If you’re reading this blog, you probably want to build wealth.
You want to be able to buy a house, help your kids with college, and retire.
If you share these goals, then one of the best tools for the task is the stock market. Newsflash: investing in the stock market without understanding the industry is like going on an African safari with a wooden baseball bat instead of a .375 H&H…
I’m a math guy, so here’s an equation: you + your goofy baseball bat + a lion = a lion with a full stomach
You wouldn’t go hunting in Africa with a baseball bat, so don’t dive into the stock market without having a clue what’s going on! You’ve probably heard quite a few of your friends tell you horror stories about how they lose money every time they invest in the stock market. Well, they probably don’t know how the stock market works.
Here’s the actual truth: over the last 87 years, the average annual return of the S&P 500, (which tracks the performance of the 500 largest publicly traded companies in America,) was 11.41% (information courtesy of NYU’s Stern School of Business). For those of you who are skeptical, that time frame includes the Great Depression, Black Monday, the dot-com bubble, and the great recession.
The numbers don’t lie. The stock market is an excellent wealth building tool. But, you have to know how to use it.
So, if you want to learn more about the stock market, and if you don’t want to become a lion’s lunch, read on.
You have 3 basic options for investing in the stock market:
- choose individual stocks to purchase yourself
- purchase shares of a mutual fund and have individual stocks chosen by a professional investor
- purchase shares of a fund which mirrors an index
For this article, I’ll discuss each of your 3 options: what they are, how they’re different, and where they give an advantage.
1. Individual Stocks
As I described in my last post, buying shares of a company’s stock makes you a partial owner of the company. This entitles you to part of the business’s assets and profits. One way to invest in the stock market is purchase shares of companies individually.
Buying individual stocks gives you the most control over your investments. You choose when to buy, what to buy, how long to hold, and when to sell.
If you make your own decisions, you won’t have to pay for the administrative or management costs required to operate a fund. Investing on your own can even serve as an entertaining, mentally stimulating activity. You have the chance to learn about the market and try to beat it. However, picking individual stocks comes with a slew of problems.
First, you’re probably going to have to pay a commission every time you buy or sell stocks. That might not seem like a huge deal because it’s usually only a $5-$8 fee. But, if you have a diversified portfolio of 10 or 15 stocks, that’s going to add up quickly, especially if you trade regularly.
Think about it this way. If you have $10,000 to invest in the stock market, and you split that into 15 different stocks with a $8 commission on each, you are paying 1.2% when you buy and 1.2% when you sell. Those kinds of fees will kill your returns over time, which is why picking individual stocks with a limited amount of cash is not a winning strategy. You will need a considerable amount of capital to reduce the impact of commissions on your portfolio.
Let’s face it: you’re just not as awesome as you think you are, and this can be a problem if you try to manage your own investments. The market is crazy, and there are countless factors that influence a stock’s performance. You may think that you’re a great investor, but you probably don’t understand the topic like you think you do.
According to a study by the psychology journal Acta Psychologica, 93% of Americans think they are above average drivers. Keep in mind that by definition, only 50% of a population can be above average. This tendency for us to lean toward overconfidence in our abilities can lead to some pretty costly mistakes in the stock market.
Along the same lines, it can be difficult for anyone to stay disciplined enough to stick with an investment strategy. It’s easy to talk about buy and hold, investing for the long term. But when you own a stock that takes a 10% hit, and all of the analysts on the news are saying it could get clobbered, you will be tempted to sell when the price is at a low. This can be flipped: it’s easy for a part time investor to jump onto the bandwagon of “the next Microsoft”, but those deals rarely work out.
Do you even want to take the time to pick individual stocks? If you do it the right way, you will spend hours every week researching the market and your specific positions. This might be something you enjoy, but one of my financial goals is to create an automated system so that I can spend my time enjoying the things I love to do. I would rather hang out with my friends on a Saturday afternoon than read earnings reports, buy hey: you do you.
