Most people, unfortunately, don’t invest well.
They sell stocks in frustration after the market has already fallen, they buy stocks with excitement after the market has already surged, and they waste money on paying high fees to people and companies that don’t deserve them.
Even most people that do this for a living perform poorly. People with Ivy League MBAs still usually make bad professional stock pickers compared to simple low-cost index funds. Not all of them, but far too many.
Imagine if the medical profession had this inconsistent of a track record, where a guy trying random things on your body statistically works just as well if not better than a talented surgeon fixing the specific problem after doing a series of scans and assessments to figure it out. That would be crazy, right? And yet that’s how a large portion of the financial industry works, and is why index funds have grown in popularity.
Even with index funds though, individual investors face several pitfalls in practice. They don’t put enough money in to begin with, and they time the market poorly. A lot of investors end up underperforming the funds that they invest in.
My father, for example, sold all his stocks in his 401(k) at low prices after the recession in 2002 and stayed in cash. The end result was that he locked in his losses by selling at the market bottom (when he should have been buying more), missed out on the recovery, and never invested in stocks again. Years later, having stayed in cash the whole time since then, he never fully recovered his net worth from that mistake.
Consider this a guide for new investors on how to seriously up your game. Not just from me to you, but for all of us to continually be aware of our faults and build wealth more quickly and reliably.
How to Invest Money Intelligently
Fortunately, you don’t need to be the smartest person in the room to do well with your portfolio. Sure, you need a solid grasp of basic math, but beyond that, it’s more about managing your emotions and looking at good evidence for what works, rather than relying on raw brain horsepower.
There was a great article published by The New York Times back in September of 2016 called, “The Difference Between Rationality and Intelligence“, which describes this point excellently.
The summary of that article is that rationality and intelligence are different from each other, and not very strongly correlated. You can be rational without being particularly intelligent, and you can be intelligent without being particularly rational. There’s only a weak correlation between them.
In this context, intelligence is like raw horsepower in the brain. How quickly can you identify a pattern in a series of numbers, or grasp extremely complex mathematics? That’s raw IQ, raw intelligence. For the most part, we can’t really change this; we have to work with what we’ve got.
Rationality, on the other hand, is mainly about being resistant to logical fallacies. It’s about critical thinking, and about being able to take a step back and examine our own thought process to identify and correct the faults in our way of thinking. Unlike intelligence which is largely set in place by the time we are adults, rationality can be learned and improved. Studies have shown that by learning the various logical fallacies that humans are prone to, we can improve our ability to identify and avoid them.
Successful investing, most evidence seems to indicate, is more about being rational than intelligent. You don’t need a ridiculous IQ, but you do need to be able to detach your emotions from your reason, and be able to identify when you’re doing something irrational with your money. In that sense, being an intelligent investor actually means being a rational investor.
Investing vs Gambling: The Key Difference
People that aren’t knowledgeable about investing often view the stock market as a casino. You put money in, and you might or might get it out later, they say.
But that’s not how it works, even though there is always a degree of chance involved.
Investing means to buy an asset with a high probability that it will produce substantial cash flow or capital appreciation over time, and grow your wealth. Markets go up, and markets go down, but over the long-run, investing in profitable companies is one of the most consistent ways to build wealth.
Performing discounted cash flow analysis, or at least understanding the basics of it, is a good start on being able to differentiate between an investment and a speculation because it helps you determine the maximum amount of money you should pay now compared to the cash flow you expect to receive over time.
Examples of Investing:
- Putting money into index funds each and every month.
- Building and holding a diversified portfolio of dividend-paying stocks.
- Buying rental property for a reasonable price and maintaining it well.
- Thoroughly analyzing a company and investing in it for the long-term.
- Selling options with the intention to buy good stocks below current market prices.
- Starting a business and putting your time and money into growing it.
Examples of Gambling:
- Betting $50 on Blackjack (obviously).
- Putting $3,000 into a hot tech stock because your uncle said it’s gonna be big.
- Buying call options, hoping for a multi-fold gain, without any sophisticated options risk mitigation strategy to put the odds in your favor.
- Using very high leverage in your investment accounts.
- Changing your portfolio constantly because you think you reliably know what is going to happen in the markets next month.
How to Start Investing Today, if You’re New
Don’t jump into anything yet. You need to plan out a few things first if you’re looking to start investing or do an overhaul of your current investments.
Jumping too quickly into something before you understand your options can lead to hassles down the line, so it’s best to start out the right way.
