Joe is a average worker. Joe saves a little each month and has managed to build up 6 months of emergency funds. When it comes to credit cards, Joe is anything but average. Joe does not carry a balance on his credit card. Recently, Joe came across a large sum of money as inheritance – $10,000. Joe has no experience investing in the stock market. Joe ponders: where to invest?
Joe is purely fictional. But his situation lays the foundation for this post. It would make so sense to apply my advice if Joe carried a credit card balance.
By the end of this post, you should be able to grasp the basics of investing. I’ll try to make this as simple as possible.
The primary goal of any long term savings plan should be to beat inflation. Inflation is the silent killer that chips away at your money over a period of time. $10,000 today will be worth much less 10 years from now.
Let’s look at the basics of investing and the choices Joe has.
Put the money in a bank. The interest rates for savings account are set so that they are always below current rate of inflation. CDs pay a slightly higher rate, but they too won’t beat inflation. With a savings account, you money is liquid, that is, available when you need it. With a CD, your money is tied up for the duration of the CD and hence the higher interest.
If you can’t beat inflation, you can at least keep up with inflation. There is one way to keep up with inflation. Joe can invest is what’s called I-Bonds. These are issued by the US Treasury and their rates are set so that they keep up with inflation.
That’s still not good enough. Joe should make the money work for him. Historically, the stock market has managed to beat inflation. But stocks carry an additional element of risk. You could theoretically lose all or part of your principal. This wasn’t the case with 1 and 2.
There are different strategies to investing in the stock market. Some are very risky (penny stocks), some involves trusting your instinct (market timing) and some, just handing over your money to a stranger(mutual funds). I wouldn’t recommend any of these for a beginning investor like Joe.
When you buy a stock, you buy a small piece of the company. If the company does well the price of the stock goes up. If the company does poorly, that’s reflected in the share price. If the company folds, you get nothing. That’s a huge risk, betting all your money on a single company. Joe ponders what if he bought shares of say 10 companies? Not all can go bankrupt? That’s actually a wise idea. Mitigate the risk.
But Joe has no idea how to pick these companies. There are thousands of companies in the New York Stock Exchange alone. Maybe Joe should pick only the top companies. But if Joe is going to pick only the top companies, he’s going to miss out on the next Google or Microsoft. So Joe has a daunting task ahead. Not only he has to decide what to pick but also figure out how much to allocate toward each.
The above illustrates 2 important concepts. It is called diversification (what to pick: spreading your picks across stocks) and asset allocation (how much to allocate).
With me so far? Excellent!
Seems a lot more complex than putting the money in the bank and not worry about it, doesn’t it! Here’s a radical idea: what if Joe bought the entire US market? A little piece of all the companies in the stock exchange? That way Joe wouldn’t miss the current Google and the next Microsoft. Maybe extend this crazy idea to buy all the companies in the world! And for some safety, some inflation protected securities as well?
Joe likes things simple. He doesn’t want to constantly monitor his finances. Money in the bank would be perfect for Joe, but Joe knows he’ll lose money by putting it in the bank. What if the $10K were to be divided like this:
3,400 – Own the entire US Market (34%)
3,300 – Own the world excluding the US (33%)
3,300 – Inflation protected securities (33%)
Portfolios similar to the one above is called a Lazy Portfolio. This particular portfolio is called the ‘Margaritaville’ portfolio. It is very simple but quite effective. The objective of any portfolio is just not to maximize returns, but to minimize risk as well. But allocating is not the end of the story. Periodically, Joe must rebalance his portfolio so that it maintains the 34/33/33 ratio.
Why is rebalancing so important? When you rebalance, you take profits out of your best performing sector and buy from poorly performing sectors. Huh? That seems counter intuitive? Ever heard of ‘buy low sell high’? That’s killer advice for anyone investing in the stock market. Rebalancing forces you to do just that.
Why not individual stocks instead of owning the markets? I thought we went over this! Well, apart from the reasons mentioned above, when you buy individual stocks, if a stock does really well, you tend to fall in love with it and refuse to sell. If the stock drops rapidly, your instinct is to sell and cut your losses. Both are extremely harmful to your financial health. You are doing exactly the opposite of ‘Buy low, sell high’. When you buy baskets of securities, you take emotion and greed out of the equation. And emotion and greed fuels the stock market. One who can play these two correctly wins.
Back to our portfolio. So how has this performed in the recent past? For the past one year this portfolio has returned a whopping 30.29% returns! That is, $10,000 invested a year back will be $13,029 today. But then you should never look at short term returns. It is great it did so well, but it may not next year. The key is to keep at it and keep rebalancing regularly.
Joe wonders if all this means he should never buy stocks? Well I wouldn’t say that! But this is a good start. This lays a good foundation with low risk. Consider stocks once you are better informed. Picking stocks is no easy task! But this should get you started on a very prosperous journey!
So how should Joe go about doing all this? In my next post I’ll take you step by step on how and where to open an account, what securities to buy, when to rebalance and how to handle taxes. This is a HOWTO blog after all!