Beginner’s Guide to Investing

Invest in yourself 

When asked by friends who are just getting started with investing about what they should invest in, I often tell them that the best thing they can do is to invest in themselves. Learn a new skill to help advance your career or start a business to learn about sales, accounting, managing cash flow, the importance of growth, etc. Being a better business operator will help you become a better investor. It is not a coincidence that some of the richest folks on earth are either entrepreneurs or investors.

They say only one in five startups succeed (some estimate only 1 in 10 succeed). That is an 80% or 90% rate of failure. The same is true of investing. Only some of your investments are going to work out and quite a few will fail (ideally well below the 80% failure rate of startups). Each of those failures will teach you a lot and can be considered paying tuition to the market.

The key is to,

i) have more investments succeed than fail

ii) letting your winners generate outsized returns while cutting your losses early

iii) truly accept your mistakes so that you don’t repeat them again. Experience is an expensive teacher and a much cheaper way to learn is vicariously through the experience of other investors. Our reading list has a group of books that will help you partially avoid paying expensive tuition to the market. History does not always repeat itself but it often rhymes.

Build a safety net

Financial advisors often recommend keeping at least six months of monthly expenses in cash. This is sound advice and I would go so far as to say that keeping nearly a year’s worth of expenses in cash is important given the effects of globalization, automation and recurring recessions. Not only will this cash cushion help you sleep peacefully at night, it will prevent you from liquidating investments at an inopportune time should an emergency arise.

In order to build this cash cushion, you should build an annual budget of expenses and divide them into two categories. The first category of “essential expenses” are expenses (housing, food, utilities, insurance, etc.) that you cannot reduce without significant changes. The second category of “discretionary expenses” are expenses you can scale back on without a huge impact (gym memberships, entertainment, etc.). The goal would be to build a safety net that covers 12 months of essential expenses.

Insurance is another key component that is often overlooked by do-it-yourself investors who are getting started. The amount and type of insurance you will need (term life, disability, etc.) is beyond the focus of this investment guide for beginners and should be a conversation between you and your financial advisor.

There are no free lunches 

Successful investing is a difficult endeavor that requires,

i) a lot of hard work

ii) focus

iii) the ability to see what is coming around the next bend (foresight or pattern matching)

iv) intestinal fortitude (making a decision and having the conviction to stick to it through tough times)

v) flexibility of thought (changing your decision when the facts change, new information becomes available or you realize you made a mistake)

vi) patience (the ability to sit tight and do nothing) and

vii) a large amount of luck.

There is no easy money to be had, no free lunches and for the most part the consensus view of the market as a whole is right. In the words of Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s business partner, “Investing is not supposed to be easy. Anyone who finds it easy is stupid.”

That said, there are times when exceptional opportunities do present themselves and that is where the hard work, pattern matching and intestinal fortitude come in. We will get to that later.

Markets are usually right

Markets are right more often than not. In other words the consensus view of all investors participating in a particular market is usually right. Burton Malkiel does a great job of explaining this in his book A Random Walk Down Wall Street and I highly recommend reading it before embarking on your financial journey. The markets being right is also similar to the “outside view” as described by Dr. Tetlock in his excellent book Superforecasting: The Art and Science of Prediction.

There are times when the markets are wrong and these times may present opportunities for great profit. One example of this is bear markets where selling begets more selling on account of forced liquidations, margin calls and just plain old fear. There is a reason they say buy when there is blood on the streets or be greedy when others are fearful. Despite hearing that advice over and over again, few investors had the intestinal fortitude (a strong stomach) to stick with their investment plan or the courage to add new investments during the 2007-2009 bear market, which in hindsight was a generational opportunity.

Have an investment plan

A 100 year flood happens more frequently than people imagine and not just once in a 100 years. Similarly unexpected events are surprisingly frequent in financial markets and you can expect at least one major shock to the financial system or the economy once a decade. Having an investment plan will help you navigate these troubled waters instead of reacting with fear or uncertainty.

An investment plan should not just consist of your investment goals, expected large expenses (weddings, tuition for college, etc.) and how you plan on achieving those goals but should also have a section on how you will handle external volatility (sudden movements in the market) and unexpected life events or large expenses.

Art and Science

Investing is as much an art as it is a science. A lot of market movement, at least in the short-term, is driven by investor psychology (fear and greed) than the value of investments. A fitting anecdote about short-term movements in the stock market was provided by Ralph Wanger, the portfolio manager of the Acorn Fund, as recalled by Bill Bernstein:

He likens the market to an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner.

If investing was all science, the algorithms, which already account for over 80% of all trading, would eliminate any possibility of additional profit by market participants of the homo sapiens variety. We would all be better off investing in the entire market through an Exchange Traded Fund (ETF) like VTI or in an ETF of large cap stocks like the ETF that tracks the S&P 500 index (SPY).

