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- Why should you invest? By investing today, you invest in your future with the hope of a better quality of life.
- Investing has become more accessible than before. Commission free trading provided access to financial markets for investors of all sizes, it created a greater opportunity to profit even for small investors.
- Open the right type of the investment account for your needs.
- Smart cash management may decrease risk and increase return for investors.
- Patience may help pay off in the long run.
- Start early and contribute regularly to your investment portfolio.
- How investment returns may improve your quality of life?
- Understand your risk tolerance before you invest.
- Diversification may lower volatility and help you achieve your financial goals.
- Be aware of individual company risk and do your homework.
- Select the right financial advisor who will represent your best interest.
- There are no short cuts. If it is too good to be true, it probably is.
- Information travels near the speed of light. Do not try to overrun it.
- The stock markets are informationally efficient and may provide opportunities for long term investors.
- The stock market is forward looking.
Investing Principle # 1: Why should you invest? By investing today, you invest in your future with the hope of a better quality of life.
When you invest today, you may earn a future reward which you can then enjoy later on. It is prudent to balance the future reward with today’s pleasure. Spend some of your monthly budget on pleasure today, but also save some of your money and invest in your future. It is good to have a healthy balance. In contrast, when you use a credit card to receive a joy today, you borrow against your future. You will have to work more to pay back your credit card balance in the future. Instead of borrowing against your future time, you should start investing in yourself. You will feel better each month knowing that in the future you may have more free time and ability to enjoy a better quality of life. Invest in yourself starting today.
Investing Principle # 2: Investing has become more accessible than before. Commission free trading provided access to financial markets for investors of all sizes, it created a greater opportunity to profit even for small investors.
Before, investing was more accessible to wealthy individuals. Wealthy people own most of the stock market and their wealth increases over time widening the inequality gap. The richest one per cent of Americans own more stocks than half of the US households, according to the Goldman Sachs (Financial Times). Also, the top one per cent of Americans own 31% of all household wealth. In contrast, the bottom 50% of Americans own only 2% of household wealth according to the Federal Reserve (see Chart 1). Available access to investing should improve inequality and create opportunities for investors of all sizes. All investors have an opportunity to increase their wealth and enjoy a better quality of life.
Recent advances in the financial world provided opportunities for everybody to become an investor. There is no minimum account balance required. With as little as $100 you can become an investor today. That is a low barrier to enter. A while back, mostly wealthy individuals could benefit from the stock market. Wealthy people became even wealthier by investing (see Chart 1). It is important to know about today’s opportunities and how you can benefit from investing.
One of the major recent improvements in the financial system is commission free trading for US stocks, ETFs, and options. That is a huge benefit for the beginner investors. It allows low barrier to enter. In 2015, Robinhood started offering commission free trading. Later, in 2019, Charles Schwab began offering commission-free online trading. Soon after, the rest of the major financial institutions started offering zero trading costs in the US. Today, you can open a brokerage account at TD Ameritrade, Fidelity, Charles Schwab or Robinhood and pay zero trading costs.
Why is zero commission so important for the beginner investor with little money to invest? Before, companies like Charles Schwab charged $4.95 per trade or TD Ameritrade used to charge $9.95 per trade. Trading fees are the negative drag on your investment returns. Let’s assume you have $1000 to invest and you decide to buy ten securities. If you had to pay $9.95 per trade, you would have spent $95.50 to purchase ten securities. Similarly, it will cost you another $95.50 to sell these ten securities. The round-trip investment would have costed you $191. That is equivalent to the 19% of your total portfolio value. From the start, you had to recoup $191 or 19% just to break even. Before zero commission trading era, small investors could not afford to buy and sell individual securities without falling behind in performance. Smaller investors were at disadvantage. However, everything changed now. Now, all investors regardless of their size have an opportunity to participate in the stock market.
Investing Principle # 3: Open the right type of the investment account for your needs.
Selecting the right type of the investment account may improve your after-tax investment returns. Most of the time you will have to select between taxable, tax exempt or tax deferred account types. In many cases you may need to have both taxable and non-taxable accounts. What are the benefits of taxable and non-taxable accounts? This is a very brief description of just a few available options. For better understanding, you should consult with your accountant or financial advisor to determine which account type meets your needs.
