Investment basics
This post is part of the Financial Freedom Guide series
Welcome to Investment 101! Let's get you started:
Investment vs speculation
The first thing you should understand when looking to invest is the difference between investing and speculating.
Investing is buying assets that have intrinsic cash flows, such as corporate earnings, dividends, rental income, crop yields, and so on. You'd be happy to own these assets and benefit from their cash flows independently of what anyone else is willing to pay to buy them from you at a given moment. Ideally you'd like to just own these investments forever!
Speculating is buying assets that have limited or no intrinsic cash flows and whose value principally depends on whatever someone else is willing to pay to buy them from you at a given moment.
While you can make fortunes speculating, you can just as easily lose your shirt. For every Bitcoin or Gamestop millionaire, there are plenty of people who lost everything - and some who tragically committed suicide - after day-trading on Robinhood. As exciting as gambling is, it is not a reliable path to Financial Freedom.
Instead, put all that energy and heartburn into doing something you reasonably enjoy, can get good at, and will get paid for by others. Then take your earnings and buy yourself Financial Freedom through long-term investing.
Once you have accumulated sufficient assets to be able to meet your financial needs solely through your investments' intrinsic cash flows (e.g., dividends), you have achieved full Financial Freedom. At that point your financial well-being no longer depends on the moods of others - be that your boss, customers, or the swings of the market.
Diversification
Keep in mind that even assets with intrinsic value can go bust, however: Companies face technological innovation all the time, which can impair (or improve) their ability to generate earnings and pay dividends. Your rental property can burn into the ground. So can that timberland you invested in.
The only way to mitigate this risk is to spread your bets and diversify - just don't put all your eggs into one basket. Instead of one company, buy 30 - or just as easily thousands via an index fund. Instead of one rental property, buy thousands via a REIT index fund. Then, if any one of the companies or properties you own faces an impairment, it will only make up a small portion of your overall portfolio and your other investments will more than compensate for it over time. You may even already be invested in the innovative company that just took over that bankrupt company's market share.
As a rule of thumb: Any individual asset probably shouldn't be more than 10% of your overall portfolio.
Many people violate this rule by owning expensive houses that make up a substantial portion of their net worth. That's OK - but it’s also risky and expensive (you'll want to buy good homeowner insurance). Also see my article on Housing - Rent vs Buy (coming soon - subscribe to encourage us to hurry up) for more on this.
Investment horizons
Any investment should be done with a goal in mind. This can be achieving Financial Freedom, saving for a home down payment, affording college, or any number of objectives. How much time you have before you'll need the money will make a huge difference in what you can (or should) invest in. This is called your investment horizon.
Generally speaking, you should not invest in the stock market or real estate if you think you may need your money in less than 5-10 years. The risk that the market will have a temporary downturn just as you need to withdraw your money is simply too big. Remember sequence of returns risk? For real estate, the transaction costs to buy and sell in such a short time are likely to eat up most of your gains and there are housing downturns like in 2008, too.
On the flip side, here is some great news for anyone pursuing Financial Freedom: If you build up enough capital so that you can meet your financial needs entirely with the intrinsic cash flows of your investments (dividends, limited capital gains), you never actually need to sell. This “never sell” mindset means your investment horizon effectively becomes infinite and you can invest in any number of high volatility, high return investments - emerging market stocks, for example.
That is as long as you have the emotional fortitude to stomach the volatility.
Emotional fortitude
No amount of rational investment planning will help you if, when you see the stock market crash 50%, you panic and sell all your stocks. Or if you cautiously sit on cash until you get swept up by the mania and buy at the peak, just to promptly panic again on the inevitable correction. In fact, research shows that those individual investors who trade least tend to have the highest returns. The problem is all of us - perhaps with the limited exception of some psychopaths - are emotional animals, ruled by fear and greed.
If you know you don't have the emotional fortitude to invest in the stock market even in a hands-off way, don't do it. You may struggle to achieve Financial Freedom but you'll only find grief if you ignore this valuable self-knowledge.
