Learning how to invest money was one of the most important lessons that I’ve learned. By investing consistently and in a principled way, I was able to escape the clutches of poverty. Sure, I’ve made some foolish mistakes along the way, but to not invest would have been the biggest mistake of all.
My First Investment Was the HaRdest
Money and investments weren't discussed in my household, and even though I was interested in the newspaper’s stock tables when I was a kid, I never had a mentor to discuss them with. In fact, I didn’t make my first investment until I was 25 years old. Thankfully, new investors no longer have to worry about some of the things that I did. For example, many mutual funds and brokerage accounts that once required a $3,000-$10,000 minimum investment now have no minimums.
Defining an Investment Goal
Everyone has different financial goals and there is no “right” or “best” path. But, here's a basic financial goal that many investors would do well to strive toward:
“My goal is to spend less than I earn and to invest the difference. Over time, I’d like the cash flow from my investments to provide me with a sustainable income.”
Notice that this goal doesn't talk about selling investments. Rich people rarely sell-off their assets for spending money; if they did, they wouldn't be rich for long. The rich stay rich because their assets provide enough cash flow to support their lifestyle. These cash-producing assets can be passed down from generation to generation through careful estate planning.
Investment Options
The most common investments are stocks and bonds, which most financial advisers agree should be held in some proportion based upon personal circumstances. Stocks represent partial ownership of a company and bonds are a form of "I owe you." Mutual funds and exchange-trade funds (ETFs) allow investors to purchase a diverse mix of stocks, bonds or a blend of both.
There are other ways to invest: for instance, real estate investment trusts (REITs). These types of investments have their place, but novice investors needn’t focus on them. Sticking to stocks, bonds and the funds that hold them is fine for beginners (and pretty much everyone else).
To Invest, or To Pay Down Debt?
Those can't make minimum debt payments shouldn’t be investing at all. But, those who have extra money left over from each paycheck have several ways to improve their finances:
1.) paying down debts
When interest payments are higher than 10%, it is almost certainly a better idea to pay down existing debt than to invest. The stock market has returned about 11% per year in the long-term (far less after taxes and fees), but there are no guarantees in stock investing. Debt is guaranteed, however.
2.) buying investments
When debts cost less than 5% interest, it may be advantageous (in the long-term) to carefully invest in well-chosen stocks or stock funds. Buying bonds is a different situation, however, especially for mortgaged homeowners. It doesn’t make sense to buy a bond or bond fund that yields 2% when a mortgage is accruing interest at 5%. The prudent decision is to make a larger mortgage payment.
3.) buying investments and paying down debts
Benjamin Graham, Warren Buffett's teacher, once suggested that investors should hold no more than 75% of their investment money in a single asset class (he was referring to stocks vs. bonds). This same logic can be used when deciding how much money should be used to make investments.
Low-interest debt is like a bond. That means that, at minimum, 25% of extra income can be allocated to paying this debt off; the remaining 75% could be invested in stocks. If stocks or stock funds became too expensive (the higher a stock is priced relative to its earnings, the more expensive it becomes), then 75% of extra income would be used to retire debt. The remaining 25% of extra income could be invested in stocks, even at high prices.
It often makes sense to pay down debts with the highest-interest rates first, but a fee-only financial adviser who is familiar with an investor’s personal situation may have other strategies. A financial planner is only as good as the information that he or she is provided with, so it pays to be honest.
Saving vs. Investing
Savings and investments are very different things. If the stock market crashes and an unemployed investor doesn’t have cash on hand, he or she may be forced to sell at the worst possible time.
Being employed, having essential insurance coverage, having personal debts under control and having an emergency savings account are all important prerequisites to investing.
Long-Term Investing Strategies
Two proven investment strategies are explained below. The first strategy requires minimal effort; and while the second strategy may seem to require minimal effort, in reality, it requires more investor education than this article can provide.
1.) Investing Regularly in Low-Cost Funds
Jack Bogle, founder of The Vanguard Group, dedicated his life to showing investors how no-load low-cost index funds (specifically, those that buy the entire stock market) are the best way for an investor to succeed. Indeed, buying low-cost index funds is a smart strategy.
