How To Invest And Get Wealthy

In the news a few months back I read a headline about how the markets were down based on China trade fears.  Right below it, another headline said stocks rise based on encouraging news from the federal reserve.  These were published within an hour of each other! What?  I chuckled but then a weird unease came over me as I thought that some people might actually think that newspaper articles about the market are written by smart people who actually know what is happening in the market.  The truth is that much of the news about the market is largely noise and/or spin.  It has been that way my entire life.  The real message from those headlines that an experienced investor might glean is that the markets opened essentially flat and a couple of columnists had a deadline to hit.  My next thought was that the financial media is hugely misleading, and basic investing is not really taught to most of us.  Maybe I should write a decent summary post about investing as a follow up to Why You Will Not Beat The Market But Still Can that shares some more details about investing.  Even if you are an experienced investor, I think that you will find this entertaining and a bit insightful. I am not a financial professional and this should not be considered financial advice.

Why Has The Market Trended Upward

The market is volatile in the short term and unpredictable.  In 2008 it fell almost 40% in one year and on Black Monday in 1987 it fell over 20% in one day.  However, over the long term the market has historically gone up with an average of about a 7% annual return. In fact here is a fun chart of the market over the last 100 years along with some historical events:

See that relentless 100 year march upward? The takeaway here is that the market has trended up over time.  An economist might note that the US economy has also expanded over time and posit that if an economy grows over time, the market trading that economy should do similarly.  So, if you believe that the economy in which you are invested (US, EU, global) will continue to expand, then over the long term, stocks should continue to rise as they have for the past 100 years.

Is Learning About Investing Really Worth It?

After paying off high interest debt and saving up an emergency fund, a great next step to financial independence is investing.  In the beginning for me it was boring as hell.  For easy math, let’s say that I saved $10,000 in the first year.  Even at a nice 7% annual return that was only $700 more in my savings after a year of interest.  Learning all about investing is a pain in the ass and all I get is $700?  Well, let’s fast forward investing $10K every year for 30 years.  In this scenario I have invested a total of $300,000 of my hard earned cash.  However at a 7% annual return and the magic of compounding, I now have just over one million dollars.  My learning about investing has made me a millionaire!  All I had to do was put in the time to learn some fundamentals, stay invested over a long time period, and let time do the work. 

If you don’t know what a stock or a bond is, you may want to start at investor.gov.  This government site gives an overview of investing and the different securities. It comes from the SEC which regulates investing in the USA.  A great first place to start investing is through a tax advantaged account through your workplace like a Roth IRA or 401k.  Often employers match some portion of your investments which is also like getting free money!  A great overview for just beginning in investing through your retirement account is this bigger pockets podcast episode with Broke Millennial. 

What Stocks Should I Buy?

The research shows that most professional money managers underperform the market average.  What this means is that if you bought a tiny bit of every single stock that makes up the market rather than trying to pick winners, you would on average make more money than the pros.  It also perhaps suggests that if the pros suck at picking stocks that you as a brand new investor probably should not attempt it. 

While single companies may go up or go out of business, the market as a whole has kept that relentless march upward as shown in that chart above.  Hence, if you buy a broad portfolio of stocks to average out the winners and the losers, you will be well diversified and approach that average market return.  The good news is that you can easily invest in the whole market by buying a low fee mutual fund such as Vangaurd VTSX.  This awesome stock series by JLCollins explains this approach well and is also about as entertaining a read as an intro investing primer can be. 

Why Do Investing Fees Matter?  

Mutual funds allow you to hold lots of stocks without having to buy all of them yourself.  You get that sweet diversification that I just mentioned.  For smaller investors it is sometimes not possible to buy all of the individual stocks because holding even one share of each costs more than one may have to invest.  It may also not be practical because of trading fees to own more than a hundred different individual stocks as a beginning investor for example. 

