In this latest installment of my Financial Planning 101 series I am moving onto the topic of investing. The last installment found here wrapped up my coverage of insurance and it is time to move into a new area. I am guessing more people will find this more interesting but I started with those other topics for a reason as I believe the previous topics dealt with the issues that form the foundation for solid personal finances.
Covering investing will take some time so there will be a number of individual postings on this larger topic. This post will act as an introduction to investing. Later posts will get into more specific topics.
Let’s establish some basic terminology that will come in handy to understand this and future installments.
Stock Market: People will generally refer to the “Stock Market” but what does that really mean? The definition of stock market doesn’t really match up with what most people mean when they mention the ‘market’. The stock market is an established exchange where stocks of individual companies are listed for buying and selling. We have two primary stock markets in this country, the New York Stock Exchange (NYSE) and NASDAQ. NYSE is considered the leading stock exchange in the world with 2,800 companies listed and over 1.4 billion shares traded daily on average. NASDAQ tends to have more tech centered focus with 3,300 companies and 1.8 billion shares traded per day.
Stock Index: A stock index is a group of stocks that have their collective performance measured. These stock indexes are what most people are actually referring to when they talk about the stock market. There are dozens of indexes used between the stock markets in the U.S. but there are three primary ones we follow.
Dow Jones – This is the granddaddy of all indexes and the one that gets the most coverage on the news. We are all familiar with hearing The Dow was up or down in a given day. The Dow Jones is actually comprised of just 30 stocks that are selected to represent a cross section of the America economy. The Dow is a price weighted index meaning that a company like McDonalds which is trading at $200 per share has four times the impact on the Dow that Coca-Cola has which is trading at $51 per share. Because of this companies with high share prices such as Google and Amazon while amongst the largest companies in America are not part of the Dow.
S&P 500 – This is a collection of 500 of the largest US companies. This index is maybe the best barometer for the overall market given the breadth of companies and industries represented. This index is market cap weighted meaning that a company like Apple which is worth near $1 Trillion will have 200 times the impact on the index than Nordstrom which has a market cap of just over $5 Billion. As a result this index largely influenced by Microsoft, Apple, Amazon, Facebook, JP Morgan Chase and Google.
NASDAQ – This index spans the entire 3300 companies listed on the NASDAQ market. This is also a market cap weighted index and since this is a tech heavy index it is most influenced by Microsoft, Apple, Amazon, Google, Facebook, Intel, Cisco, and Netflix.
Portfolio: This is the collection of your investments. This includes everything in all of your investment accounts, including retirement accounts and other types of investment accounts.
Now that we have established some of the basic terminology let’s go over some of the basic principles of investing:
Risk vs. Reward
This is the name of the game when it comes to investing. The more risk you are willing to take on with investing the greater the returns you should expect over the long run. Stocks are considered a more risky investment but over the long run has averaged a 10% return (S&P 500 average return from 1926 to 2018) compared to bonds which had an average return of 5.4% over the same timeframe.
The risk of course is in the short run. The stock market is more vulnerable to a sharp downturn than bonds which are viewed as more stable. And we don’t really know when that downturn might happen. TV is full of talking heads who may claim they do and there is some statistical evidence that is available that might be a gauge on what could happen but it does not always play out that way.
We recently have come through one of the more volatile times in market history. In 2008 the S&P 500 was down 38.5% and is up roughly 400% in the years since. So while overall the returns since the beginning of 2008 have averaged 6.5% there were very nervous times for many investors for a period of time.
2. Invest early, invest often.
We have all seen the charts that show the impact of investing over a number of years. I will include one here as well just to hammer home this point. The most powerful tool you have as an investor is compounding interest. The longer your money stays invested and can continue to grow the better. This chart illustrates that point. The person who began investing at age 25 has a slow build of their nest egg. But once they hit roughly age 50 the portfolio begins to grow much more quickly. Let’s assume an 8% rate of return. Once they have accumulated $400,000 the 8% return starts to really add up. That alone is worth 32,000 plus the 5000 they invested. That brings the total to 437,000. Another 8% return on top of that is 35,000 plus the 5000 that was invested is 40000 of growth for new balance of 477,000 and the growth continues to accelerate from there.
On the flipside, the person who didn’t begin investing until age 35 never really gets a chance for those big gains because by the time they would start to happen they are at retirement age and now need that money for expenses.