A taxable account can be Individual or Joint account. With a taxable account you share the tax risk with the IRS. Capital and incomes gains are your tax liability – IRS gains. In contrast, capital losses are your tax deductions – IRS losses. It might be prudent to have growth stocks with no dividends in your taxable account. When you have realized capital losses you may be able to deduct them on your tax returns. Another benefit of a taxable account is flexibility. There are no penalties for early distributions or limits for deposits. Taxable accounts give you the most flexibility, but they are typically more expensive. All your contributions are after tax and you are required to pay tax on all realized capital gains and income every year.
Tax advantaged accounts are your 401k Retirement Plans, Regular IRA and Roth IRA accounts. Tax advantaged account are more tax efficient and may improve your investment returns. However, they come with more restrictions.
If you work for a company that offers a 401k retirement plan, you have access to a tax deferred account. A 401k plan lets you grow your investments in a tax deferred environment. You will not pay any capital or income tax while money stays in the account. Also, you may be able to contribute much more to the 401k plan than you can to the Individual Retirement Account (IRA). All your contributions are before tax. In the year 2021, you are allowed to contribute up to $19,500 in a 401k plan. If you are at least 50 years old, you are allowed an additional $6,500 catch-up contribution. Some employers offer a 401k match where the employer will match your contributions based on the specific formula. If your employer offers a 401k match it is like extra bonus available to you. You can make extra money by simply selecting to contribute to a 401k plan. You may want to contribute at least up to the full match, so you do not leave money on the table. The 401k plan is designed to save for retirement, so it might be difficult to take early distributions. Also, early distributions maybe subject to penalties.
An Individual Retirement Account (IRA) Regular or Roth are tax-advantaged accounts. If your tax level does not change over time, both Regular IRA and Roth IRA accounts should have the same tax benefit. With the Regular IRA account, contributions are tax deductible if your income is below the IRS guidelines. You will pay tax when you take distributions from the Regular IRA. In contrast, the Roth IRA works the opposite from the Regular IRA. With the Roth IRA account, your contributions are after tax, and distributions are tax exempt. All capital gains and income are non-taxable in both Regular and Roth IRA accounts. In 2021, you can contribute maximum of $6,000 or $7,000 if you are 50 or older (IRS) to the Regular IRA or Roth IRA account or both. The total combined contribution cannot exceed the maximum $6,000 or $7,000 if you are 50 years old or older. If you decide to take money out from your IRA account early, you may be subject to early distribution penalties.
Having both taxable account and tax advantage account are smart strategies for beginner investor. Taxable account will give you the most flexibility. Whereas, the tax advantaged accounts help each earned dollar to go further, and have better investment returns.
Investing Principle # 4: Smart cash management may decrease risk and increase return for investors.
Investors should have cash savings in their bank account for cloudy days. Cash savings may hedge the unknown need for cash distributions in the future (Ivan Sichkar, 2012). It is a smart risk management technique which may also improve the overall investment return. Unexpected need for cash increases during economic downturns. There is a greater probability of a job loss and prolonged unemployment during an economic downturn. Without enough cash savings, the investor may start to withdraw money from the investment portfolio. Economic downturn is the least favorable time to sell securities. You will be selling securities when the prices are low. By selling securities when the prices are down will prevent the investor from participating in the future stock market recovery. In contrast, smart cash management may provide necessary cushion for investors to weather the economic hardship and wait for the financial markets to recover. Instead of relying on the investment portfolio, investors should have at least 6-month worth of living expenses saved as cash.
Investing Principle # 5: Patience may help pay off in the long run.
You should allow enough time for your investment strategy to become successful. Assuming your original investment thesis was correct, the more investors wait and not react on news the better performance results maybe. However, it is important to distinguish between patience and pride. Sometimes, it’s important to realize that we all make mistakes and to cut your losses. We are all subject to behavioral biases which are very difficult to control. Investors are subject to loss aversion and are likely to sell positions when prices are down in order to limit their losses. Loss aversion expresses the intuition that a loss of $X is more aversive than a gain of $X is attractive (Daniel Kahneman and Amos Tversky, 1984). Representativeness heuristic explains how investors base their predictions on descriptions and recent data instead of personal beliefs and fundamental analysis. By watching CNBC and Bloomberg, investors may rely on incomplete analysis and make decisions that are not based on comprehensive fundamental research. Be patient with your investment decisions. Take your time to do research and make decisions based on your homework results.
Investing Principle # 6: Start early and contribute regularly to your investment portfolio.
