Investing on your own can seem scary. The world of finance appears to be, at least in the beginning, a complex maze of numbers and movements, leaving new investors wary of going at it alone.
I used to think of the finance world as a bunch of slick-haired Pat Riley types yelling ‘buy’ and ‘sell’ across a crowded room. Heck, even a stock ticker bar has confusing hints of the matrix if you don’t know what you are looking for.
The good news is, becoming an investor isn’t half as scary as it seems with a bit of education and a splash of gumption. The really good news is that investing on your own can save you a ton of money over the course of your lifetime without adding additional risk.
In a post-pension world there may not be anything more worthy of your time. So in this two-part series we will cover what investors need to know before they start, the 3 most important investment statistics, and 3 critical pitfalls to avoid, but first a quick story.
When I began investing on my own I was only 13 and had yet to develop that sense of rational fear that pulls us through most of our adult lives. Coming from a family where financial education was highly valued, I had learned to save as much of my money as I could from an early age.
Once I hit adolescence that pool of cash had grown sizable enough that there were alternative options to my Junior Savings Account, which at the time yielded a sub-inflation rate of about 0.9%. At first the options seemed overwhelming, after all there were bonds, stocks, mutual funds, money market savings accounts and of course my twin size mattress.
Being the stand-up folks that they were, my parents encouraged me to join other investors in buying shares of a group of socially conscious funds. These were mutual funds – or groups of stocks – which invested purely in companies involved in ethical businesses.
Overall I had some strong short-term success, enjoying the monthly statements with giddiness normally reserved for Christmas. Then something happened… a recession. After years of diligently investing my hard saved money I suddenly found myself with less than what I had at the start!
Learning About Risk
This was a pivotal moment in my financial education and even though it hurt at the time, I am better off because of it. That one downturn coupled with the subsequent rebound taught me 3 very important things about investing:
- It is very possible to lose money investing
- If you have the ability to ride out periods of losses you will experience even more over the long-term.
- You have to know your risk tolerance
Before that event, the stock market and investing as a whole seemed easy to me. Investors simply pick some fun things to invest in, buy some shares, and as those companies earn more money they pay me over time. Piece of cake right?
What I learned was that if you are not wise and do not invest over an appropriate time frame one downturn can clear you out.
Having the ability to invest over a longer time frame, where I did not immediately need to remove my money from the investments meant that I could ride out the recession and enjoy the long-term success trends that investment markets offer.
That difference between short-term and long-term investing is one of the most important aspects for individual investors. Another key principle is knowing and understanding your risk tolerance.
What Good Investors Know – Risk Tolerance
Risk tolerance has two main components; at its core risk tolerance deals with the amount of financial risk you can handle. I however, take it a step farther and add a second component, the amount of emotional stress you can handle.
Your financial risk tolerance deals with how long you can afford to wait if things get dicey. For example, if you know that your car is on its last leg and you have very little money available to purchase a new one, that is definitely not a good time to lock up all of your savings in investments.
The general rule of thumb is that you should never invest any money that you reasonably think you might need in the next 5 years. That time period would allow you to ride out a downturn based on historical averages.
Keep in mind that this concept means revisiting your investments each year and may require you to withdraw some money to keep yourself appropriately liquid.
The emotional stress component of risk tolerance might be even more important if you decide to invest on your own.
When I began investing at a very young age the emotional risk shouldn’t have mattered much. I knew my parents would take care of me even if I lost all of my savings through investments.
However, even though there shouldn’t have been much stress involved, I found myself deeply upset by any setbacks. It turns out that I am a bit of an anxious person and the idea that I would lose something I worked so hard to gain really bothered me.
This is when I realized that my emotional or stress tolerance was not as high as I had anticipated.
In itself there is nothing wrong with that. You should never be proud or ashamed of your risk tolerance, it just is what it is, but when investing it is good to at least know what it is.
At the end of the day individual investors are the one who has to be comfortable with where their money is and as an investor, you are the one who has to sleep soundly at night.
It is a personal decision and is yet another reason investing on your own makes sense. If you aren’t comfortable with the amount of risk you are taking then you are more likely to react too strongly when things change.
Being able to keep a level head by owning the right investments – and more importantly being actively involved and knowing what they are – is a huge advantage over the long-term.
I have personally talked to far too many people who don’t even know what the bulk of their retirement savings is invested. In my book, that is a scary prospect.
What Good Investors Know – Ignoring the Herd
While adapting your investments to fall in line with your risk tolerance is a huge benefit of becoming your own financial advisor it isn’t the only advantage.
You also are not a member of the Wall Street crowd after all and that means you are less likely to fall into the short-term herd mentality trap.
Investors typically see more success through less action and many times brokers see moving cash around to different investments as a way to prove their worth.
Obviously those two positions oppose each other, which is making many folks in the finance industry question the true function of advisors in the first place.Individual investors will also be able to react quickly when their lives change.
Maybe you lose a job or find out there is going to be a new addition to your family. Not having to go through a third-party to realign your investments can save time and quite a bit of money depending on how their commissions are structured.
That gets us to the most important reason you should consider investing for yourself: expenses.
What Good Investors Know – Expenses Destroy Wealth
The financial advisor industry it littered with hidden expenses and fees. If you have ever sat down with a financial advisor you were most likely recommended a list of funds to invest in. What you might not know is what fees you are paying or already paid for these funds.
One example is the notorious 12b-1 fee. Many ‘investor recommended’ funds hocked by advisors contain 12b-1 fees. This is a fee that you pay for the ‘marketing’ of the fund.
In other words you are paying the advisor, through fund kickbacks, for the privilege of them telling you to invest in it. Now just so we are clear, that adds absolutely no value to a fund. Those fees can even cost up to 1% of your total investment!
