The Definitive Guide to Investing: 20 years of Investing Experience in 7 Minutes

how the stock market worksDo not invest in the stock market to make money.

If you want more money, start a business, work more hours or increase your earning power with new skills.

Do not be deceived by the allure of making money in the stock market.

It’s not going to happen without improbable luck. You cannot depend on bad odds.

Investment growth is a byproduct, but the stock market is primarily a place to preserve your wealth and stay ahead of inflation.

Most middle class Americans that invest, do so for retirement or college expenses that come years in the future.

In 1921, a can of Coca‐Cola cost a nickel. Today it’s over a dollar.

Investing provides the opportunity for your earnings to grow along with the rising cost of retirement.

Who Needs to Invest

Everyone needs to invest.

Yes, especially business owners.

Entrepreneurs resist stock market investing because they want to earn more by investing in their own business. They have more control over their company, but that overlooks why they should invest in the market.

Entrepreneurs tend to overestimate the probability of their business success. They must be optimistic, but the odds are against their long term survival.

Small business owners face inordinate risk. If you invest all earnings back into your business, you might earn more, but you risk losing everything.

Entrepreneurs should invest in the stock market, not to earn more profits, but instead to divide risk among multiple businesses.

The same rule applies to investing in your employer’s stock. Companies encourage employees to commit with stock options and discounted employee stock purchases, but be weary of over committing to one investment.

If your employer is your sole source of income, and also your retirement plan, you are at great risk if the business fails–Enron is a good example.

Separate your income source from your retirement holdings.

Types of Investment Risk

There are three types of risks you face as a stock market investor.

The first is Market Risk, which cannot be avoided.

The second and third are Individual Stock Risk and Stock Sector Risk. Both can be avoided.

Market Risk

You cannot avoid the inherent risk of the overall stock market. The market will rise and fall because of factors beyond your control.

Market risk cannot be avoided, but it can be reduced with less volatile stocks and by holding higher percentages of cash type investments in your portfolio.

Market risk is a concern in the short term if you need to sell investments to raise cash when the market is low.

The problem is not the market, but a matter of whether you can hold your investments long enough for the stock market to rise again.

Market risk presents the danger of buying when prices are high or selling when prices are low.

This is why the emergency fund is so important. You can learn more about that here.

Individual Stock and Stock Sector Risk

Prices of individual stocks, or stock sectors, can fluctuate wildly and vary significantly from the overall stock market. However, you can diversify that risk away.

For example, if you invest $1000 in XYZ computer company stock, there is a chance it will rise to $2000 or plummet to $0.

Each additional company you invest in reduces your odds of failure, but it also reduces your opportunity for huge profits if one of those companies were the next Microsoft.

To avoid single stock risk, an investor might instead invest in the entire stock sector – in this case the technology sector.

By investing in several stocks in the technology sector, you diversify away the risk of an individual company’s business blunders, but you do not get away from the risk of an entire sector tanking.

The challenge of picking individual stocks, or stock sectors, is that without a crystal ball it’s impossible to pick tomorrow’s winners without luck.

Beat the Market

The Market” is often loosely described as the Standard and Poor’s 500 Index (S&P 500), which is a market‐weighted list of 500 leading U.S. companies from several industries.

From 1928 to 2014, the U.S. stock market has averaged over 9.6% per year. Some years more – others less – but in the long run it has grown.

Professional investors with armies of paid “experts” and often illegal, inside information still can’t consistently “beat the market.”

In study after study, there is no single investor that has picked stocks that outperform the market in the long term.

If you had the time and interest to analyze thousands of individual companies, you might get lucky. But if the “experts” cannot beat the market, what are your chances?

Instead, you should just invest in the market.

And the easiest way to invest in the market is with index funds.

Mutual Funds

Mutual funds are a collection of stocks and bonds owned by a pool of investors. Each investor owns part of the mutual fund in proportion to how much money they invest. Mutual fund shares rise and fall in value depending on the price of the stocks and bonds in that fund.

There are active and passively managed funds.

Actively managed funds have professional managers that research companies to buy for their fund. These managers come with a hefty price – fees that you pay from your investment.

The major drawback of actively managed funds are the expenses which cut into your earnings.

