio should take on the imprint of your personality and unique situation in life.

Investing personas are as varied as individual investors. For example, a wealthy, former private banker who is capable of reading an income statement and balance sheet may want to collect a six-figure passive income from dividends, interest, and rents resulting from having put together a collection of blue-chip stocks, gilt-edged bonds, and trophy commercial buildings. In comparison, a young worker may want to buy the cheapest, most diversified, most tax-efficient collection of stocks through a low-cost index fund in their 401(k). A widow who is leery of stock market crashes may want to acquire a portfolio of cash-generating rental houses with surplus funds parked in certificates of deposit.

None of these options is wrong or better than the others. The question is whether the portfolio, method, and holding structure are optimal for whatever goal the person wants to achieve.

Prepare To Experience Drops in Market Value

Asset prices are always moving. Sometimes these movements are irrational, such as market turmoil from Holland's tulip bulbs, and sometimes they are caused by macroeconomic events. For instance, you might see a mass markdown of stocks due to large investment banks hurtling toward bankruptcy. These banks might need to sell all they can, as quickly as they can, to raise cash, even if they know the assets are dirt cheap. Real estate prices also fluctuate, with prices going down, then coming back up.

As long as you have built your portfolio wisely, the underlying holdings are backed by real earning power, and you purchased assets at reasonable prices, you should be fine.

The Dow Jones Industrial Average fell 34.6% from August 1987 to December 1987. It dropped 34.4% from March 2000 to October 2002, then rose 94.4% by October 2008. Between then and March 2009, equity prices declined 53.8%.

If you are a long-term investor with a reasonable life expectancy, you will experience these drops more than once. You may watch your $500,000 portfolio decline to $250,000—even if it is filled with what you think are the safest, most diversified stocks and bonds. A lot of mistakes are made—and money lost—by trying to avoid the inevitable.

Pay a Qualified Advisor to Work With You

Before the rise of behavioral economics, it was assumed that most people made rational financial decisions. Studies produced by the academic, economic, and investment sectors over the past few decades showed how wrong that assumption turned out to be in terms of real-world outcomes for investors.

Unless people have the knowledge, experience, interest, and temperament to ignore the market's inherent fluctuations, they tend to do some foolish things. These mistakes include "chasing performance" by throwing money into assets that have recently increased in price. Another example is selling high-quality holdings at rock-bottom prices during economic distress.

Conversely, investors who pay an advisor reasonable fees, so someone else is doing the work for them, have far better real-world outcomes, despite the added fee cost.

In other words, classic economists had it wrong, including some of the high priests of low-cost investing, such as John Bogle, who founded Vanguard. It turns out that an investor's return was not simply the result of gross returns minus costs, with paid advisors extracting value. Instead, advisors earned their fees, often in spades. A typical investor could end up with much higher returns because an advisor held their hand and changed their behavior.

Employ Tax and Asset-Protection Strategies

It's possible for two people with identical saving and spending habits and the same portfolios of stocks, bonds, mutual funds, and real estate to end up with wildly different amounts of wealth, depending on how they structured their holdings.

From simple techniques such as asset placement and using traditional or Roth IRAs, to more advanced concepts such as setting up a family limited partnership to reduce gift taxes, it is worthwhile to learn the rules, regulations, and laws, and to apply them to your benefit.

For instance, you may be entitled to unlimited bankruptcy protection of the assets held within the confines of certain types of accounts. If you find yourself facing bankruptcy, your first course of action should be to consult with a lawyer. They might counsel you to declare bankruptcy and start over. You might end up walking out of the courthouse with most, or all, of your retirement plan assets intact, continuing to compound returns for you as they pump out dividends, interest, and rents.

Know the 3 Approaches to Acquiring Assets

In the end, there are only three ways you can acquire assets. Whether they work depends on the amount of investing savvy you have.

Systematic Purchases

You make systematic purchases when you regularly buy and sell parts of a collection of assets over time, regardless of valuation, hoping to balance the good and bad times. This approach is used by the "Defensive Investor"—in Benjamin Graham's words. This approach has made many people wealthy. It is for people who don't want to spend a lot of time thinking about their portfolios. Instead, they let diversification, low-cost and long-term passive ownership, and time do all the work for them.

Valuation

Valuation investing is buying or selling based on price, relative to the conservatively estimated intrinsic value of an asset. This strategy requires significant knowledge of business, accounting, finance, and economics. It requires you to evaluate assets as if you were a private buyer.

Many people have grown wealthy this way, too. Graham terms the person who uses this approach as the "Enterprising Investor." They want to control risk, enjoy a margin of safety, and know that there are sufficient earnings and assets relative to the price paid for each position in their portfolio.

This strategy is for the investor who wants to fall asleep at night without worrying whether the country will experience another 1929—33 or 1973—74 market crash. Actually, the entire financial system rests on this method. This is because prices can deviate from the underlying reality for only so long.

Almost all high-profile investors who have good long-term records fall into this camp, including those who have become a voice for the first approach. This list includes Vanguard founder Bogle. He liquidated a massive portion of his stock holdings during the dot-com boom because the yield on the stocks had become small relative to the yield available on U.S. Treasury bonds at the time.

Market Timing

Finally, there is the market-timing investor, who buys or sells based on what they think the stock market or economy is going to do in the foreseeable future. Market timing is a form of speculation. A few people have gotten rich off of it, but, as a matter of course, it is not sustainable. The foreseeable future is unseeable because it is the future.

If you are a new investor, stick to the first method. If you become an expert, stick to the second method. And even though it sells well, people with common sense should avoid the third method.

Article Sources

  1. Yahoo Finance. “Dow Jones Industrial Average.” Accessed July 10, 2021.