One percent might not sound like much but if the market only returns a historical average of 7% a year, that means you will automatically lose 15% of your potential gains in year one! If that sounds confusing don’t worry.
All of these fees are included in a funds’ expenses, so they show up in the expense ratio which will be covered in part 2 next week.
If you do nothing else as a result of this article, at least reach out to your advisor or even look at your own investments and try to get a handle on what expenses you are paying so they can be minimized. For example ask about marketing fees like the 12b-1, trade commissions and annual management fees charged by your advisor.
Eliminating these by becoming your own advisor can have tremendous benefits over the long-term. Plus, if you invest for yourself, follow a few basic principles and invest for the long-term you will succeed by default. Not to mention that you are the only person who truly has your best interests at heart.
Great, so you think you might be willing to give it a shot and join the hoards of investors already managing their own assets. What are your investment options and where should you invest?
Money Market Funds
Money market funds are the checking accounts of the investing world. These funds are meant to be very liquid, meaning that you can get access to your cash very quickly. Plus, money market funds are very stable.
The flip side of that stability is that they offer relatively consistent, but lower interest payments to investors. Money market funds invest in short-term securities and high quality debt, making them the ideal place for cash that you might need in the near future and are not willing to tie up for the long-term.
Personally as an investor, I use money market funds to hold cash I have set aside for the following years personal retirement contributions.
This way the funds are there ready to invest, but because I still have quick access to them they also make up a part of my emergency fund in the current year.
Think of bonds as loans you make to companies. You will often hear them called fixed instrument securities and they are an agreed upon loan that the companies themselves has structured.
By purchasing bonds, either individually or as a part of a mutual fund, you have agreed to the terms the company laid out and are loaning them your money. The result is that you now have a contract with the company to be repaid over a specific period.
There are several different types of bonds, and each and every company gets their own risk rating. The higher that risk rating the more they will have to pay the investor to borrow the funds.
That might sound simple but that additional cash also comes with the risk that they might go belly-up and pay you nothing at all.
It is a delicate balance and for that reason, many investors choose to use mutual funds for their bond exposure. Those funds will diversify the individual bond risk at a far lower cost for individual investors.
Also called a security or equity, a share of stock represents ownership in a company. In essence when an investor buys a share of stock they now have a contractual right to share in the company’s earnings.
Common stock, which is typical for most regular investors, even comes with voting rights. This means that as an investor you would have a vote at the shareholder meeting in proportion to your level of ownership in the company.
Don’t worry though, for most of us regular folks we simply vote by proxy, meaning you don’t actually have to fly out to a meeting. Of course you also have the option of not voting at all.
Another feature of common stock is the ability to collect dividends. These are portions of the company’s earnings that are paid out to the investor directly, typically every quarter.
Dividends are a fantastic way to grow your wealth over time and indicate strong company performance because they represent sustained earnings.
Stocks also rise and fall in share price based on predictions about future earnings. If you were to purchase a stock for $20/share and the outlook for the company improved, it’s price would likely rise to something like $22/share and were you to sell the stock you would have netted yourself a $2/share ‘capital gain’.
In short, you would have made money in addition to the dividends (earnings sharing) you received. Of course that also works in the other direction!
These funds are pools of money that individual investors like you or me can buy into. With that pool of money a fund manager will go out into the financial markets and invest in stocks, bonds, & money market instruments on the investors behalf.
The big benefit of mutual funds is the ability to diversify your investments at a low-cost. These funds will invest across a large number of different companies meaning that you are spreading your risk (diversifying) and not keeping all of your eggs in one basket.
What allows funds to do this more cheaply than you or I could is the scale they operate on.
Each fund will have a different objective so there is still research to be done. Before you buy into any mutual fund you should read through the prospectus which gives an overview of what returns they fund hopes to accomplish, what they invest in, and several of the basic metrics and ratios like the funds expenses.
All of this makes mutual funds fantastic for new investors, but watch out for the expense ratio! – more to come on that in the next post.
An ETF, or exchange traded fund, is similar to a mutual fund but it offers far lower expenses. That means you can keep more of the returns from each individual investment in the ETF.
It offers lower expenses by adopting a passive strategy without an active fund manager buying and selling investments all the time.
ETFs will actually track indexes like the ones you hear about on the news – FTSE, S&P500, Dow, etc. As a result, by investing in ETFs an investor can gain access to an entire range of stocks or bonds with one ETF share purchase. These ETFs trade on exchanges, hence the name, so you will pay a normal brokerage fee to buy and sell.
Note: If you are paying over $7 for a trade, no matter how many shares you purchase, you should consider switching your investments over to a low-cost investment house like Vanguard.
Where to Invest
So there you have it, several reasons you should consider investing on your own as well as the basic investment options to choose from.
To get started, just search around on Vanguard’s website to familiarize yourself with what options are available in the categories we just looked at.
Vanguard has excellent tools to analyze different funds and stocks, plus if you open an account you will have access to chat with someone to answer some basic questions.
The company has several sites set up specifically tailored to the country you live in, so be sure you are in the right section.
Vanguard also offers some of the best, low-cost investment options around and is known to be an industry leader. I have used Vanguard for years and could not be more pleased with the results.
In Post 2 we will explore some of the key stats you need to understand before actually choosing any investments as well as a few result hindering pitfalls to watch out for.
So what do you think, are you ready to become your own financial advisor?
Contribution By: Sarge began writing just this past year, following a horrendous experience with a financial advisor. Combining a knowledge and passion for finance with a real belief that through some simple education everyone can achieve the financial freedom we all long for – The Wealth Sgt was born. Check out more from Sarge over at The Wealth Sargent or on Twitter @TheWealthSgt.
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