How to become an investor? If you’ve hitched your wagon to the Deep Dish caravan, this is a problem you’re going to run into pretty quickly.
A bunch of small but powerful lifestyle tweaks have unleashed a tsunami of savings and filled your pockets with cash, to the point where you have to employ two burly men just to hold your pants up.
What to do with all that lovely money? The mattress is already stuffed to burst, and the bank’s interest rate is sadder than a teenager with a broken selfie stick.
Let’s consult the the formula for financial freedom:
Live on less than you earn. Save and invest the difference, and let compound interest do its thing.
It’s time to wrap our brains around the investing side of the equation. The first thing to know is there’s a huge payoff for getting started sooner rather than later.
Check out what happens if you start investing from age 25:
Like what you see? Let’s walk through the most important factors of investing, then finish up with a recommendation for getting your feet wet.
As the graphic above shows, it’s crucial to take on some risk rather than let your money stagnate in the bank. The question is, how much? Everyone has a different tolerance for risk.
At one end of the spectrum you’ll find nervous Nellies pulling on a hazmat suit before they venture out of their security compound to check the mail. At the opposite end, you’ve got the sort of daredevils who sprinkle amphetamines on their cornflakes before a big day of free climbing, wrestling bears, and unprotected sex with strangers.
Most of us fall somewhere in the middle, but it’s important to figure out where. If you take on more investing risk than you’re comfortable with, stomach ulcers and sleepless nights will become your constant companion, and you’re much more likely to make bad decisions.
When markets fall, people panic and sell out with the worst possible timing. Not only do they take a haircut, they miss out on all the sweet, sweet gains during the inevitable recovery. Check out what happened to the unfortunate souls who cacked their pants during the last market downturn:
Markets move up and down in cycles. Becoming an investor will almost certainly make you rich in the long run, but over shorter time periods it’s anyone’s guess.
Let’s say you have a five-year plan to put a deposit on a house, start a business, or go travelling. If you get lucky, the market will be peaking when you come to cash out your investments. If you’re unlucky and it’s in a trough, you’ll be caught with your pants down.
That means you have to match your investment choice to your time horizon. If you’re saving for a short-term goal, term deposits, bonds and other ‘fixed-interest’ investments are probably the way to go. The rewards are lower, but so is the volatility.
Riskier investments like shares and property are more suited for people with longer investing timeframes. When you’re in it for the long haul, you can safely ride out all the bumps without worrying about having to lock in a loss.
Investments can and will collapse, sometimes without warning. When they do, you want to feel as little pain as possible.
The best way to do this is to enthusiastically spread yourself around town like a 1960s flower child. When one of your lovers abandons you, plenty of others will be there to soothe your broken heart.
This principle is called diversification. It involves divvying up your investments between as many stocks, industries, and locations as possible. If any one company ends up in the poo, it won’t be ruinous to your finances.
This is one of several reasons why I haven’t invested in property (and don’t intend to). It ties your fortunes to one or a few assets, all exposed to the same economy and housing market.
(Of course, the rewards can make it worthwhile. A friend became a millionaire at age 24 by riding the property boom in my home city of Auckland. This is more risk than I’m personally comfortable with, which comes back to the first principle of risk tolerance.)
Diversification can be tough for the little guy. Someone with a million bucks can put $10,000 into 100 different companies, and pay for expert advice on the best way to do it. If you only have a few grand, you’re kind of screwed. Luckily there’s a way around this conundrum, which we’ll get to shortly.
Property investment can mint millionaires in their 20s because it uses the power of leverage. That means investing not just your own savings, but money you’ve borrowed from someone else.
Lots of people buy their first home with a 20 per cent down payment, and get the rest from the bank. They’ve borrowed $4 for every $1 they put down, which means their return on investment will be multiplied by 400 per cent if house prices increase.
Of course, it cuts both ways – any losses are also amplified several times over, which is how people end up completely underwater when housing markets slump.
Leverage is normal when buying property, but much less common for other types of investment. Again, the choice of whether to use it comes down to your personal risk tolerance.
Investment gurus love to tell people to ‘buy low, sell high’. No shit, Sherlock. Unfortunately, timing the market is impossible without psychic powers, and anyone who tells you otherwise is either delusional or trying to sell you something.
