I’ve received several questions around how someone could get started investing in the financial markets. Let me begin by saying that there are countless ways to make money in the stock market. What I am sharing is based on my experiences. It reflects how I invest. If my investment philosophy resonates with you and fits your tolerance for volatility and risk, then great. If only portions or none of it make sense for your situation, that’s fine too.
Entire books have been written on this subject so this is going reflect my personal investing blueprint. There will be suggestions for required reading. Please don’t gloss over them. Your success as an investor in the financial markets largely depends on 2 factors: Education and Psychology. Spend the time necessary to improve in both.
How do you define an investment?
In the 1930s the father of security analysis, Benjamin Graham, coined the following definition for investing: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Because I’m primarily a dividend-growth investor, I’ve slightly modified this definition in my article on the top 10 investment mistakes: “To qualify as a financial investment, the security must regularly return capital to the owner. Activities not meeting this requirement are speculation or gambling.”
In simple terms, if it doesn’t put money in my pocket on a regular basis, I don’t consider it to be an investment.
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Education
A sound approach to investing begins with acquiring knowledge around the subject. The best investors are also avid readers. If you don’t read regularly, this is something you’ll have to change. The rewards are well worth the time invested.
Recommended Reading
The book I consider to be essential reading on the topic of investing is “The Intelligent Investor” by Benjamin Graham. This book covers investment definitions and supplies various approaches to sound investing. The book also contains commentary by Wall Street Journal investment reporter, Jason Zweig. At the end of each chapter, Jason provides modern-day examples to further illustrate what Graham discussed in the previous chapter. Buy and READ this book.
Another great book on the subject that takes a slightly lighter approach than Graham is “Common Stocks and Uncommon Profits” by Phillip A. Fisher. Fisher focuses heavily on the approach to investing over detailed mechanics. Both authors do an excellent job explaining the points they make. For additional clarification on investment terms, Wikipedia is a great resource.
I also encourage you to make regular reading of financial articles a core aspect of your learning journey. The market section of the Wall Street Journal provides great insight into what is happening within various business sectors. As an investor, you are becoming partial owner in several businesses. To increase your chances of success, you must take a business-like approach to the process.
A sound approach to investing begins with acquiring knowledge around the subject. The best investors are also avid readers.
Psychology
Getting this right is just as important as obtaining the proper education. Taking the time to discover your personal psychological makeup will prevent you from becoming your own worst enemy. Understanding the cognitive biases we all have to varying degrees, will help you identify the scenarios where you are most likely to do something silly.
Recommended Reading
If you only read one book on this subject, make it “What I Learned Losing A Million Dollars” by Jim Paul and Brendan Moynihan. If the title alone doesn’t say it all, I don’t know what does. Jim Paul tells the story of how he lost over 1 million dollars trading soybean oil due to errors in psychology. It’s important to note that he wasn’t an amateur by any stretch of the imagination. As a member of the Chicago Mercantile Exchange, he was a very experienced investor.
In the book he outlines all the ways his psychology concerning the markets negatively affected his judgement which resulted in risky trades. He makes the point that while there are countless ways to make money in the financial markets, there are only small number of ways to lose money. The book will help you build your personal list of cognitive biases you need to avoid. His story vividly illustrates how badly things can get when you don’t keep your psychology in check. What I Learned Losing A Million Dollars is easily in the top 10 of best books I’ve ever read.
My secondary book recommendation in this space is “Influence: The Psychology of Persuasion” by Robert B. Cialdini. It takes a deep dive into the major cognitive biases to uncover how people make decisions. Because successful investing is largely about good decision-making, this book is required reading.
After reading both books, I encourage you to create your personal list of cognitive biases. Ask yourself how you will identify when you’re allowing a given bias to influence your decision-making process. Take the time to know thyself.
Taking the time to discover your personal psychological makeup will prevent you from becoming your own worst enemy.
Brokerage Account and Tools
With education and psychology covered, we can start getting into the mechanics and tools of investing. If you don’t already have one, you’ll need to open a brokerage account. This account is different to the 401(k) account you have through your employer. You can think of a brokerage account as a bank account of sorts for investors. It allows you to buy and sell securities like stocks, bonds, index funds, mutual funds, and exchange-traded funds.
There are several great options for brokerage accounts from Vanguard, Schwab, TD Ameritrade and E-Trade. Vanguard recently announced they would allow commission-free trades for ETFs from other providers so they’re probably worth additional consideration. Because the initial portfolio we’re going to construct will be based on index funds, I recommend that you use Vanguard. They have a great catalog of low-cost index funds that you can buy without commission.
When you reach the point of adding individual stocks to your portfolio, opening a brokerage account with TD Ameritrade or E-Trade is a good idea. These companies have much better tools for analyzing individual stocks than Vanguard. At the time of this writing, they also have lower commissions than Vanguard for buying individual stocks.
Because you’re likely to end up with multiple brokerage accounts in addition to your 401(k), it will become difficult to have a complete picture of your portfolio in one place. The free tool I use to solve this problem is called Personal Capital. If you’re interested in learning more about Personal Capital and why you should add them to your investment toolkit, read my review here.
Basic Portfolio Construction
As you get started investing, I recommend that you stick with index funds. They are not flashy but as far as less-risky financial instruments go, they’re difficult to beat. With an index fund, you’re buying ownership in a basket of stocks thus spreading your exposure and reducing risk. For example, if you were to buy an index fund that tracks the S&P 500, a single share gives you partial ownership in over 500 companies. If one of those companies experiences a reduction in market price, it doesn’t influence the balance of your portfolio as much as if you were buying individual stocks.