You can open the investment account with $100 today. Regular contributions may improve your investment returns. Also, time helps your portfolio to grow substantially. Early small contributions may have the same overall result as large but late contributions would. For example, John opens the investment account at age 18 with $100 initial deposit. He contributes $100 per month for the next 32 years until he is 50 years old. Let’s assume John puts all of his money in the S&P 500 Index which represents the large cap US companies. The annualized total return for this index was 13.5% during the last 10 years. Let’s assume John was able to earn 13.5% on his investment between age 18 and 50. At age 50, John should have $650,867 in his portfolio (see Table 1 and Chart 1). You should know that the actual future return will be different from the assumed performance in this example. The actual return will be lower or higher depending on the future market performance.
Let’s compare John who started investing early with Bob who procrastinated. By waiting to invest later, Bob had to contribute many times more each month in order to catch up to John and to have a similar portfolio value at age 50. Bob waited till he was 30 years old to start contributing. He had to contribute $530 each month in order to have the portfolio value of $651,169 when he turned 50 years old (see Table 1 and Chart 2). It is much more difficult to contribute $530 each month than to contribute $100 per month. By starting your investment contributions early, it is much easier to contribute smaller amounts which may grow into a good size portfolio in the future. As a reminder, your actual future return will be different from the assumed performance in this example. The actual return will be lower or higher depending on the future market performance.
Investing Principle # 7: How investment returns may improve your quality of life?
By now you know, what it takes to earn a good size portfolio over time. What can you do with $650,000? You may be able to use this portfolio to supplement your regular salary or completely live off your investments. Let’s assume John will live till age 100 and decided to live off his portfolio. If he can achieve the 13.5% annualized return, John will be able to take $7,331.00 per month from his portfolio for the next 50 years (see Chart 2). The assumptions are based on annualized 13.5% return which you may or may not be able to achieve in the future. It is still very attractive to see visually how $100 contributions may result in $650,000 portfolio value. The investor may then be able to use the $650,000 portfolio to withdraw $7,331.00 each month for the rest of his or her life (see Chart 2). The performance results in this example are based on the assumptions. In the real life the performance will be lower or higher based on the market conditions.
Investing Principle # 8: Understand your risk tolerance before you invest.
The first step is to realize your true risk tolerance before investing. How much risk can you tolerate in theory and in practice? It is easy to fall a victim of being a risk taker on paper but realize risk aversion in reality. When the stock market enters a correction territory by falling more than 10%, the feeling of anxiety may cause you to fall a victim of the loss aversion bias. Loss aversion expresses the intuition that a loss of $X is more aversive than a gain of $X is attractive (Daniel Kahneman and Amos Tversky, 1984). It will be the least favorable time to make changes to your portfolio when the prices are down. If you are feeling difficulty to remain calm and rational during volatile times or simply are against taking too much risk with your savings, you should have a diversified portfolio. The simple 50/50 asset allocation which comprises of 50% iShares Core S&P 500 ETF (IVV) and 50% iShares 20+ Year Treasury Bond ETF (TLT) is one example of a simple diversification strategy. A risk averse investor may still benefit from the financial markets by having a diversified portfolio which lowers the volatility. Lower volatility will make you feel more comfortable to stay invested through ups and downs.
In addition to a diversified portfolio, a risk averse investor should also use regular rebalancing. Periodic rebalancing is additional risk management took. Rebalancing is bringing out of balance securities in your portfolio in line with the original target allocation. In order to rebalance you would sell overweight securities and buy underweight securities to bring overall allocation in line with your original target. You should rebalance regularly, at least monthly. The advantages of rebalancing are that you will be selling high and buying low. This strategy will limit your risk by trimming gainers and not letting one security to become a large single risk factor in your portfolio. The downside of rebalancing is tax implications. If you have a taxable account, every time you sell the appreciated stock, you will own tax to the IRS. However, if you have a tax-deferred or a tax-exempt account, such as IRA, Roth IRA, 401k, Roth 401k, capital and income gains are tax exempt. You will pay tax from future cash distributions.
Investing Principle # 9: Diversification may lower volatility and help you achieve your financial goals.
A diversified portfolio can create a more comfortable environment for investors to weather the stock market ups and downs. A well-diversified portfolio will have a lower risk with a potential upside for investors. Investors are more likely to stay the course and remain invested when their portfolio volatility is within their comfort zone. The goal is always to be invested during ups and downs. For example, a diversified portfolio which captures 50% of the down market and 60% of the up market may ease the anxiety of a risk averse investor. There is a greater probability for a risk averse investor to stay invested during all market conditions with a lower volatility portfolio. At the end, slow but steady wins the race to the financial goal.