So the lesson is for those of you who are young and feeling like money is tight and you feel like you need to wait until you are making more money please try to find a way to start saving right away. There will always be some expense that comes up that will make it seem like it isn’t the time to start investing so do it now and just get used to that money not being there. You will thank yourself in the future.
3. Market timing is extremely difficult.
We all know the goal of buying high and selling low. The problem many investors run into is that they get hung up on selling at the absolute peak price or trying to buy at the lowest price possible. These exact price points are impossible to know. You will be much better off in the long run if you decide it is time to buy or sell and just moving forward with it. Again, none of us knows if from one day to the next the market will be up 300 or down 150. And, in the case of mutual funds, the price isn’t determined until the end of the day anyway.
Here is another chart showing the potential impact of getting too cute with the market and waiting to buy. This shows the impact on your performance of you missed out on the top five days over the past 20 years. As you can see it would make almost a 35% difference in the overall return on your investment.
Bottom line: if you are comfortable with the return you have made go ahead and sell. If you feel that an investment is a good value at the current price, go ahead and buy it and don’t worry about the couple of bucks wither way that could have been made.
The other piece of advice that goes along with this is to simply stay invested. Many people get nervous when the market gets volatile and want to sit on the sidelines until things get better. The problem is by the time they feel better about the market the gains might have already been largely realized and they are buying back in at the top of the market. I recently spoke to someone who mentioned they pulled everything out in 2009 after the financial crisis and still hadn’t reinvested yet. They mentioned they avoided losing everything. I didn’t have the heart to tell this person they also missed out on the roughly 400% appreciation that has taken place since then.
4. Most gains are a result of a diversified portfolio.
I’ll speak to diversification more in depth in a later installment but basically diversification is the principal of spreading your investments around between a variety of asset classes and individual assets. This is a key tool in the risk management of your investments. At the same time it is beneficial to your overall returns. The ‘market’ has many segmentations to it and at any given time some of these segments will be performing better than others. By being diversified you are protected against the risk of being too heavily invested in the poorly performing segment or individual asset and you will also be invested in whatever segment is performing well at the time. Admittedly, this is the glass half full take on this because at the same time one can use the rebuttal that you’re missing out on returns by not being in the hot segment. While this may be true, the fact is it is hard to know what the hot sector is until after it has made its run. A down sector might have a couple of good weeks quietly when most people aren't watching.
Many might think of tech as the hot segment and while overall for the last few years that has been the case there have been windows of time where others have been better performers. As of June 4, 2019 the top sector of the year has been Utilities which has been up 17.4% over the past year while Tech is up just 2.35%. Over the past three months Real Estate is the leading sector up 4.82% compared to 2.23% for Tech. Over the past month Utilities have been the leader up .49% while Tech is down 7.71%.
As you can see over the past month Utilities have outperformed Tech by over 8%. Now, I would challenge you to find a person who 30 days ago was so smart that they moved their investment portfolio out of Tech and went all in on Utilities. Anyone want to raise their hand who did that? Anyone, anyone? No, I didn’t think so. The reason for this was a couple of bad days killed Tech, and Utilities, which are less volatile, basically treaded water. By being diversified though you would have had a portion of your investments in Utilities which would have helped offset the beating Tech took.
5. Rebalance your portfolio periodically.
When you put together your diversified portfolio you will most likely have a target percentage for each of those assets in your overall portfolio. You will also find that individual assets will grow at different rates and this leads to individual holdings ending up in different percentages from your target. For instance, say you have Mutual Funds A and B and want each to be 20% of your portfolio. Over a period of time fund A performs well and now makes up 23% of your portfolio while fund B didn’t do as well and now sits at 18% of your portfolio. In this case rebalancing would call for selling a portion of fund A to get back to 20% and then buy more of fund B to get that back to 20% as well. Most guidelines will call for you to do this exercise once or twice per year.
This practice will also reinforce the concept of dollar cost averaging which will be discussed more later as well as locking in the practice of selling high and buying low.
6. Expenses can erode your returns.
I will devote more time to this issue in a future post but for the purpose of this installment I want to point out that expenses can be a real drag on your returns. Individual investments may have a load fee or management expense fee associated with them, There might be a fee tied to your investment account and finally, if you have an advisor they might be charging you a fee based on your investments. These fees can really add up over time.
That concludes this primer on investing. Hopefully you found something interesting or valuable here. The next installment will focus on stocks and their characteristics.