I construct the index fund portion of my portfolio so that I have exposure in 4 major areas.
Portfolio Sectors and Weighting
- Total U.S. Stock Market – 50%
- International Stock Market – 35%
- U.S. Real Estate 7.5%
- International Real Estate 7.5%
This asset allocation provides exposure to the global markets and also allows me to invest in real estate without holding physical properties. Having this broad exposure ensures I’m not overweight in any market segment which reduces risk. Vanguard offers a low-cost index fund for each one of these market segments. The initial investment cost for most of their index funds is $3,000. This means you would need a total of $12,000 to implement my strategy using the index fund approach.
Exchange-Traded Funds
If you need a less capital-intensive way to implement the portfolio, you can make use of exchange-traded funds (ETF). Exchange-traded funds don’t have initial investment requirements other than you must buy them in blocks of complete shares. For example, the Vanguard ETF equivalent of the Total U.S. Stock Market index fund (ticker symbol VTI), has a current price of $140 per share. It contains the same basket of stocks as the index fund equivalent (ticker VTSMX) but without the initial investment requirement of $3,000.
In my opinion the biggest downside of ETFs is that typically you cannot setup your account to automatically invest in them. Every time you want to add to a position, it will require that you login to your brokerage account and make the purchase. Conversely with index funds, you have the option of automatic investment. In this scenario, you configure your brokerage account to automatically withdraw money from your checking account at regular intervals. This money is then automatically invested into the index funds you designate. For the most part it’s set and forget.
Starting with index funds is an effective way to get your feet wet while also making it difficult for you to get yourself into a lot of trouble. Most importantly, they’re a safer way of allowing you to learn how you personally react when the market takes a downturn.
As you get started investing, I recommend that you stick with index funds. They are not flashy but as far as less-risky financial instruments go, they’re difficult to beat.
Adding Individual Stocks
When most people think of investing in the stock market, picking the next hot stock is often the first thing that comes to mind. In my opinion, it should be the other way around. Individual stocks are last type of security a new investor should be adding to their portfolio. The truth of the matter is not everyone has the mentality required to be successful as an individual stock investor. If you’re the type of person who feels the need to react to any kind of bad news, then stick to index funds and spare yourself the mental anguish. If I haven’t dissuaded you to avoid individual stocks at this point, read on.
Psychology aside, being a successful individual stock investor largely comes down to being able to identify the gap between market price and company value. Price is what you pay. Value is what you get. For those focusing on capital appreciation over dividend growth, this is especially true. When I look at an individual stock, I begin by reading the company financial reports for the previous 5 years. Initially I’m looking at how the balance sheet has changed over time. I’m trying to identify a trend. I also carefully read the CEO’s comments about the business and try to detect how their tone changes over the years as the company meets or misses its targets.
Questions I ask myself include:
- What competitive advantage does the company have in their sector?
- Have they always been cash flow positive? If not, why?
- How well has management been able to execute their strategy across several years?
- How long have they paid a dividend?
- What is the rate of dividend increase?
- How safe is the dividend based on the current payout ratio and other factors?
Based on the answers to these questions and a few other factors, I decide if I want to enter the position. When I add an individual stock to my portfolio, I think in 10-year increments. Due to volatility, the price of the stock is bound to move around. What I’m trying to determine is if the company will be able to maintain its competitive advantage and if its financials will remain strong. The answer to the competitive advantage question helps me determine if the company will still be in business 10 years from now. How it manages its cash flow will influence if the company will be able to continue paying a dividend.
If you’re not yet comfortable reading and evaluating financial statements, I recommend the following books:
- “How to Read a Financial Report” by John Tracy
- “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports” by Howard M. Schilit
These books combined with time spent reading several financial reports, will get you the foundational-knowledge required for evaluating companies. With individual stocks, your goal is to buy dollar bills for .50 cents. Although Graham’s concept of the Margin of Safety is important to all investment, it is critical when selecting individual stocks.
Time Horizon
In conclusion, it’s important to recognize that you don’t become wealthy in the stock market overnight. Although it is incredible what compound interest and dividend reinvestment can do for your portfolio, it takes time to get going. You can liken it to a snowball rolling down a mountain. It first starts off slow without very much momentum. Yet by the time it reaches the bottom, you have an avalanche on your hands. The more money you put into your portfolio, the faster the snowball will grow.
It’s also important to understand the distinction between risk and volatility. Risk represents the likelihood for a permanent loss of investment capital. Putting all your money into lottery tickets is a great example of a risky activity. Volatility represents market price fluctuations over time. Volatility will always be an aspect of investing in the stock market. It’s important not to confuse it with risk.
A Brief Lesson From History
Consider what happened during the 2008/2009 financial crisis. The S&P 500 lost 38.5% of its value. If you had $100,000 in the market, you watched it shrink to just over $61,000; certainly not ideal. The low point for the S&P 500 occurred on March 9th, 2009 when it closed at 676.53. Fast forward to July 2018, less than 10 years later, and the S&P 500 is above 2,800. If you’d held onto your 2008 position you would have more than quadrupled your money.
I provide this brief history lesson to impress upon you the importance of not focusing too much on the events of any given week, month, or year. Doing so would be an investing mistake. The 2008 crisis was the worst financial disaster since the Great Depression of the 1920s and 1930s. Yet, less than 10 years later, the market is doing very well.
Successful investing is a game of education, psychology and patience. If you approach it with the correct mindset, I have no doubt you’ll do very well over time. I encourage you to treat investing like a game. Always look for ways to increase your savings rate. Ideally you want to save and invest until it hurts.
I look forward to hearing from you in your investment journey.
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?