Mutual funds give broad diversification but they also charge fees to run the fund.  Some mutual funds charge high management fees of say a full percentage point or even more.  If someone is charging you 1% to manage your money and you were making 7% average annual returns, you are actually now only making 6% per year.  What difference does 1% make?  Well in the same example above, a 6% return over that 30 years leaves me with $837K rather than a cool million.  That 1% difference due to fees just cost me $163,000!  I got hosed!  Investing can be as simple as buying and holding one or two high quality and broadly diversified low fee funds.

Why Make It Any More Complicated?

For someone new to investing, it may be as simple as buying and holding some broadly diversified mutual funds and then leaving it there for years.  However, remember how I mentioned that 7% is only an average annual return?  I want to introduce you to to concepts of risk and volatility and touch on a couple of things called beta and alpha.  Don’t panic, I suck at greek letters too but these concepts are pretty simple.

Risk, Volatility, & Beta

  There have been periods of time where investing would have lost you money.  From 1966 to 1982 for example the stock market actually lost over 2/3 of it’s value!  What if you had planned to retire in 1966 and start taking out cash?  Hence, investors like to think about time horizons of investing and getting the best possible return with the lowest possible risk.  I wrote about the tradeoff of risk versus return in a prior post. 

While there is always risk in the market, volatility refers to how much one stock moves with respect to a given move in the market index as a whole.  The volatility of an investment can be measured using something called Beta.  Beta is a ratio of how volatile an investment is versus the entire market.  The total stock market has a beta of 1.  Something that goes up more when the market index rises and goes down more when the market index falls would have a beta greater than one meaning it is more volatile than the entire market.  An example of this would be high flying tech stocks.  Something that moves less when the market moves would have a beta of less than 1.  An example of this might be utility stocks.  In order to take some of the volatility out of investing many opt to hold some types of stocks versus others or even hold some bonds and some stocks.  Bonds are like loans that have less risk than stocks and also a lower return.  Holding more bonds would likely reduce volatility compared to holding more stocks.  So controlling volatility is one reason to make investing more complicated and you have a rough idea of something called beta that quantifies how volatile an investment can be.

Because investors have different time horizons and some stocks have different risk profiles than others investors like to group stocks into buckets.  These buckets help to put together a portfolio strategy with a mix of risk and time horizon that the investor prefers based on current market conditions and her personal needs.  Don’t stress too much over the specifics here I am just trying to give a glimpse of how investors like to put stocks into groups.  Some common groupings are as follows:

Sectors which are based on the industry in which a company operates:

• consumer staples (groceries and necessary stuff to live)
• consumer discretionary (things like new clothes, leisure activities, and cars)
• healthcare
• energy
• industrials (companies that provide commercial and industrial products and services)
• materials (raw materials for industry)
• financials (banks and investment firms)
• technology (IT & computers).

Market Cap which is based on how big and/or valuable the company is:

• Small Cap (<$2B smaller companies.  Some investors believe these tend to have faster growth but are more risky and may not perform as well during a recession)
• Mid Cap (companies worth $2-10B somewhere between large and small like goldilocks’ porridge)
• Large Cap (>$10B corporations that often pay dividends and some investors believe have slower growth but are more stable during recessions)

Where the companies are located:

• US Stocks (or any single particular country)
• Emerging Markets (global markets where economies appear to be growing but are not yet mature like the US or EU is.)
• International (anything that is not USA)

Asset classes for those that invest in alternative investments beyond stocks and cash:

• Stocks (what we have been talking about)
• Bonds (you loan your money to an organization at an agreed interest rate)
• Real estate or REITs (either investing in a trust that holds and manages real estate or directly buying properties)
• Cash (money in bank accounts or somewhere that it is available.  Often earns some interest in accounts)
• Commodities (a basic good that sells by the unit regardless of who produced it like pork, gold, or coffee for example)

Portfolio Management

A common approach for a professional money manager might be to take all of the money that a client gives her to invest and then invest it in different percentages across the groupings I just mentioned above.  For example: 

• 20% Total Stock Market
• 20% International
• 20% Intermediate Bonds
• 20% Commodities
• 20% REITs

This example happens to be a portfolio model that Harvard and Yale once followed with all that endowment cash to invest.  This really awesome link shows you loads of well known portfolio allocation models, who came up with them, and their historical performance.  Seriously, take a moment and check out a few of them.  However, at this point I feel compelled to pause and say that all of these groupings and portfolio percentage allocations as well as any others not shown are just someone’s theory on how to think about investing.  While some are based on nobel prize winning research, no one of them has been determined to be the best in all market conditions and the market is always changing hence the theoretical best allocation is also changing.  

