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 have made their way through booms and busts, war and peace, major life events, and every twist and turn that life can throw at you. With patience, discipline, and sense of a calm, you too 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 make an honest assessment of 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 someone who is one, for their expert guidance and advice.
  • Begin investing early in life so your money will have plenty of time to grow. A 10-year difference can have a significant effect on compounding returns.

Take Advantage of the Power of Compounding

You may have heard this a million times, but it's important 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 specific legal structure, methodology, 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, methodology, 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 fluctuations 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 everything they can, as quickly as possible, to raise cash, even if they know the assets are dirt cheap. Real estate prices also fluctuate, with prices collapsing and then recovering.

So 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 in the end.

The Dow Jones Industrial Average fell 34.6% from August 1987 to December 1987. It dropped 34.4% from March 2000 to October 2002 and 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.

Sadly, unless people have the knowledge, experience, interest, and temperament to ignore the market's inherent fluctuations, they tend to do some really 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 that 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.

Why Vanguard Makes Sense

To its credit, Bogle's enterprise, Vanguard, has consented to this reality, albeit in a quiet way. The well-known, low-cost asset management company oversees about $1.6 trillion in active assets. It offers more than 70 actively managed funds and over 100 passive index funds.

Vanguard is famous for charging annual expense ratios of only 0.05% or 0.1% to manage passive index funds. Some of them have their problems, which have not been Vanguard's fault, such as quiet methodology changes that would make past performance impossible to replicate and potentially painful embedded capital gains. As a whole, though, they are among the best in the industry. In theory, it should be easy for a person who is willing to deal with the drawbacks to regularly buy and stay the course throughout an entire career until retirement approached.

However, seeing how bad most investors were at "staying the course," Vanguard launched an advisory service that will manage the client's portfolio of Vanguard funds in exchange for as much as an additional 0.30% per year. That means, depending on the underlying funds, the effective fees might amount to 0.35% to 1.26%.

Vanguard estimates that using the service could lead to as much as a 3% increase in the rate of return enjoyed by the investor. The increase would not happen every year; it would be rather irregular. And Vanguard believes half of the return increase would come from helping improve people's financial behavior.

The occasional 3% added return could result in a large amount of extra wealth being accumulated over 10, 20, or more years. And that's despite the higher fees.

Employ Tax and Asset-Protection Strategies

It's possible for two investors 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, like asset placement and using traditional or Roth IRAs, to more advanced concepts, like 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 utmost 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 an attorney. 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. And 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 portfolio. Instead, they let diversification; low-cost, 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 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, 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 spokesmen 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 tiny 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.