Unfortunately, most people believe they have their emotions totally under control - right until the market goes crazy and fear and greed take over. Instead use a few tricks to manage your emotions:
Think of the market as your crazy neighbor. Call him Mr. Market. Every day he rings on your door and offers to buy the solar panels on your roof - or sell you some of his. Now these solar panels reliably provide you with electricity and a tidy profit every day (intrinsic cash flows). Sometimes Mr. Market's price is fair, other days it's completely insane. Do yourself a favor and mostly ignore Mr. Market. Don't buy today because you think his price will be higher tomorrow. Don't sell tomorrow because you think his price will be lower the day after. Simply buy whenever the price is reasonable and, if you are pursuing Financial Freedom, never sell and be happy about those solar panels writing you a check every day.
When the market crashes, celebrate! It's like your favorite store just put up huge “FOR SALE” signs on their entire inventory. Buy buy buy! In the reverse, would you go into a buying frenzy right after your favorite store just raised all their prices? No. So don't do the same when the markets just went up. Instead, simply cost average, calm and steady, and otherwise try to ignore the mania.
Write a contract with yourself. I personally have a golden rule to never sell (other than to rebalance), even when prices seem crazy. Market timing will not work out for you on average. For anybody who times the market right, by definition, somebody else didn't - or else the market wouldn't swing at all. Are you truly smarter than all the Wall Street Quants out there? I'm not.
When market ups and down, or the prospect thereof, drive you nuts - or, worse, cause decision paralysis and stop you from investing - consider cost averaging. The idea is simple:
Pick a certain dollar amount to invest at a regular interval (e.g., every month). Better yet, have your broker automatically deduct that amount from your savings account. Then, when stocks are expensive, your fixed dollar amount will buy relatively few shares. When stocks are cheap on the other hand, your fixed dollar amount will buy lots of shares. This way you will buy most of your shares when they were relatively cheap.
Congratulations, you just succeeded at the first mantra of investing - buy low! If you are pursuing Financial Freedom and have decided to never sell, that means you are already done. If you are saving for a one-time goal like a house down payment, check out unit averaging for how to best draw down capital.
Cost averaging is pretty much the only "method investing" strategy that actually works. Your dollar amount also doesn't have to be fixed forever. It should grow with inflation and will change with your ability to save. The critical point is that this amount should be determined by your ability to save, not based on your current assessment of market prices. Remember: Nobody can time the market, not even the experts, or else everything would be priced perfectly at all times and there wouldn't be any wild market swings at all!
What should you do if you suddenly sit on a big pile of cash? Perhaps you've already been saving but have neglected the crucial step of investing and putting those Financial Freedom dollars to work. Or perhaps you received a year-end bonus or inherited some money. Well, think of the stock market as an irregular oscillation around an upwards pointing trend line. On average, you'll do better investing your pile of cash as a lump sum right away.
Of course, you might be right on the cusp of one of those market corrections and then you may end up feeling regret. If this paralyses you, consider compromising and cost averaging your lump sum over a relatively short time horizon, say 1-3 years and taking advantage of any market corrections during this timeframe. Yes, this behavior would be "irrational" but if it calms your nerves and helps you avoid decision paralysis, it's worth it. We are emotional animals after all. Vanguard has a great summary and detailed whitepaper on this.
Or that’s what I’m going to call it. Assume you need to sell some investments over time. Per the above logic, you would on average be best off to wait as long as possible before selling. But what if you need cash but don’t need all of it now and can stretch your asset sales over time? Then rather than selling a fixed dollar amount at regular intervals (so called “reverse cost averaging”, which has the opposite effect of cost averaging and results in you selling more shares when they aren’t worth as much), you may be able to sell a fixed number of shares at regular intervals. That way you “buy more dollars” when they are cheap vs when they are expensive. Of course that only works if you can buffer the varying cash payouts.
Do you have any questions and thoughts? Please leave them in the comments section.
Alright, we've covered the basics. So what can we invest in anyway?
Go back: How do I invest?