Lesson 1 - Dollar Cost Averaging
By investing the same dollar amount each month, you will buy more shares when stock prices are low and fewer shares when stock prices are high. If the price moves up and down over time the average stock prices that you paid for the stocks in your portfolio will get lower. If set up automatically from your paycheck or bank account, it is effortless and you invest the money before you have a chance to spend it. My father helped me get started with this method and now I am doing the same with you.
Lesson 2 – Picking Stocks
It is really hard to consistently pick stocks that will beat the market. Professionals can’t even do it. That’s because the Efficient Market Hypothesis says all public information about the stock is already baked into the stock price. If you think a certain stock will do well in the future, other investors think that too and bid the price up. Then future price moves are mostly a random walk. I don’t buy individual stocks. I buy index mutual funds instead. More to come on those.
Lesson 3 – Timing the Market
It is really hard to time the market. Professionals can’t even do it. The adage “buy low, sell high” is easier said than done. You can look at a price history chart and look for trends. You can see what happened, but you can’t see what is about to happen. For every loudmouth who says he cashed out of the stock market before the plunge in 2008 and then jumped back in at the lower prices in 2009, there’s another fool who did the opposite. So it is better to buy over time using Dollar Cost Averaging and then hold the investment for a long time, even as the price rises and falls.
- Note: These 2 lessons are controversial – Picking Stocks & Timing the Market. There is an entire financial industry with brokers, advisors, and fund managers who make big bucks and will tell you they can pick stocks and buy or sell at the right time to beat the market. But studies show it is not true. Only 25% beat the index they measure against once you include the fees they charge. You might say, well I will pick an advisor that’s among the 25% that beats the market. Trouble is, you might know who did well in the past, but nobody knows who will win in the future.
Diversification reduces risk. If the prices of the stocks in your portfolio rise and fall at different times (that is, out-of-phase like a sine and cosine wave), it tends to smooth out the total returns. An index fund diversifies across a broad family of stocks. But then you can diversify further with total market index funds that include smaller companies and international companies.
Lesson 5 – Asset Allocation
Asset allocation refers to the types of investments in your portfolio. Broadly there are Stocks, Bonds, Real Estate, and Cash. When you are young it is OK to put 100% of your Retirement savings into Stocks. Stocks have high Risk & Reward, but retirement is so far off. It’s good to buy a house or condo as your real estate play. And you need enough cash for emergencies (maybe 2 months’ pay). Mid-career 70% Stocks / 30% Bonds is a good mix. Now at my age I am shifting it to 50/50 to make sure the money is still there when I retire even if the stock market goes down.
Lesson 6 – Fees
Pay attention to fees (aka commissions, loads, expenses). They can have a big impact on total returns over time. A stock broker charges a commission for each trade. Discount brokers’ commissions are much less (under $10/trade). Mutual funds might have a sales load (up-front fee), so only buy no-load funds. Even no-load funds have expenses that are pulled from your returns. Typically expense ratios run above 0.75% for actively managed funds, but index fund expense ratios are typically under 0.2%.
Lesson 7 – Index Funds
Index funds track to all the stocks in a broad market index at very low fees. You won’t get rich quick, but over time it will outperform actively managed funds after their fees are subtracted. S&P 500 index funds track the biggest 500 US companies. Total stock market funds track the entire US stock market. International index funds cover foreign markets. And world funds have US and foreign stocks. Similarly, there are bond index funds and real estate investment trusts (REITs).
Lesson 8 – Taxes
Tax laws change over time, so this is an area where a tax advisor can really help. Income taxes are paid on stock dividends and bond interest, and on capital gains when sold at a higher price than when originally purchased. There are ways to avoid these taxes or defer them until later. One way is to buy & hold, because whenever you sell, capital gains taxes are due. Most employers offer 401k plans that allow you to invest with your earned income before income taxes are assessed. And the dividend and interest are reinvested and not taxed until the funds are withdrawn in retirement. If you change jobs, you can roll-over your 401k into an Individual Retirement Account (IRA) to continue the tax deferral. Another tax-efficient investment are government or municipal bonds. The interest on these bonds is not taxable. If you buy a house or condo, the mortgage interest and property taxes are deductible which reduces your taxable income. Think of it as part of your real estate allocation. So it makes sense to buy a house or condo as soon as you have saved enough for a 20% down payment (to get the best mortgage interest rates).
Lesson 9 – Risk & Return
Historically, stocks make about 10% per year. Bonds return about 6% with less risk. Cash in a money market or savings account earns the lowest interest but there is virtually no risk. So as you can see there is a relationship between risk and return. The higher the risk the higher the return. This is because investors evaluate the risk and it gets built into the trading price of the investment. As risks increase, investors are willing to pay less for the investment so subsequent returns are more as a percentage of the original investment.
Lesson 10 – How Much to Save
If your company offers matching contributions to your 401k, then save to the maximum they will match. It is free money. Once you have 2 months’ salary saved in your bank account, then your 401k retirement investments plus your non-retirement automatic monthly investments should equal 20% of your salary -- rule of thumb.
Lesson 11 – Buy & Hold
Each trade has a transaction cost, a tax impact, and requires time and attention. So along with my advice to keep down costs and the difficulty of timing the market it all adds up to a buy & hold strategy. The best reasons to sell are to rebalance the asset allocation and when you need the money.
Lesson 12 – Simplicity
One of my main investing objectives is to keep it simple. The advice I’ve given here just isn’t that complicated. It might even be boring. Investing is important but I’d rather spend my time doing something else.
Lesson 13 – Education
If you think education is expensive, try ignorance. My father put me through college and then got me started saving for your education. Our family has invested heavily in education. It’s an investment in ourselves. You need to continually educate yourself. It does not end at graduation. As soon as you have children, it will be time to start saving for their education.
Now I can confidently say that I’ve taught my sons what they need to know – at least about investing anyway. These lessons are part of my program as a wise-elder-in-training, learning how to pass my knowledge on to the next generation – or to anyone who cares to listen.
References:
Random Walk Down Wall Street by Burton Malkiel
Index Revolution by Charles Ellis
Elements of Investing by Malkiel & Ellis