If you invest a big lump sum all at once, your timing might be perfect, but it could equally be disastrous. The best strategy is to invest steadily over time, paying no attention to the ups and downs. Drip-feeding cash in every month helps to spread your risk over different time periods.
If you can completely take yourself out of the equation by making the drip-feed automatic, so much the better. That will protect you from your own greed and fear, both of which lead to bad decision-making.
Fees and Expenses
Stopping every other bastard from skimming the cream off your hard-earned returns is one of the biggest factors in investing success.
Transaction fees will gobble up plenty of your cash if you’re not careful. Brokers – the people who buy and sell investments on your behalf – clip the ticket on every transaction, which means constantly buying and selling stocks is expensive.
Trading is for chumps anyway. While you think you’re making a genius move, the person on the other side of the trade has an equal and opposite opinion. Only one of you can be right. Don’t feel bad, because the exact same conundrum applies to so-called professionals. Fund managers charge exorbitant fees to pick hot stocks on your behalf, but there’s no evidence that any of them can consistently beat the average market return (most struggle to even match it). To put it bluntly, they’re no better than monkeys throwing poop at the business section of the newspaper.
Not convinced? This topic is really important and the psychology behind it is fascinating, so I’ll write a dedicated post on it soon.
(UPDATE: Check out How a Billionaire Taught me to Invest Using the Force)
Barriers to Entry to Becoming an Investor
As an investing noob, some options are automatically out of your reach. Getting started in property usually requires a big chunk of change to begin with, and if you buy stocks individually it’s difficult to get enough diversification.
Thankfully, there’s a great option for all of us little fish. By pooling your piddly amount of cash with my piddly amount of cash and Jimmy’s piddly amount of cash, we can band together and become very strong indeed. Collectively we can buy tens of thousands of companies, and own a tiny slice of each.
This type of investment is called a mutual fund. There are thousands of funds to choose from, and many have basically no barriers to entry. You can get started with $500 (sometimes less), and build from there.
Recommendation for New Investors
Obligatory disclaimer: This blog post is meant for educational and entertainment purposes only. Any resemblance to a real financial adviser, living or dead, is purely coincidental. Do not read while operating a motor vehicle or heavy equipment.
Finally, we get to the good bit! Seriously though, you better not have skipped ahead to this part because all the other stuff is really important (plus it took me ages to write).
The one type of investment that’s especially well-suited to beginning investors is (drumroll please) …a passively managed mutual fund.
Wait a second – didn’t I trash fund managers, calling them no better than poop-flinging monkeys?
Yes, yes I did. All fund managers are monkeys, but some of them have the good grace to acknowledge their simian shortcomings. Passive fund managers don’t muck around trying to time the market or pick hot stocks, and they don’t take outrageous performance bonuses either. Instead, all they do is match an entire market or stock index, then put their feet up and take the afternoon off.
Passive funds tick all the boxes: enormous diversification, different levels of risk to match your preferences, rock-bottom fees, low barriers to entry, and the ability to set up an automatic drip-feed. The biggest and best known are the likes of Vanguard and iShares, which are US based. Vanguard is an absolute monster non-profit with $3.6 trillion of assets under management, which gives it huge economies of scale.
Vanguard’s Total Stock Market Index fund invests your money across every single listed company in the United States – all 3613 of them. That diversification comes with a management fee of just 0.05 per cent, which is literally 20 times cheaper than a typical actively managed fund.
If you’re outside the US there can be a few complications in investing directly. If that’s the case, you can always find a middleman in your country who can channel you into the big funds, although it won’t be quite as cheap.
(For New Zealanders: check out Superlife or Smartshares, or Simplicity for your retirement savings.)
Robo-advisors like Betterment and Wealthfront also act as a front-end for passive funds, and are starting to really take off. They may offer some slight advantages over the direct investment route, which I’ll get into in another post.
I’ve been championing passive investing for years, but in my wayward youth I wasn’t smart enough to take my own advice. Instead I bought individual stocks, mostly because it was fun and I liked to think I was a special snowflake.
I did pretty well, but still left some money on the table. If I hadn’t tried to be clever, I would have hit my $100k goal faster, and my net worth would be higher. I also made one really dumb mistake, which I’ll explain in a future post so you guys don’t fall into the same trap.
