I am an amateur value investor. I am, and have always been, interested in business, finance and economics. Recently a few friends and team mates have asked me about how they can get started investing in stocks. I have few thoughts about the goals and process of investing that are relevant and important but unknown to most folks. I hope to shed some light on them in this post.
Investing is unique to every individual
This is one of the most important points to remember when you wish to start investing. Investing, to define simply, means growing your savings at a certain rate of return. This definition implies that you don't lose money when investing. Most people save for a future event like paying for a wedding, buying a house, kid's college education, retirement, etc. These events are unique for every individual based on their desire, ambition and life style. Investing is tool to achieve one's unique goals and thus it has to be tailored to their needs.
For example, a recent college grad (Bob) has different goals than some one who is about to retire in a few years (Alice). Bob wants to save for a wedding and a house while Alice needs to save for retirement and medical costs. The difference is that Bob has decades of work life ahead of him and has plenty of opportunity to earn money. Alice doesn't have a salary, so she needs safety of fixed income. Both have different goals and will need different investing tools.
Stocks and Bonds
There are various instruments for investing like stocks, bonds, real-estate, commodities, futures, etc.
Broadly, stocks and bonds are the two main investing tools in the financial markets and others should be left for an advanced investor or a professional.
Stock of a company represents a unit of ownership in that company/business. When business profits are increasing, you as a owner get to enjoy those profits in terms of dividends. On the flip side, if the business suffers a loss, you may lose money. The key point to remember is that increasing profits mean your stock is more valuable. As the earnings grow year over year, so does the value of your stock. While earnings of a business might fluctuate for a few quarters/years, stocks are a great tool to grow your savings over the long term.
Bond is an obligation of a company/business to pay back the money borrowed along with interest. A bond is similar to an interest bearing bank deposit where you give your money to a company and they repay you the sum after a defined period of time along with interest. The key point to remember is that you always get your money paid back in full along with the interest, irrespective of the earnings of the business. So, if the company's earnings are poor for a period of time, you are not affected by that. On the flip side, if the company does really well, you have no claim to the extra earnings. Bonds are a great tool to protect your savings and grow them at a small rate of return.
A well rounded personal portfolio contains a mix of stocks and bonds. Based on your goals, the ratio of stocks to bonds will vary. Bob from our previous example will have a larger percentage of his savings in stocks to make them grow aggressively. Alice on the other hand will have most of her savings in bonds to protect the wealth she has.
A general rule of thumb for determining the ratio of stocks in your portfolio is to subtract your age from 100. For Bob who is 25 years of age, 75% (100 - 25) of his retirement savings should be in invested in stocks and 25% in bonds. Remember that this only applies to goals that are years away. If Bob is saving to buy a house next year, he should keep that money in a bank deposit.
Can we pick stocks already?
Now that we have determined how one's savings should be divided between stocks and bonds, the next step is to go buy them. You have two options here:
1. Buy individual stocks in businesses
2. Buy mutual funds
Buying stocks in the companies you know and love is a good way to invest in stocks. But it also requires a lot of effort on your part to do it right. You must know how to read financial statements and make sense, follow up with the company and sector related news, and keep with the local, country and world economy. This sounds like a lot of hard work and it is. You might not have the time to put in the effort or simply might be not inclined to do so. If that is the case, you are better off buying mutual funds rather than individual stocks.
When faced with ignorance in investing, diversification is your friend.
Mutual funds are a great way to invest in stocks. You pay a professional to invest the money for you for a fee. You might not have the bragging rights of investing in the latest "hot" company but you will have a better overall rate of return than most people. You can increase your returns further by investing in a index mutual fund that buys a broad set of stocks instead of an active mutual fund where the fund manager chooses which stocks to invest in.
Active mutual funds are generally a loser's bet. While the fund manager might generate a great rate of return on your money (and that's a big assumption) compared to an benchmark index, he will also charge you a large fee to manage your money. After all the fees and taxes, you actually end up under performing the index mutual fund. To be fair, there are some skilled mutual fund managers who have consistently beaten the benchmark index. But it is near impossible to separate the wheat from the chaff. You are almost always better off buying an index mutual fund.
Which funds to buy? Where to buy them?
For stock portion of your portfolio, you should buy the mutual funds that track S&P 500 index or the total stock market index. S&P 500 index is a collection of top 500 companies in America and is published and maintained by Standards and Poors. It is the world's most widely tracked index. The total stock market index consists of all stocks in the US. For the bond portion of your portfolio, you should buy a total bond market mutual fund.
You can buy these mutual funds directly from the company that manages them or from your broker. Having decided on the index that you want to track, the golden rule of buying mutual funds is to buy the ones with the lowest expense ratio, not the past performance.
I recommend buying the mutual funds from Vanguard as they are usually the funds with the cheapest ratio. In addition to that, Vanguard is owned by the investors that put money in its mutual funds. This aligns the incentives of the company and management with its investors. This is not true of other fund companies like Fidelity, BlackRock, etc. which exist to enrich their shareholders, not its investors (which is YOU).
Your retirement savings are most likely in a workplace 401K plan. This is the money that is deducted from your paycheck before any taxes and invested for your retirement. Ideally, you would withdraw this money on your retirement at age of 60, giving it at least 35 years to grow. Your choice of funds in the 401K plan is determined by your company and is usually limited. Given a choice, always choose a Vanguard fund.
By this point, I hope you have a basic understanding of how to think about investing. The topic of investing is too big to cover all the details in a few blogs posts. There are numerous books that go into all aspects of investing in detail. I recommend "The Four Pillars of Investing" as a great beginner's book. Remember, investing is always for the long haul and requires a lot of patience. If you were planning to double your money in the next few weeks, you will have better luck in a casino than in the stock market.
Market, like the Lord, helps those who help themselves. Unlike the Lord, it doesn't forgive those who know not what they do. -Warren Buffett
If you have more questions, post them in the comments or email me. I ll try my best to help you.