There are many ways to diversify. One simple solution that may work is to combine asset classes that behave differently in relation to each other when the stock market declines. I find the US Government long-term bonds tend to provide a valuable benefit of a negative correlation to the stock market during economic recessions. I have written about the Simple 50/50 model before. The Simple 50/50 model consists of 50% of the portfolio value invested in the iShares Core S&P500 ETF ticket IVV and the remaining 50% of the value invested in the iShares 20+ Year Treasury Bond ETF ticket TLT. This model was successful at mitigating the downside risk during the financial crisis as well as during the Covid-19 pandemic (Simple 50/50). It is just one of the simple examples of a diversified portfolio.
Investing Principle # 10: Be aware of individual company risk and do your homework
Investing in individual company stocks may provide an attractive potential return but it comes with both company specific and market risk combined. Most investors like to brag about the high performing stock picks they made during cocktail parties, it is very exciting to pick the winner and tell stories. Nobody is excited to talk about investing in a well-diversified Exchange Traded Fund (ETF). ETF is the basket of securities designed to follow the performance of its benchmark. Sometimes boring investing is more prudent for beginner investors.
Investing in individual company stocks may provide an attractive return but it comes with a significant risk. The investor takes on both market and individual company risk. When the overall market is down, the individual company stock is likely to be down as well. Also, by purchasing the company stock you assume its individual risk. Individual risk consists of company’s business performance, financial results, competitive environment, and changes in management. It is time consuming and requires both knowledge of financial statements and practical experience to learn about company specific risks. Beginner investor may find it easier to pick ETFs and create a diversified portfolio without exposing yourself to the company specific risk.
Investing Principle # 11: Select the right financial advisor who will represent your best interest
At some point in the future, you may want to seek help of a financial advisor. Financial advisor can provide education, advice and help you reach your financial goals. He or she can also do all the research and monitor your portfolio, so you can enjoy life. How should you select the right financial advisor? To help you with that, the CFA Institute has developed the Statement of Investor Rights. They reflect fundamental ethical principles, understanding of your needs, clear communication and full transparency. The next time you interview a prospective financial advisor, you can bring the CFA Institute Statement of Investor Rights with you to make sure your rights will be protected (CFA Institute Statement of Investor Rights).
Investing Principle # 12: There are no short cuts. If it is too good to be true, it probably is.
With a recent hype around GameStop and stories of investors turning $500 into $200,000, you may fall a victim of the cognitive bias – bandwagon effect. Just because more and more people are buying GameStop, you may want to join the group, be included in making a lot of money fast. The cognitive bias makes it easy to jump in without doing your homework. You may ask yourself: what can go wrong if everybody is doing it? Investments that are based on hyped news and popularity, without fundamental reasoning are very risky. At some point the market price will have to match the true value of the company. The disaster will happen sooner than you think, when reality settles in. It is very difficult to time the market and be the first one out of the door. When suddenly the music stops and everybody runs for the exit, the price will fall dramatically.
There will be many more GameStop like companies in your life. You will hear many classical pump-and-dump stories of people trying to profit from trusting investors. Pump-and-dump scheme is illegal activity by perpetrators trying to boost the stock price through false, misleading or greatly exaggerated information (Investopedia). The perpetrators have already purchased the stock at a low price and want others to drive the price higher based on false information. The perpetrators will then sell shares at a higher price.
Besides unpleasant learning experience, large speculative losses have come with a significant negative social impact on investors. Many investors in speculative securities will lose a lot of money. With large losses, these investors will also lose confidence in the financial system. They will be afraid to invest again and will miss on future opportunities to benefit from the financial system. These people will have more difficult time breaching the inequality gap without the stock market help. That is a negative social effect of the stock market on new investors.
Do your homework before you invest, if there is no fundamental value behind the stock price, it becomes a speculative bet. You can invest some of your money that you can afford to lose. Your main portfolio should be well diversified with good quality companies or broad market ETFs.
Investing Principle # 13: Information travels near the speed of light. Do not try to overrun it.
The financial markets are pretty efficient. High frequency traders have fiberoptic cables in close proximity to major US stock exchanges. Many trades are done using computer algorithms. These trades are executed near the speed of light. Whenever you hear or see new information, it is already incorporated in the stock price. All the news you hear on CNBC or Bloomberg are already reflected in stock prices within fractions of a second. The light travels about 124,188 miles per second through the fiber optic cables (Brodsky). So, if a trading firm has a server within a mile of major stock exchanges, it can execute trades within 0.000008052 second after the news hit the market. Most retail investors do not have the technology to execute trades before professional traders with computer power and fiberoptic cables in close proximity to exchanges.