If We All Figured Out the Market, It Would Change 

It is important to remember that whenever you buy something or sell it, there is a person on the other end who has to make the opposite decision for the trade to happen.  Hence if we all knew the best method at any given time, then those with the optimal holdings would refuse to sell them and then the price would go up making that approach too expensive and no longer the best.  In other words, since investing is a zero sum game, the pros spend loads of money and time trying to out think each other and get some advantage. 

Billions of dollars and millions of hours of time has gone into trying to get the best possible returns at the lowest attainable risk.  Most of the model portfolios mentioned above perform to within a couple of percent annual returns of each other.  Even a fraction of 1% better performance edge is a billion dollar idea in big money investing.  A good take away from this discussion on investing portfolios might be to educate yourself on different common and successful models and consider one that seems sensible for you, your time horizon, and the risk level that suits your financial goals. This might be considered more involved than just picking one highly diversified mutual fund but it is certainly more straight forward than individual stock investing.

Individual Stock Investing and Alpha

Earlier in this post I mentioned alpha and beta.  We talked about beta as a measure of volatility of investment sectors and now I want to return to talk about alpha.  If you are like me, this has been bugging you because you thought I forgot about alpha. I got you boo!  Alpha refers to trying to get better returns than the market index average.  The total market index has an alpha of 0.  If something yields a 2% higher rate of return than the market index over a period of time it would have alpha of 2 for example. 

However, let me reiterate that beating market average returns is something that no one has successfully created a repeatable process for doing ever.  Some have beaten the market over long periods of time such as Peter Lynch or Warren Buffett.  However, the multi-billion dollar question is whether they are better investors or simply disciplined and lucky anomalies.  Heck Buffett has been getting smoked by the index lately and even his and Charlie Munger’s successes have not been duplicated using similar strategies to Berkshire’s.  With this in mind, why even attempt to learn about individual stock investing and seeking alpha when even portfolio theory just made your brain hurt?  My short answer is 2 fold.  

Why Go Down The Rabbit Hole of Stock Analysis?

#1 Let’s go back to the example from the beginning where I started learning about investing and in that first year it only made me $700 richer.  An extra 1% return in that year would have put $100 in my pocket.  However, after my 30 years of investing and becoming a millionaire I now have much more money to invest which means a much bigger incentive to optimize my portfolio.  If I can just get a 1% better return on my money, that is $10,000 extra dollars in my pocket in my 31st year.   Hence as one’s savings grows, there is a big monetary incentive to care about really trying to optimize one’s portfolio or at least giving it some more thought.

#2 The 2nd reason some like to go all in and learn about individual stock investing is human nature.  If I put you in front of a bowl of strawberries and asked you to pick the best tasting average of strawberries would you sort out some ugly looking ones or just take the average of the whole bowl?  Oh yeah and there is ten thousand dollars riding on your choice remember?  Most people would inspect the hell out of those berries right?  This is why some like to read company financial statements and pour through data to decide for example whether the energy % of their portfolio should include more Exxon or Chevron as a holding. 

To most of us it makes sense that the more we learn about something and practice it the better we get.  If the same market conditions present themselves again, maybe the same thing is more likely to happen with the stock?  If interested, you can also read more about why I feel one might want to become a stock analyzing champ in this previous post on Why You Will Not Beat the Market But Still Can.

