How to Invest
How to Invest Correctly and use Index Funds and Begin your Investing Education How do I Invest
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” -Warren Buffett
This is the place to begin to learn how to invest. If you have have a 401k, IRA (Individual Retirement Account) or you’re looking for the best way to invest 10K. This article will set you straight. The best way for most people to participate in the stock market is to index. Selecting individual securities is much more involved. This article covers what most people should do. Most people should compound the power of their earning abilities from their careers. The key is to continually save more and more and keep your spending low. That’s a whole another topic but we’ll get in to what to do with all the money you’re saving from not spending. The answer is you invest and we break it down to a really simple strategy so it’s pretty mechanical and you don’t have the stresses of investing in individual companies. If you believe you have the temperament for investment in individual securities, go on to the Recommended Reading and start with all those books. If you are at all deterred by the fact I am suggesting all those books and that it will be the tip of the iceberg then get back to this article and learn how to do things the easy way with a peace of mind. The sheer purpose I’m writing this is to handle the typical questions:
“What is the best way to invest 10k?” “What is the best place to invest money now?” “Where should I invest my money now?” “Where do I invest?” “How do I invest?”
Most people fall into several groups when it comes to investing:
- They have some sort of work retirement but pretty much went with the default and could be risking paying high fees. It pays to learn
- They believe the stock market is just some sort of big casino with flashing numbers running across the screen and they are terrified of it.
- They don’t believe in index funds or mutual funds. They believe they can pick the winners. The next Apple or they have some sort of other various strategy. They think index’ing is throwing up the white flag or something
“Can you really make money in them [stocks] without taking a serious risk? Yes indeed if you can find enough of them to make a diversified group, and if you don’t lose patience if they fail to advance soon after you buy them. Sometimes the patience needed may appear quite considerable. [But] most of the bargain issues in our experience have not taken that long to show good profits. ” -Benjamin Graham
All of these approaches are dead wrong and will lead to trouble for a number of reasons and much more stress then is necessary. I don’t know about you but I like easy. Most people have no clue at all how a market works and even how the economy operates. Knowing what you’re doing and having confidence in your strategy is key. The reasons using index funds will beat most of your others options come down to them being less bad. Yes less bad. The average return of the mutual fund barely beats the indices even though it has the benefit of survival bias benefit meaning the losers are wiped out. Just as it’s not easy to pick individual securities it can be very difficult to pick the best fund managers. Fund managers can get lucky or you can invest in their funds at a bad time. Past performance is no guarantor of future. There is also the affect that the more money that pours into a superstars fund the smaller his universe of companies to invest in becomes. If you’re investing billions of dollars you have a lot less options then someone investing millions. Fees. Hot shots command large fees and index funds do not. You make up a great deal of the over performance through the lack of fees being paid long term. Peace of mind . You don’t have to worry that the indices know what they’re doing. I’ve seen many fund managers make the cover of Businessweek for being the next greatest thing and then years later as a loser.
Eddie Lampert and Sears is whole different case story but the first cover was from 2006 and then the last was from an article in the same publication Businessweek in 2013. Times change quickly on Wall Street. In 2011 Bruce Berkowitz was maligned for his huge bets on AIG and Bank of America and then he was one of the biggest winners on Wall Street. If you listen to the noise of Wall Street you’re apt to make actions just based on noise and the crowd. We’re trying to stop you from doing that. The Vanguard Total Stock Market Index fund owns everything. If a company is added it is added. If a company is delisted from the stock market it is removed. The losers get eliminated. You don’t worry about picking the winners or losers you worry about accumulating when others are pessimistic more shares and laying off the gas when others are too optimistic. Why worry about who the next winners will be. Bet on the economy and human’s finding ways to use technology to become more productive. That’s really what we’re doing. Becoming an investor can be one of the best things you can do with your money and can insure you retire younger. The abilty to build a nest egg large enough so that you can live off the dividends is an empowering ability that can provide you freedom.