Try These 4 Steps to Start Investing:
- Learn the #1 sin of investing, and avoid it
- Select the right account type
- Pick a platform and strategy
- Select your investments
Step 1) Learn the #1 Sin of Investing, and Avoid It
The biggest mistake you can make when you invest money is to pay high fees.
If you’re paying any more than a fraction of a percent on your money per year, you really should switch to a lower cost solution. That is, unless you’re also getting a full suite of other services, like tax management and estate planning.
These are some of the lowest fee investment methods you’ll find:
- Thrift Savings Plan for US Federal Employees: 0.029% expense ratio
- Vanguard Index Funds: 0.05% to 0.40% expense ratio
- Fidelity Index Funds: 0.045% to 0.21% expense ratio
- Motif: $9.95/trade for up to 30 stocks or ETFs
- Buy-and-Hold Dividend Stock Picking: A few bucks per stock purchase
To put it into perspective just how important it is to keep your fees incredibly low, let’s look at the numbers. Suppose your investments grow at 7% per year, and you pay 0.1% per year in fees, over a 40 year investing career. That gives you an effective rate of return of 6.9% before taxes and inflation. For every $10,00 you start with, you’ll have over $144,00 by the end.
Now, assume again that you grow at 7% annually, but pay 1.5% per year in fees. I know people who have 401(k)s that charge this amount, and I know people that pay for active management that costs this much or more. Your effective rate of return will be only 5.5%. For every $10,000 you start with, you’ll have only $85,000 by the end. That’s an enormous negative difference.
If you’re putting away thousands of dollars per year into your retirement accounts, then any fees you pay can totally derail your retirement over a 30 or 40 year period. Now, if higher fees meant better performance, then it would be a fair trade. But for the most part that’s not how it works, and high fees usually just enrich the people charging them.
Step 2) Select the Right Account Type
The next step is to figure out where you want to put your money. If you’re in the United States, you’ll have a few different type of retirement tax shelters to take advantage of, like traditional and Roth 401(k)s and IRAs, or the TSP if you’re a federal worker. Canadians and folks from other developed countries have other systems.
If high fees are the #1 sin of investing, then unnecessary taxes must be the #2 sin. If you’re paying 15-40% of your capital gains or dividends in investment taxes, when you could be paying 0% with a Roth IRA, then you’re crushing your returns. Paying a 20% tax rate on an 8% rate of return, for example, bumps that after-tax effective rate of return down to only 6%. Over a multi-decade period, that’ll literally cut your money in half compared to what it could have been.
Here’s the standard order to follow, and you can adjust it to your situation:
-If you have an employer that offers 401(k) or TSP matching (or similar solution if you’re in another country), put enough money into that account to achieve full matching. That’s an immediate 100% return on your investment, so even if your employer has a lousy 401(k) provider that charges high fees, it’s still worth it. In a traditional 401(k), you don’t pay taxes on the income you put in, and don’t pay taxes annually on your investment gains. Instead, you only pay taxes when you withdraw money. You get to defer taxes and compound your money for decades before paying the government.
-Next, if you have more to invest, consider setting up and annually maximizing a Roth IRA if you’re under the income limit. A Roth IRA lets you put in after-tax money, and then never pay taxes again on any of your investment gains in that account. Also, Roth IRAs are really flexible; they have a lot fewer restrictions on when and how much you can withdraw from them without penalty compared to 401(k) plans, and there’s no age limit where they force you to start withdrawing from it.
-Then, you probably should go back and put more money into your 401(k) plan to max it out. And remember, if your income is a bit over the Roth IRA income limit, you can lower your effective income level by maxing out your 401(k), which might get you below that threshold.
-Lastly, if you still have additional funds to invest, you might want to open a regular, taxable brokerage account. I have mine with Charles Schwab. There may be times when you contribute to a taxable account even if you aren’t maxing out a 401(k), though, such as if you plan on retiring early. All else being equal, taxable accounts won’t perform as well due to having to pay taxes each year on your gains, but they’re the most flexible. You can withdraw money when you want, you can pick any brokerage or platform, you can invest in anything, and you can begin living off the income at any age.
Knowing what your goals are helps you prioritize your account types. The longest term money, meant for late retirement, should be put in tax-advantaged retirement accounts like 401(k)s. Medium-term money can be put in taxable accounts or Roth IRAs, and can be more easily tapped into if you retire early or need the money at some point.