By dollar-cost averaging, the practice of buying the same dollar amount of a fund on a regular schedule (many brokerages allow scheduled investments via a connected bank), investors needn't worry about timing their purchases. The average purchase price will ultimately reflect a "fair" value.
Fidelity Investments now offers stock funds with no fees, expenses or minimum investment amounts. There has never been a better time to be an index fund investor!
2.) Buying Carefully Chosen Stocks
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks," wrote Benjamin Graham in his classic book The Intelligent Investor.
It's true: A total stock market index fund that is purchased at regular intervals over a long enough timeline will almost certainly provide satisfactory results. Yet many investors forgo the financial rewards of simplified investing for the psychological thrill of "stock picking."
For small- or beginning-investors, trading stocks is a fool's game because they’ll be up against PhD-level mathematicians as well as the computer programs they've written to exploit foolish mistakes.
But, there is long-term value to be had in buying the stocks of great companies and holding on to them for many years. Even more so when stocks pay dividends (an actual cash payment of the company's profits). The amount of wealth that reinvested dividends can create is simply amazing. What's even more amazing is that many online stock brokers offer dividend reinvestment as a free service. This luxury gives the patient investor an even bigger advantage over the frenetic stock trader.
An Extreme Example of Buy and Hold Investing
There's a mutual fund, about as old as Warren Buffett, that has never changed the stocks it holds; not in over 80 years. $10,000 invested in the Corporate Leaders Trust (LEXCX) in 1935 would be worth tens of millions of dollars today. Yes, some of the fund's original 30 stock holdings disappeared over the years, but even so, the fund has outperformed the S&P 500 over many periods.
Kevin McDevitt, CFA wrote the following when highlighting the fund's 75-year birthday:
“With the very long term in mind (the fund was originally scheduled to liquidate in 2015, since extended to 2100), the original advisors wanted to find blue-chip, dividend-paying companies that could thrive for decades...When looking this far out, decisions are driven more by enduring factors such as brands and sustainable competitive advantages rather than earnings projections... It’s notable that no financials companies of any kind were included originally.”
Buying a Stock Is Buying a Business
Buying a stock is buying part-ownership of a company. Therefore, if it makes financial sense to buy the entire company, it would make sense to buy a fractional part of the company. When I consider buying a stock, I first ask myself this question:
"If I bought this entire company, assumed all its debts and then collected 100% of profits from now until forever, how long would it take to make my money back?"
Figuring this out takes a little bit of math, but nothing more difficult than multiplication and division. There are several ways to value a company and its stock. I even created my own formula.
Once an investor has the understanding and confidence to answer this question, it becomes clear that a $1 stock isn’t necessarily cheaper than a $50 stock, and in many cases, it is more expensive!
How Future-Proof Is a Company?
Valuing a stock would be an exact science if investors knew that a company could maintain or grow its profits at a fixed-rate every year in the future. However, many companies (especially those that specialize in technology) can watch their products fade into obscurity and their profits disappear. I remember when Nokia was the king of cell-phones and Apple was a $7 stock.
Inevitably, some stock picks will lose money, but one great investment can make up the difference and then some. Many investors who own at least 20 to 30 stocks that aren't very similar, and who haven't overpaid for those stocks, will do just fine in the long run. Then again, buying a mutual fund or ETF that owns the entire stock market is a time saving way to own a diversified portfolio (see above). It's up to each investor to determine how much his or her free time is worth.
Learning More About Investing
Then first investment book that I read was Benjamin Graham's The Intelligent Investor. Later, I discovered that Warren Buffett's annual letters to shareholders are free to download on the Berkshire-Hathaway website. I’d be hard pressed to find two people with more investing wisdom, and sometimes, I find myself re-reading things that Graham and Buffett have written. It is pure gold.
Since then, I’ve grown particularly fond of Eddy Elfenbein’s stock market commentary. I think he is one of the best fundamental analysts working today and I continue to learn a lot from him.
Postscript: I originally published this article on TheStreet.com, but since the original text has been edited and rewritten to include advice that I don’t agree with, I've reproduced my own version here. Please note, this article is not personalized financial advice and it shouldn't be treated as if it were.