The Top 6 Things Every New Investor Should Know
Starting out 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 navigated booms and busts, war and peace, major life events, and every twist and turn life can throw at you. With patience, discipline, and a calm temperament, 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 financial success.
Take Advantage of the Power of Compounding
You've probably 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 interest and the outcome differentials are staggering. For example, an 18-year-old who jumps straight into the workforce and saves $5,000 a year in a tax shelter such as a Roth IRA, earning long-term average rates of return, would end up retiring with $4,359,874. For a 38-year-old to achieve the same thing, he or she would need to save more than $36,000 per year.
To become a believer, read how a recent college grad could end up with $4,426,000 by saving $111 per paycheck throughout their lifetime or how to improve the quality of your life by using the time value of money formulas, both of which explain the formula in detail.
Tailor Your Portfolio to Your Unique Life Circumstances, Objectives, Risk Tolerance, and Goals
People have a tendency to get emotionally involved in their holdings, sometimes even worshiping a specific legal structure, methodology, or even company. They lose their objectivity and forget the adage, "If it looks too good to be true, it probably is." If you come across an offering positioned as "This is the only stock you'll ever need to buy," or "Buy these three index funds and ignore everything else," or "International stocks are always better than domestic stocks," run for the hills.
You have a job to do as the "manager" of your investment portfolio. That job depends on various factors including your personal goals, objectives, resources, temperament, psychology 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.
For example, a wealthy, well-heeled former private banker 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 lovingly putting together a collection of blue-chip stocks, gilt-edged bonds, and trophy commercial buildings. A young worker may want to buy the cheapest, most diversified, most tax-efficient collection of stocks through a low-cost index fund in his or her 401(k). A widow leary of the stock market gyrations may want to acquire a portfolio of cash-generating rental houses with surplus funds parked in certificates of deposit. None of these options are wrong or better than the others. The question is whether the portfolio, methodology, and holding structure are optimal for whatever goal you are attempting to achieve.
Prepare to Experience Drops in the Market Value of Your Portfolio Over an Ordinary Investment Lifetime
Asset prices are constantly fluctuating. Sometimes, these fluctuations are irrational (e.g., tulip bulbs in Holland). Sometimes, these fluctuations are caused by macroeconomic events. For example, mass markdowns on securities due to investment banks hurling toward bankruptcy needing to liquidate everything they can as quickly as possible to raise cash even if they know the assets are dirt cheap. Real estate also fluctuates over time with prices collapsing then recovering. As long as the portfolio you've built is constructed intelligently, and the underlying holdings are backed by real earning power and assets were acquired at reasonable prices, you will be fine in the end.
Consider the stock market. Between April 1973 and October 1974, stocks fell 48 percent; between August 1987 and December 1987, the drop was 33.5 percent; from March 2000 to October 2002, it was 49.1 percent; from October 2007 to March 2009, the decline in equity prices was a heart-pounding 56.8 percent. If you are a long-term investor with a reasonable life expectancy, you will experience these kinds of drops more than once. You may even watch your $500,000 portfolio decline to $250,000 even if it is filled with the safest, most diversified stocks and bonds available. A lot of mistakes are made, and money lost, by attempting to avoid the inevitable.
Pay a Qualified Advisor to Work With You to Manage Your Financial Affairs
Before the rise of behavioral economics, it was generally assumed that most people were rational when making financial decisions. Studies produced by the academic, economic, and investment sectors over the past few decades have demonstrated how catastrophically wrong this assumption turned out to be in terms of real-world outcomes for investors. Tragically, unless a person has the knowledge, experience, interest, and temperament to ignore the market's inherent fluctuations, they tend to do extraordinarily foolish things. These mistakes include "chasing performance" (i.e., throwing money into what has recently increased in price). Another example is selling otherwise high-quality holdings at rock-bottom prices during times of economic distress (e.g., selling shares of well-run, financially sound banks when they dropped 80 percent in value a few years ago before recovering in subsequent years).
One now-famous paper by mutual fund giant Morningstar showed that during periods when the stock market returned nine percent, 10 percent, or 11 percent; the fund investors were earning two percent, three percent, and four percent. That's because investors had no idea what they were doing. They were constantly buying and selling and moving from this fund to that fund, not taking advantage of intelligent tax strategies while they committed a host of other transgressions. This led to an almost paradoxical outcome. Investors who paid an advisor reasonable fees so that someone else was doing the actual work for them (including holding their hands and being the face of "professionalism"), experienced far better real-world outcomes, despite having to pay more.