Beginners Suck At Investing Because They Are Beginners

Most beginning investors get excited about stock picking and many often throw money at high flying tech stocks or something they saw in the news. Since this is often a recipe for disaster, I am going to offer up a suggestion that helped me when I started investing. I created a play money portfolio and tracked my own performance over a period of time. It was humbling to see those stocks that I was sure were going to double or triple in value end up totally tanking. Human emotion can throw some great strategies out the window. Later I competed against some friends for a cash prize to make it more real. This helped me practice analysis, put together a strategy, and stick with it unless information changed materially. You may be saying great but let’s get to it! How do I actually analyze stocks?

How To Analyze Stocks

Breaking down analyzing individual stocks might take me 100 posts.  I don’t think anyone could be ready after reading just one.  However I can crack open the door and give a peak at the beginnings of analysis.  Let’s continue the example above and say that I want to buy an energy stock. Maybe I chose energy because my portfolio model has a percentage in energy or because by some advanced stock strategy I like energy.  Since buying stock is buying a small piece of an actual company, I can analyze the underlying strength of energy companies by digging into performance metrics and financial statements. I can then choose which one or more to place my investment in.

Performance Metrics

These are the numbers that you will see on Yahoo finance or Google finance when you look up a stock ticker symbol. A good place to start is Yahoo finance summary and statistics tabs.  A few of the many commonly referenced metrics are:

• Share Price. Has it gone up or down recently and over time? Why? 
• Dividend. How much is it and when does it pay? How does this affect share price?
• Price to Earnings ratio or P/E. How much the stock costs divided by it’s earnings per share. How much return can you expect on your investment? Is this a trailing or forcasted P/E?
• Beta. Hey we talked about that one earlier in this post! Amazing how it all comes together.
• Analyst Recommendation. Have analysts at big investment firms recently changed their stance on the stock? If so why? What about news on this company? Pending lawsuits etc?

Financial Statements

Financial statements include company balance sheets, and earnings reports that come out annually and quarterly.  These are required to be filed in a standardized way by the SEC.  You can view these under yahoo finance’s financials tab for any ticker for example.

Earnings Reports: How are earnings trending and why? What are profit margins and could the company make money if price was pressured? Where does income come from and how does it change over time? What are major expenses and how do they change over time?

Balance Sheets: How much debt vs. equity does the company have and why? What are the sources?

The above description is the tip of the iceberg for individual stock investing analysis. In short, it involves analyzing data that is deemed relevant to the strength and performance of a company. Some also analyze individual stocks and employ advanced theories.

Simplifying Some Advanced Theories in investing.    

There are loads of advanced investing strategies / theories that some have employed effectively. Most of them have worked over some period of time and can be proven right or wrong depending on what timeframe one chooses and what assumptions were made. These include following market cycles, value investing, rebalancing strategies, and more.

There is an old saying in investing that bulls make money and bears make money but sheep get slaughtered. What this saying means is that perhaps it is less important which specific strategy you follow and more important that you have a well thought through strategy based on solid information and analysis and that you follow that strategy through for that particular investment unless new information changes the validity of your strategy. This suggests that one can employ a variety of strategies for different investments but may want to remain diligent to that strategy rather than constantly changing strategies or responding emotionally to market gyrations. One may also want to be sure that the individual investment strategies come together in a cohesive portfolio that meets his risk and return targets over a defined time horizon.

Your Next Steps to Building Wealth Through Investing

Everything that I have written about in this post is my learnings and opinions alone. I am not a financial professional and none of this information should be misconstrued as a recommendation for actual investment advice. The information above is simply a quick dive into investing as I have learned it and an invitation to learn more about it yourself. Investing has built substantial wealth for me and many others over time and it can be very rewarding to learn more. Here are some books that I found very helpful when I started learning: 

• The Intelligent Investor -Ben Graham
• The little book that beats the market -Joel Greenblatt
• One Up On Wall Street -Peter Lynch

What do you think? Any questions as a new investor? Any glaring omissions or things you disagree with as a seasoned investor? Please chime in on the comments below.

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