(UPDATE: Read about The Worst Investment Ever)
How to Become an Investor: One Last Step
Great news for lazy people! Becoming an investor can be as simple as finding a low-cost fund that matches your risk profile, setting up regular payments, and forgetting about it for a few decades.
If you choose to go down one of the other pathways, you’ll need to do anywhere from a little more homework to a fairly enormous amount of research and training.
To anyone for whom this article was old hat, I’ve got some more advanced stuff in the pipeline.
(UPDATE: here’s the Barbell Strategy for Advanced Investing)
For everyone else, I strongly recommend dipping your toes with some basic investment strategies before you dive in the deep end.
One last step: After you make your first investment, you’ll want to go and get yourself a top hat and monocle. Congratulations! You’re officially one of those dastardly capitalist barons making a dollar off the back of the hard-working masses.
Any questions? Something I haven’t explained clearly enough? Shout out in the comments below.
Hey Guys, I am new here so don’t know a great deal apart from the fact that I see Australian shares have done relatively well lately however I don’t know much about US companies. Does anyone have some tips on which companies to invest in? It’s not a great deal of money in fact not near a $1000 but some tips and pointers would be greatly valued.
hi Rich, what are your thoughts on those who have started waaaaay too late (decades, unfortunately), and have the cash in the bank, but now want to start investing. What is too much to invest at once?
The classic advice is that if you have a lump sum to invest, technically the best strategy is to put it all in at once, rather than trying to spread it out. However, psychology is such a strong component that you might be more comfortable just dipping your toes to begin with, and investing more and more as time goes on (e.g. to protect against heartache if you invest the lot tomorrow, and then the market enters a major downturn again).
Hey Rich – interested to hear your thoughts on some of the mechanisms for index investment, particularly on choosing between purchasing ETFs (where you have to pay the brokerage fee as well as the MER – I assume the Vanguard 0.05% you mention in the article is an ETF MER?), a passive index fund (where you pay higher fees than ETF’s but no transaction costs), or a robo-advisor (which invests in a range of ETFs on your behalf)? In Australia, management fees for robo-advisors are coming in cheaper (~0.5-0.6% pa) than for Vanguards single indexes (0.75-0.9% pa) at the moment, and also offer a portfolio approach to further increase your diversification.
Hey Joel – honestly, just go for whatever’s cheapest, once you figure out the tax implications and any transaction costs e.g. brokerage, forex, custodial fees. The reason I haven’t given a specific recommendation is that this will vary from country to country and even person to person. The traditional critique of ETFs is that they encourage trading behaviour, which is obviously disastrous, as compared to a mutual fund. But in this context (buying and holding) it doesn’t really apply, so IMO the vehicle doesn’t matter. Interesting to hear the robo-advisors are coming out cheaper in Aus – we’ve just had our first one licensed in NZ, so I’m planning to do a deep dive on it soon.
Is the deep dive something you’ve done? I’d be keen to have a read and can’t find anything from you on it with a cursory search. Apologies if I’m just being an idiot and can’t see it.
Hey Cam, you’re not an idiot – I never got around to it! It’s still on the list, but I’ll probably just write a (New Zealand-specific) column about it, rather than a blog post.
Do you have any thoughts on how one should decide to stop focusing on paying off debt (either good or bad) and starting this kind of investing? I’ve heard the ‘invest in index funds ASAP’ idea many times but never seems to take into account the reality of say, a mortgage or student loans, so would be interested in your take on it.
Hey Stephen, as a general rule I prefer repaying debt to investing, in that it gives you a guaranteed, tax-free return.
Of course, there’s always an opportunity cost – could you increase your net worth more by investing instead? The choice comes down to two factors: How much interest you’re paying on the debt, and what your tolerance for risk is.
For something like credit card debt, it’s screamingly obvious that you should pay that off before you invest a solitary cent. For low-interest mortgage debt, it’s not such an obvious choice.
Some people prefer to clear the mortgage entirely before they begin investing. At the other end of the spectrum, a risk-taker might go interest-only on the mortgage and invest the whole lot (which is essentially what serial property investors do).
There’s a middle-ground option too: I’d probably be comfortable channelling around half my savings into repaying the mortgage (depending on the interest rate), and the other half into an index fund. Basically, there’s no hard-and-fast rule.
For a longer explanation, check out this article. Hope that helps somewhat!