“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” -Benjamin Graham
What is a stock? A stock is a security that represents an ownership interest in a business. Some portion of the company is attributed to you. If the stock pays a dividend then you will receive a payment per share as defined by the company in exchange for ownership. For example if you own a share of Exxon Mobil Corp that you bought for $100 and it paid a quarterly dividend of .60 a share, for a total of $2.40. You get a 2.4% annual yield for owning the shares. Important factors in this equation is how the total amount of dividends a company is paying out relate to its net income. The better the payout ratio the more safe the dividend tends to be. A company like Exxon Mobil has a net income of 34 billion dollars and the dividend only represents 31% of that. If you owned 10,000 shares you would receive $24,000 a year in income at this rate. Not all companies pay dividends. Smaller younger companies tend not to because they reinvest the money back into themselves to grow and hopefully use that money to make their business larger at a rate greater than the money they are reinvesting. Good businesses can continually do this and create value.
Why is the stock market so volatile? It always seems to go up and down. While in the long term the price of an individual stock roughly represents the value created through its reinvestment in cash and the amount of dividends over time that it will pay. Nobody really knows in advance what that will be in the future so you’re guessing. Wall Street Analysts have a dubious record as a whole for picking what stocks or even the market will do. Complex systems are hard to estimate. The stock market is very focused on what happened today or this quarter and tends to have a tunnel vision.
“The memory of the financial community is proverbially and distressingly short.” -Benjamin Graham “Be fearful when others are greedy and greedy only when others are fearful.” -Warren Buffett
Each day there’s fear of the next Greek debt crisis, or some emerging country going bankrupt, or some war and in the short term the stock market can be extremely volatile. There’s times like in 2000 during the Internet bomb when it thinks the good times will never end and gets excessively optimistic. The NASDAQ didn’t hit heights it reached that year until 2013. There’s times like 2008 after the financial crisis where it leaves this country for dead and you would have done well buying as much stock as you possibly can.
If the stock market is so crazy, how can I best make money from the stock market? In the long run all that speculation and volatility just goes away and as the companies’ earnings increase and the GDP of our country increases the price of its stock increases and the stock market price increases. An index represents a basket of companies. Over time our countries GDP goes up and the companies earnings go up. These increases in efficiency create more profit and so because of this stocks will go up over and time. As you can see below as our Gross Domestic Product goes up, the earnings per share of the S&P 500 goes up.
The total return has averaged an extremely wild ride of a 10 percent per year before inflation and 7 percent post inflation with 2% of that coming in the form of the dividends.
When you’re young you can continue to reinvest these and accumulate more. When you’re older you hope to be able to live off these. The quicker you build the nest egg. The sooner you can live off of it!
Okay so what to invest in? Which companies should I invest in to get this average return? For 95% of people coming here to learn how to invest and how to best invest your money or the best way to invest 10K, or how do I invest, or where to invest cash. The best way for most people to invest their money is to simply buy an index fund, which is like a mutual fund but instead is a very low cost fund that automatically buys appropriate ratios of every major stock in your country’s stock market. With index funds you alleviate the guessing which stocks are better than others. The reasons the index fund tend to beat all these fancy mutual funds is because they can be run by a very basic strategy and don’t need to pay huge management fees. Most people trying to beat Wall Street will not. They will trade too frequently benefiting Wall Street with the fees they generate. They will get scared in panics. They will buy when they should do nothing. They will sell when they should buy. They will invest in some hot fund because their Financial adviser told them to. They will lose on average but the person with the index fund will accumulate wealth. Get used to getting excited accumulating shares and things will work out.
What Index fund do I want? The best choice is the Vanguard Total Stock Market Index Fund that tracks every single stock in the US stock market. It has a minuscule expense ratio of 0.17% If you’re stuck with some employer plan then try to find the closest thing to that or the S&P 500 Index fund which is a collection of the 500 largest companies in the US. The S&P is an excellent basket of stocks and represents business interests in a wide variety of businesses from Finance to Technology to Energy to Health to more… Some people like to get fancy and chose some other funds like International but always keep in mind that on the whole the most business friendly country is still the US. At least of size. In another article we’ll discuss how to determine whether the stock market is on sale or whether it is fairly valued, or whether it is too expensive. At those times it can be better to lower the size of stock purchases and to purchase increasing amount of bond funds.
My friend invested in this company and it went up a lot and he made tons of money. Why can’t I just find a few of those? Maybe your friend is an advanced investor or maybe he got lucky. People do things irrationally all the time. They gamble even though Las Vegas isn’t built off of nothing and they don’t understand basic statistics or math. If you don’t enjoy business, finance, reading, have an outstanding temperament and a thrist to learn new things every day then don’t bother investing in individual stocks just index!