Investing Principle # 14: The stock markets are informationally efficient and may provide opportunities for long term investors.
The stock market is informationally efficient. It reflects nearly all available public information in the stock prices. You have an opportunity to know about the company and the stock price as much as anybody else can legally. For the most beginner investors, selecting a broadly diversified ETFs with a low cost is probably the best way to start investing.
Eugene F. Fama won Noble Prize in Economics for his work on the efficient market hypothesis. According to Fama, the stock prices fully reflect all available information if the following conditions are met:
- Transaction costs are zero.
- All available information is freely available to all investors.
- Investors agree how information effects the stock prices and distribution of future prices.
According to Fama, markets may still be efficient even if sufficient number of investors meet the above three conditions (Fama 1970). Fama showed that the financial markets may fully reflect past price, return history, and publicly available information. It is highly unlikely that past price data may predict future stock performance consistently and with high enough profitability margin. Only monopolistic access to information may not be reflected in stock prices. The example of such information is the specialist’s confidential book information about submitted limit orders to buy and sell stock (Fama 1970). The specialist’s book information is material and nonpublic. Retail and institutional investors do not have the monopolistic access to information.
However, it is possible to have information which is not immediately reflected in the stock prices. According to Fama, there can be informational signals that are not immediately accepted by the stock market. In this case, the future value will be higher than present value. It is analysts’ job to interpret information correctly and take advantage of investment opportunities over time.
In the long run, the stock market may provide an opportunity to profit. If you are willing to do the homework and learn financial statement analysis and economics, you may try to outperform the market by selecting individual securities. One way to do that is to interpret information correctly and define information which is not currently reflected in the stock price. When you discount the future information to present time, you can compare your target price with the market price. If your target price is significantly higher than the market price, you may decide to purchase this security. After the purchase, you will have to wait for the market to realize what you have forecasted. If your predictions are correct, the future stock price will move closer to your target price. Here are some of the risks in trying to outperform the market:
- It may take a long time for the market to realize what you have predicted. You may not have the ability or wiliness to wait that long.
- Your forecast maybe incorrect.
- There can be a black swan event which you could not have foreseen.
- It is very difficult to have consistently correct projections it requires skills and knowledge.
Investing Principle # 15: The stock market is forward looking.
As we have discussed in section 14, the stock market is informationally efficient. The efficient market hypothesis gained even more strength recently with the technological advances in commission free trading, fiberoptic internet speed, and greater market participation. Most of the historical information is immediately reflected in the stock prices.
Besides being informationally efficient, the stock market is also a forward-looking indicator. Analysts evaluate stock prices based on companies’ future revenue growth and profitability expectations. Active investors position capital into securities of companies they feel could benefit from future growth. As the result, today’s stock prices reflect not only historical information but also future expectations.
The fifteen investing principles create the foundation of investing. Before you go on to build your wealth castle, you need to understand how to build a strong foundation. This is the starting point of your investing journey. The learning process of being a successful investor only starts here and continues through your life.
Brodsky Paul. The Speed of Light Never Changes—Except When it Does. https://blog.telegeography.com/the-speed-of-light-never-changes-except-when-it-does
CFA Institute Statement of Investor Rights.
Daniel Kahneman and Amos Tversky. “Choices, Values, and Frames.” American Psychologist. Vol. 39, No. 4, p. 341-350. April 1984.
Fama Eugene F. Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 383-417
Financial Times, How America’s 1% came to dominate equity ownership; https://www.ft.com/content/2501e154-4789-11ea-aeb3-955839e06441
Investopedia. Pump-and-dump. https://www.investopedia.com/terms/p/pumpanddump.asp
IRS. Traditional and Roth IRAs. https://www.irs.gov/retirement-plans/traditional-and-roth-iras
Ivan Sichkar. “Smart Cash Management Can Decrease Risk and Increase Returns.”
The Federal Reserve, Distribution of Household Wealth in the U.S. since 1989; https://www.federalreserve.gov/releases/z1/dataviz/dfa/distribute/table/#range:2005.3,2020.3;quarter:124;series:Net%20worth;demographic:networth;population:1,3,5,7;units:shares
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor, before making an investment decision. Neither ECNFIN.COM nor its author are responsible for any damages or losses arising from any use of this information.
ECNFIN.com and its podcast are not associated with nor do they necessarily represent the opinion or advice of Epiqwest Culver Wealth Advisors LLC. Past performance doesn’t guarantee future results.
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