In this context it is equally important to know yourself by understanding your strengths and weaknesses as it is to evaluate an investment based on a set of fundamental criteria. It is also important to understand the motivation of other market participants (are they forced sellers?) and the big picture as it relates to market cycles, credit cycles and cycles within a particular sector driven by supply and demand. This is why some of the books in our investment reading list are about investor and social psychology.

The art of investing comes into play when,

i) you gauge whether you want to stick to a clearly defined set of investment principles or make an exception to the rules because a situation warrants it

ii) you determine the probability that your alternative view of the investment is correct when compared to other market participants. For an investment to be mispriced and hence attractive, there has to be divergence between your opinion of this mispricing and the general market consensus (unless it is a unique situation where animal spirits of fear and greed are in control)

iii) finding the conviction to stick to your investments when they go against you

iv) and at the same time recognizing that you are clearly wrong if the investment unfolds in a manner that was not anticipated and minimizing the losses

v) knowing when to double down on an investment and when to cut your losses

 

Do you have what it takes to be an active investor? 

If you have read this far, here are a few questions that will help you determine if you have what it takes to be an active investor.

1. Do you have an edge over the rest of the market either in terms of speed of access to information, a deep understanding of specific sectors, access to unique resources, etc.?

2. Do you have the ability to see where the puck is going instead of where it has been?

3. Do you have the ability to stay calm and act in a rational manner when animal spirits have gripped the market?

4. Do you have the ability to understand the probability of success or failure of each individual investment and its impact on the overall portfolio?

5. Do you have the ability to think of the big picture and understand economic and sector cycles?

6. Do you pay a lot of attention to detail and have the ability to calculate the intrinsic value of an investment?

7. Do you have the humility to admit when you are wrong and change course if the situation demands it?

8. Are you willing to constantly learn from others and from your mistakes?

9. Do you seek out and even entertain opposing view points?

Now that you have answered these questions and internalized this guide by reading it with the same attention it took me to write it, you are ready to get started. This guide was in no way designed to discourage you from becoming an active investor but I wanted to lay out all the cards on the table so that you understood the rules of the game (and a game it is) before diving into the deep end.

The feedback I received on the first version of this guide was that it focused too much on the risks involved in investing and not enough on the rewards. The feedback was spot on. So this next section is dedicated to the upside represented by investing over long periods of time.

The benefits of investing

Albert Einstein is purported to have said that compound interest is “the most powerful force in the universe”. Whether Einstein did in fact say this is undetermined but the gravity of the statement cannot be dismissed (no pun intended). The power of compounding can do wonders for a well managed portfolio over a long period of time. A $100,000 portfolio will grow to nearly  7 times its size ($672,750 to be exact) over a period of 20 years at an annual rate of return of 10%.

How did I come up with a 10% rate of return? That was the return of the largest stocks as represented by the S&P 500 over the last 100 years including dividends (data here) but before inflation. The rate of return dropped from 10.22% to 6.83% after inflation*.

If you let this portfolio grow for 30 years, it would grow to $1.74 million. This is just through passive investing where you put your money into an index ETF and forget about it. Obviously this very simple example ignores the impact of fees, taxation, etc.

Let us assume that after answering the questions in the previous section, you determine that you have what it takes to become an active investor and can generate just 2% more annualized returns per year. That $100,000 portfolio would end up growing to $3 million over a period of 30 years without a single extra dollar added to it. Before we get too excited, it is important to point out that most active managers tend to underperform their benchmark index and taxation and fees can take a big bite out of returns. Using very low cost ETFs like the ones offered by Vanguard and using a tax protected account like an IRA could mitigate the impact of fees and taxation.

Investing is not all about stock picking. The key is to generate returns that protect against the erosion of inflation and help you achieve your long-term goals. When I first read the book Unconventional Success: A Fundamental Approach to Personal Investment by Yale University’s Chief Investment Officer David Swenson, I was surprised to read the following paragraph,

A number of well-regarded studies of institutional portfolios conclude that approximately 90 percent of the variability of returns stems from asset allocation, leaving approximately 10 percent of the variability to be determined by security selection and market timing. Another important piece of research on performance of institutional investors suggests that 100 percent of investor returns derive from asset allocation, relegating security selection and market timing to an inconsequential role.

Nearly a decade after reading that book, it makes perfect sense now. Success investing is about getting the big picture right (asset allocation) and then picking individual investments if you have the aptitude for it.

Footnotes:
* The starting point can make a big difference. If you started investing right at the outset of the great depression in 1930 and ended at the nadir of the great recession in 2008, your annualized returns would have dropped to 9% (5.75% after inflation). Using a more recent example, if you had started on January 1, 2000 (the dot com bear market) and ended on December 2008 (close to the end of the housing led great recession), your annualized returns would have been -3.7%.