Finally, consider the stress that selecting your own stocks can add to your life. You are now doing research and making choices that could potentially cost you thousands of dollars. Make sure you are comfortable with that.
What if you want an active investment approach that has the potential to beat the market, but you don’t want to spend your own time picking stocks?
2. Mutual Funds
If you don’t want to pick your own stocks, then a mutual fund may be for you.
When you invest in a mutual fund, it’s like joining a co-op with a few people picking the stocks. The fund will have either 1 or several managers who decide when to buy and sell securities. This means that your money will be managed by a trained, experienced, certified professional (hopefully).
This approach offers you the potential to beat the market, as your money is actively invested where the manager thinks it has the best chance to profit. Additionally, because a large number of people invest in the fund, your money can be diversified across a wider assortment of securities, which can be traded at shorter intervals. If there are millions or billions of dollars invested in a fund, commissions won’t make any noticeable impact on overall return.
As nice as this sounds, mutual funds still have some fundamental problems.
First, the goal of the manager and the company that owns the fund is to make a profit, so they are going to convince you to invest in the fund even if it’s not in your best interest. The entire financial industry wants you to accept an active investment approach because this keeps the fund managers and analysts in business, but it’s not necessarily the best strategy.
According to Morningstar, you can expect to pay a fee of about 1.25% for an actively managed stock mutual fund. This means that in order to match the performance of the market, a manager must outperform with his picks by 10 to 20 percent to make up for his fees, and this doesn’t always happen.
Finally, remember that even when you invest with industry experts, they are still human beings. Yes, fund managers are generally disciplined stock pickers, but they are still prone to emotional reactions that can lead to mistakes.
3. Index Funds
If you don’t want your investment portfolio to get clobbered by fees, then I have good news! Enter the index fund.
This is an approach that was really transformed into a mainstream strategy by John Bogle, founder of Vanguard. His company is the industry leader in low cost index funds. The goal is to match the market’s performance, not beat it.
An index operates under a set of guidelines. For example, the S&P 500 index holds a weighted collection of stocks from the 500 most valuable, publicly traded companies in America. If you purchase shares of an index fund, it will hold exactly what the original index contains, buying and selling shares periodically to keep up with changes in the index.
You can diversify across the entire world equity market, a specific country, or a specific sector, but regardless of the specific investment you choose, you are guaranteed to receive the performance of that section of the market. This is great because over the long term, the market has always done well.
If you invest in a passive fund, you have to accept the tradeoff. You no longer have any chance of beating the market, but you also remove the risk of human error – no emotions or judgement are involved in buying and selling securities. The fund buys and sells when the rules of the index dictate buying and selling.
Because of an index fund’s method of operation, you pay almost nothing in fees. The company doesn’t have to hire a team of analysts to research new stocks to pick or pay a team of highly trained managers to make decisions. These savings are passed on to the investor in the form of fees of about 0.05% to 0.10%.
So, which of these 3 options is the best fit for you? I’ll leave you to make that decision. However, I will share my personal thoughts.
I like to stick with index funds. This is a decision that I’ll go into more detail on with a post in the near future, but I don’t want to pay extra fees for investments that generally don’t outperform the market.
The world economy has been growing for the entirety of human history. Population growth adds new consumers and technology adds new products. These 2 factors combine to create business opportunities, which expand the market.
Over the long term, the global economy will grow consistently. I’m willing to take the periodic bumps in the road because when I invest money in the stock market, I plan on leaving it there for at least 20 years.
Hopefully reading this article helps you understand the stock market a little bit better. Don’t waste this knowledge! Use it as a foundation to learn more and more about investing. Go buy a book or read some of the other great personal finance blogs. Whatever you do, don’t leave your money in cash simply because you don’t understand the market. Stocks are a great tool for building long term wealth, so don’t waste the opportunity to use them. Just make sure you do it the right way.
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