In other words, classic economics had it wrong, including some of the high-priests of low-cost investing, such as economist John Bogle who founded Vanguard. It turns out that an investor's return was not the result of gross returns minus costs with financial advisors and registered investment advisors extracting value. Instead, advisors earned their fees, often in spades, because a typical investor could end up with much higher returns because the advisor held their hand and changed their behavior. Human irrationality meant that the theoretical perfect was, in fact, detrimental.
Why Vanguard Makes Sense
To their credit, Bogle's enterprise, Vanguard, has recently acquiesced to this reality, albeit quietly in a way that has gone virtually unnoticed. The well-known, low-cost asset management company has roughly one-third of the money under its supervision in actively managed funds with the remaining two-thirds in passive index funds. The latter is famous for charging between 0.05 percent and 1 percent annual expense ratios. Some of them have their problems (which are not Vanguard's fault) such as quiet methodology changes that would make past performance impossible to replicate and potentially painful embedded capital gains but overall, they are among the best in the industry. In theory, it should be easy for a person willing to deal with the trade-offs to regularly buy it and stay the course for an entire career until retirement approached.
Seeing how incapable investors were at "staying the course," Vanguard has launched its own advisory service that will manage the client's portfolio of Vanguard funds in exchange for an additional 0.30 percent per annum on top of the underlying fund expenses. That means, depending on the specific underlying fund selected, the effective fees on all levels might amount to anywhere between 0.35 percent and 1.26 percent. (Although trust fund accounts are a bit different, with the effective fees on a $500,000 trust amounting to somewhere around 1.57 percent per annum.) According to Vanguard's own publications, the firm estimates this could lead to as much as a 3 percent per annum increase in the actual real-world compounding rate enjoyed by the investor, with half of that stemming from the benefit of having someone serve as an emotional coach during economic, political, and financial maelstroms. Over 10, 25, or 50+ years, that is a staggering amount of extra wealth, despite the theoretically higher fees that "took" hundreds of thousands of dollars in lost compounding (i.e., the mythical wealth that never would have materialized due to operator error).
Employ Tax and Asset Protection Strategies
It is entirely possible for the exact same investor, with the exact same saving and spending habits, with the exact same portfolio of stocks, bonds, mutual funds, real estate, and other securities, to end up with wildly different amounts of accumulated wealth depending upon how he or she structured the holdings. From simple techniques such as asset placement and taking advantage of a Traditional or Roth IRA to more advanced concepts such as using a family limited partnership liquidity discount estimate to reduce gift taxes, it is worth the time, effort, and trouble to make sure you understand the rules, regulations, and laws and use them to your maximum benefit.
For example, if you are experiencing extreme financial stress, it may be a terrible mistake to pay bills with money from your retirement plan. Depending on the type of account you have, you may be entitled to unlimited bankruptcy protection of the assets within its protective confines. Consulting with a bankruptcy attorney should be your first course of action. An attorney 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, compounding interest for you as it pumps out dividends, interest, and rents.
Know the 3 Approaches to Acquiring Assets
There are only three approaches an investor can take to acquire assets. These include:
- Systematic Purchases: Regularly buying or selling a collection of assets over time regardless of valuation with the hope that time will balance the good times and the bad times. This is the "Defensive Investor" in Benjamin Graham's work and its made many people wealthy. This approach is for individuals who don't want to think about their portfolio. Instead, they let diversification, low-cost, long-term passive ownership, and time do all the work.
- Valuation: Buying or selling based on price relative to the conservatively estimated intrinsic value of a firm. This requires significant knowledge of everything from business and accounting to finance and economics. It basically requires you to evaluate assets as if you were a private buyer. Many people have also grown wealthy this way. This is the "Enterprising Investor" in Benjamin Graham's work; the person who wants to control risk, enjoy a margin of safety and know that there is a substance (i.e., real earnings and assets sufficient relative to the price paid) for each and every position in their portfolio. This is for the investor who wants to fall asleep at night without worrying if the country will experience another 1929-1933 or 1973-1974 market crash. Actually, the entire financial system rests on this method because prices can only deviate from underlying reality for 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 includes Vanguard founder John Bogle, who quietly liquidated a massive percentage of his personal equity holdings during the dot-com boom because the earnings yields on the underlying stocks had become pathetic relative to the yield available on Treasury bonds at the time.
- Market Timing: Buying or selling based on what you think the stock market or economy is going to do in the foreseeable future. Market timing is a form of speculation and while a few people have gotten rich off of it, it's not sustainable.
If you are a layperson, stick to the first method. If you become an expert, stick to the second method. Even though it sells well, anyone with common sense should avoid the third method.