It’s often a good idea to mix traditional and Roth account types in your overall investment strategy. Generally speaking, a Roth IRA or 401(k) is better if you believe your tax rate will be higher in the future. If you’re young and not making a ton of money yet and have a low tax rate, but expect to make a lot more money in the future at the apex of your career, then putting money into a Roth IRA might be for you. On the other hand, a traditional IRA or 401(k) is better if you believe your tax rate will be lower in the future than it is now, such as if you are making a lot of money now and expect to have a lower income in retirement.
Truth be told, it’s hard to accurately predict how much you’ll make in the future compared to now, or how politicians will change around the tax rates decades from now. I like to have both a Roth and traditional account; on one account I pay taxes now and never worry about them again, while in the other account I defer taxes now and will pay them later. That’s the middle-of-the-road strategy.
Step 3) Pick a Platform and Strategy
One thing that new investors mix up, is the difference between account types and platform types. For example, they think that a Roth IRA is a type of investment, like a certificate of deposit.
Account types, such as normal brokerage accounts, Roth IRAs, and traditional 401(k)s, are just containers that other investments are put in. They hold stocks, bonds, cash, options, and so forth, rather than being investments themselves. After you determine what type of account you need, the next step is to figure out what types of investments to fill it with.
This choice of which platform to go with is important to know up front, because it determines what kinds of investments you can pick down the road. Some platform selections will limit what kinds of investments you an pick. If you open a Vanguard account, for example, it locks you into a simple investment strategy, which may or may not be the best fit.
Here are some of the basic choices:
-Index funds are the best if you want investments that have the lowest time commitments, plenty of diversification, and aren’t trying to beat the market. For most people, this is a great place to be. Open an account with Vanguard or another provider of very low fee index funds or ETFs, and add money to it like clockwork.
-If you want a slightly more hands-on approach, then dividend growth investing can be a viable strategy. With this buy-and-hold type of strategy, you could potentially reduce your fees to even lower levels than index funds if you have a large enough portfolio, while building the most reliable growing dividend income streams. The trade-off is that it takes more time, and is more prone to human error. If this is what you’re after, then opening up an account with a quality online broker is the way to go. Look for ones that have low fees and good research options.
-Another slightly more hands-on approach is to build your own ETF portfolio, and/or to sell cash-secured puts or covered calls. This can be a great strategy for adopting to overvalued markets. Again, if this is the route you want to take, open up a brokerage account. If you plan on trading options, then you’ll want to stick with some of the higher quality brokerages that have a good track record with options.
Step 4) Select your Investments
Lastly, pick which investments you want to make. This is the part that could be the hardest.
I suggest you sign up to my free investing newsletter, and get some examples of portfolios and market updates.
Or, if you want to stick with the simplest of hands-off investing, check out Vanguard’s Target Retirement Funds. Regardless of whether you plan on investing on that platform or not, it’ll give you an idea of what type of diversification to build in a portfolio between stocks, bonds, and their various sub-categories.
Last Tip: Don’t Chase Markets
There are two smart ways to time the market.
The first method is to simply ignore market timing altogether, and invest money in a balanced portfolio that contains equities each and every month like clockwork. That’s the simplest and most reliably way to go about it.
The second method is to pay attention to the CAPE ratio and other valuation metrics of the market, and try to buy more when stocks are cheap. This is where most investors are irrational; they ignore valuation and become filled with euphoria as the market keeps going higher, and they start putting more into equities then. When the market inevitably goes through a recession or correction, they panic and sell when stocks have fallen in price, locking in their losses. The rational approach is to do the opposite; be a value investor and become excited after market prices have dropped and stocks are cheap, and become cautious when stocks are historically expensive.
Right now, for example, we’re almost 8 years into a market expansion. That’s the third longest market expansion so far in US history, with the longest ever being only 10 years. Concurrently, the CAPE ratio is the third highest it’s ever been, market capitalization divided by GDP is far higher than normal, the official unemployment rate in the US is very low, and the economy is humming along decently. It’s the calm, expensive situations like this when market risk is actually closer to its peak.
The rational time to be excited by buying equities was back 5-8 years ago when stocks were cheap and well below all-time highs. Now that we’re later into a market cycle with highly valued stocks, it’s time to be conservative. That doesn’t mean to avoid buying equities (I’m still heavily invested myself), but it does mean to pay keen attention to valuation of stocks you do buy, and be prepared for a market correction that could occur at any time, whether it’s this quarter or two years from now.
For more detail on this last tip, check out: Risk vs Volatility: How to Profit from the Difference