If actively managed funds never beat the market in the long run, it’s difficult to justify paying their extra expenses.

Index Funds

Passively managed funds (index funds) have significantly lower expenses because there are no managers hired to pick stocks. With index funds, the mutual fund company simply buys the stocks listed on the index – there is no need for expensive research.

Historically, index funds offer better long term returns, lower expenses, lower taxes, lower risk of errors and lower anxiety about mistakes.

Behavioral Economics

The beauty of index investing is that it removes emotion from your choices.

As much as we pretend, we are not rational creatures. Most investor make obviously dumb decisions.

When the market is booming, investors buy high. When it is tanking, investors panic and sell low.

With index investing, you can set it and forget it.

Technology has been detrimental to individual investors. IPhone apps with minute by minute stock updates are unnecessary. The banners along the bottom of the financial news channels are equally absurd.

These instant updates cause anxiety and increase the likelihood that you will make a mistake.

Asset Allocation

The wise investor goes in with a time horizon – a plan for how much you will need and when you will need to access your money. With a timeline, you can use asset allocation to adjust the amount of risk you should take along the way.

There are various asset classes to choose from to adjust the level of market risk your portfolio is exposed to.

Remember, by using broad index funds, you have diversified away individual stock and stock sector risk. Market risk is all that remains, so we use asset allocation to minimize the fluctuations in your portfolio.

In broad terms, there are three asset classes:

  • Stocks
  • Bonds
  • Cash

If you wanted a risk free investment portfolio, you could invest 100% in cash. That would yield a portfolio that guarantees you would never sell at a loss, but it’s not that simple.

If you only invest in cash, you risk inflation eating away at the future value of your money. You will go into retirement able afford a $.05 coke – instead of at the necessary inflation adjusted prices.

If you take a low amount of risk, you will end up with a low return on your investment. Investors are often rewarded for taking greater risk, but there is a point where greater risk does not normally pay off.

Stocks tend to rise and fall more than bonds, and bonds fluctuate more than cash.

Stocks can be further divided into small, medium and large companies.

Small companies historically earn more, but are riskier. If your time span permits greater price fluctuation, an investment portfolio with more stocks than bonds tends to earn more, as does a higher percentage of small companies to large companies.

Here are some common asset allocation ratios taken from Vanguard target date mutual funds. These are examples, do not take them as gospel. In my portfolio I hold significantly more cash than these here.

IMG_7460

Above is the asset allocation of the Vanguard Target fund with about 40 years until retirement.

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IMG_7461

Above is the asset allocation of the Vanguard Target fund with about 15 years until retirement.

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Above is the asset allocation of the Vanguard Target fund in retirement years.

Speculating

Before I wrap up, a quick word on speculating: day trading, market timing, options, futures, commodities, gold, trading on margin, hedge funds or anything that suggests huge profits with considerable risk and little way to predict the outcome.

Speculating, as opposed to investing, provides little to no historical data or company fundamentals to enable an informed decision about the likely future outcome.

We can’t predict the future, nor does past performance guarantee future results, but it does give us something to analyze, unlike in many of these more “exotic investments.”

Speculating is gambling with your retirement.

Here’s the Investment Plan

This is the quick and easy summary.

  1. Choose an asset mix based on how much time you have before you need the money. (If you don’t want to think about that, choose a target date index fund.)
  2. Choose index fund(s) to create your investment portfolio with the asset class mix in step one.
  3. Make consistent monthly contributions.
  4. Check once annually to rebalance – buying and selling assets to readjust back to your original asset class mix ratio.
  5. Adjust this ratio more conservatively as you near retirement or college years.
  6. Ignore the market. We survived the 1593 tulip bulb explosion, The Great Depression of 1929, the Internet Bubble in the 1990’s and we are probably going to weather the next crisis too. Everything that happens between now and your end point does not really matter – as long as you stick to your plan.

There are many different investment philosophies.

I’ve tried them all through the years with my money and also with my clients when I worked ran a financial planning practice.

Above is how I invest.

It is the easiest and the most predictably successful investment strategy for average investors with jobs, spouses, kids, and life.  But I also think it’s the best philosophy for the wealthy, professional investor too.

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Photo: I took this on the island of Roatan, Honduras.

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