The Basics of Investing
By Jeff Greenspan, Managing Director, Financial Modeling Services
Many people consider investing to be confusing, but it doesn’t have to be. The most important thing to know about investing is that time is your best friend and worst enemy, so don’t wait to GET STARTED! Here is an overview of everything you need to know to invest with some degree of competence. Let us start with a few definitions.
INVESTING: The process of setting money aside for the future with the hope that the money that is set aside can grow and have more buying power than it does today.
ASSET: Anything that has value. From an investing perspective, assets should generate a positive return over the time period of the investment, meaning they are worth more in the future than you are paying today. Your personal home is not generally considered an investment asset.
ASSET CLASS: A set of assets that are similar. Examples include stocks, bonds, real estate, and cryptocurrencies. Note that most asset classes can be subdivided; for example, stocks can be broken into large cap vs small cap, or international stocks vs domestic stocks.
RISK: All investing contains an element of risk, no one can predict the future, and past returns are no guarantee of future results!
- Systematic Risks – affect all assets. They are created by general economic conditions.
- Specific Risks – affect only one company. Could be based on operational factors (like deciding to roll out a new product) or financial factors (like how much debt a company has).
- Investors can reduce specific risk through diversification. Combining different investments and/or different asset classes improves diversification and therefore reduces specific risks.
- Risk is defined by volatility, how much an investment’s value swings around its average price over time. Investments whose prices go up and down frequently and by a large percentage have high volatility.
Because EVERY investment has risk, and because the market price of an investment already incorporates the perceived risk of that investment, investing in only one stock is almost the same as gambling! You have no idea what direction that investment will go.
The rest of this document will focus on the stock market. Though a prudent investor will also want to own real estate, business(es), or alternative assets, you have to get started somewhere, and it is easy and reasonable to get started in the stock market!
The quickest, easiest way to invest in the stock market is to invest in one or more Exchange Traded Funds (ETFs). These index funds attempt to replicate an entire asset class or subclass. Table 1 below lays out the five primary asset classes, suggests one or more representative index funds, and displays the returns and volatility for each fund for the period from 10/17/2019 to 10/16/2020. Note that higher annual returns are almost always associated with high volatility (risk). Your job is to pick fund(s) based on your tolerance for risk. Note however that high risk isn’t always bad depending on your time frame! If you are investing for the long term, higher risk investments should provide higher returns.
|Asset Class||ETF||Ticker||Returns – Volatility|
|U.S. Equity||Russell 3000 - The largest 3000 U.S. stocks||IWV||19.24% - 34.68%|
|Fixed Income||Barclay’s Aggregate Bond||AGG||6.97% - 8.4%|
|Barclay’s TIPS Bonds (inflation protected bonds)||TIP||10.07% - 8.9%|
|International Equity||MSCI EAFE - developed market index||EFA||0.19% - 30.37%|
|MSCI EAFE SM - EAFE small-cap stocks||SCZ||5.09% - 30.1%|
|Emerging Markets||MSCI EM - emerging market index||EEM||10.81% - 33.52%|
|Alternative Classes||Dow Jones U.S. real estate index funds||IYR||-10.93% - 40.58%|
|SPDR Gold Share||GLD||26.94% - 18.43%|
|GS Connect Commodity||GSG||-27.24% - 31.99%|
|United States Oil Fund||USO||-68% - 69.83%|
|Bitcoin||GBTC||42.46% - 85.06%|
Academic studies point to two methods of investing that generally result in higher returns over time. See https://www.investopedia.com/articles/stocks/07/dcavsva.asp for more information about these two methods:
- Dollar Cost Averaging: You invest the same amount every month. This is a common method typically associated with an automated payroll deduction. Many companies match a certain percentage of your investment, and you would be foolish not to participate. I suggest that you pay yourself first and allocate 10% of your salary toward retirement investing.
- Value Averaging: This method is optimized for investing toward a specific goal. If your goal is $60k after 60 months, you know that your portfolio needs to be worth at least n x $1000 after the nth month, so you invest the appropriate amount each month to meet your monthly target.
There are also several types of accounts for your investing:
- Tax-deferred accounts: Designed for retirement savings, these accounts grow tax free. Roth accounts also allow tax free withdrawals in retirement, so they are the best thing since sliced bread. Everyone should make every effort to maximize their Roth account every year. IRAs and 401Ks grow tax free, but earnings are taxed at the ordinary income rate upon retirement.
- Taxable accounts: If you will need the money before retirement, you should open a normal brokerage account. Fees matter, so lower cost brokerage accounts are better than higher cost accounts.
Investopedia: www.investopedia.com is the first place I look for definitions and straight-forward explanations.
Yahoo Finance: finance.yahoo.com provides financial news, data and commentary including stock quotes, press releases, financial reports, and other content.
Marketwatch: marketwatch.com provides financial information, business news, analysis, and stock market data.