Welcome to the Become an Investor series – the place where you will learn everything you need to know to start investing as an amateur individual investor. No prerequisite knowledge is required, as the posts will be self-contained and no familiarity with any concepts or terminology will be assumed.
Let’s start.
Introduction
You’re probably here because you want to understand the basics of investing, having little to no knowledge about the (stock) market. You may also be overwhelmed because you’ve read people assuming ~7% returns per year or taking their portfolio growth for granted. And you feel like you’re missing something… Or even worse, fear missing out. Especially when someone, like me, mentions the importance of starting early.
From Investopedia:
A 25-year-old who wishes to accumulate $1 million by age 60 would need to invest $880.21 each month assuming a constant return of 5%.
A 35-year-old wishing to accumulate $1 million by age 60 would need to invest $1,679.23 each month using the same assumptions.
A 45-year-old would need to invest $3,741.27 each month to accumulate the same $1 million by age 60. That’s almost 4 times the amount that the 25-year old needs. Starting early is especially helpful when saving for retirement, when putting aside a little bit early in your career can reap great benefits.
And again that assumed growth! If making profits was that easy why isn’t everyone doing it?! FOMO kicking in again? Relax, you’re at a way better place just by stumbling upon this post. So, let’s take this non-random walk one step at a time.
Let me comfort you by saying that the “Become an Investor” series will be the introduction to the basics of investing in a way that I would have liked to have them laid out for me when I started. Once you have a firm grasp of the fundamentals, you can graduate to a post where I explain how to do the investments or which brokers to use. Let’s focus on the what for now.
That being said, if you’re not new to terms such as brokers, stocks & bonds, market capitalization, P/E ratio, market index, ETFs, TER, forwards, shorting, or dividends, then there may be no need to read these posts. But if you want to refresh your knowledge without the information being scattered everywhere, this is a great place to do it.
However, one of the goals of the series is to make the absolute beginner able to understand financial concepts and terminology, so he’s not overwhelmed when he proceeds to explore on his own. The other goal is personal, as every time I mention investing in other posts I feel incomplete because I haven’t already defined the terms used. Referencing this post will come in handy during such OCD attacks.
So, what is investing?
Investing is allocating resources into something and expecting some form of returns in the future. In the terms that interest us, these resources would be your hard earned money, allocated, usually long term, into something you think has value, growth potential, or is undervalued.
And here is exactly where the confusion for many beginners happen – assuming that undervalued means “buying low”. Actually, let me get something really important out of the way before proceeding.
What investing isn’t?
The reason I highlighted the “usually long term” part in the previous section is because investing shouldn’t be confused with trading – terms that are often used interchangeably by financially ilitterate… iliterate… how do you spell this?! … illiterate people.
Many of these people think that, unlike the rest of us, they’ll be able to incorporate the ancient technique of buying low and selling high in real life. However, when they’ll find themselves past the rewarding experience of the Dunning Kruger effect kicking in, they might do quite the opposite. And what does “buying low” even mean? How do you detect that something is low if the future hasn’t happened yet? What about “selling high”? What is it? 50% returns? Doubling your investment?
For example, on the leftmost point from the chart below you somehow knew that the asset plotted is undervalued and will go up. You successfully timed the market and placed a buy order for 2000$ – buying 400 stocks at 5$ in April. Now, when is the moment you would “sell high”? Is it when the stock would be valued at 10$ in mid October that year (at 100% profit) or would you have predicted that it will go to nearly 30$ before a pullback and sold right at the top 2 years later (rightmost part of the chart)?
Impressive if you timed it that well and made ~500% in profits, because the stock indeed experienced a pullback and didn’t recover for almost 2 years after that point. But regardless of which option you chose (100% or 500%), you would have missed out on 40x returns, because the price of the stock is north of 200$ at this moment. Our successful sale is highlighted using a red arrow in the image below.
At this point, it’s crucial to understand that timing the market, especially as an amateur, is impossible… And history shows that it’s impossible to do repeatedly as a professional on the long-term as well.
How different the graph look once we know what happened… Hindsight is always 20/20, but remember, anything could have happened, this is just what has happened. Do you recognize the graph, by the way? It’s AAPL, which is the ticker symbol of Apple stock.
Let me present you with another graph.
Do you recognize this one? 🙂 It’s the confidence plotted as a function of one’s experience – the Dunning Kruger effect.
I got really side-tracked here… What was the section about? Yes, what investing isn’t! The take-away should be a clear distinction between investing and other types of allocating our means. Investing isn’t closely following daily chart behavior to realize big profits. Investing isn’t doing technical analysis or exchanging assets just because their price moved in a certain direction. Investing isn’t actively managing a portfolio, buying on margin, or leveraging tiny discrepancies between stock prices listed on different exchanges. Investing isn’t short-term stock picking, getting lucky, timing the market, or “beating the market”.
To be perfectly clear, I’m not saying that day trading, hedging, speculating, or arbitraging don’t work (wtf :)) or anything in that sentiment! Trading is a career and/or a lifestyle choice that requires lot of time invested to understand (even a particular segment of) it and even more to actively pursue it. That’s why I won’t go into it, especially not in this post.
Why investing is important?
It was good to get that out of the way.
I may have framed the whole section in a crude way, but I think that putting an accent on what investing isn’t is really important, especially for a beginner. After all, the last thing you’d need is a post advertising getting rich by trading penny stocks taking your attention away from where the money is not, actually… Lost.
Oh, and don’t respond to Instagram messages offering Forex training or free BTC. Whatever happens with your money will also fall in the “not an investment” category.
All jokes aside, the wealthy investor has his money in a broadly diversified passive portfolio yielding 5-10% per year on average and, if still in the “accumulation phase”, does periodic contributions to it and reinvests the dividends, while rebalancing his assets quarterly, biannually, or yearly. For the record, this investment strategy (where you contribute a fixed dollar amount frequently regardless of stock prices) is called dollar cost averaging (DCA) and I will cover it in detail in later posts.
So where is the catch?
On one hand I’m claiming that it’s impossible to do forecasts, on the other hand I take market returns for granted! But we’re taking this step by step… There is a lot to be learned and instead of overwhelming you right away, let me first summarize the key takeaway of this post with one of my favorite one-liners:
Time in the market beats timing the market.
Note that I’m not saying that you can’t successfully time the market (by getting lucky in most cases), but that time in the market for sure beats it on the long-term – which is the exact term we’re preparing for. Let me illustrate why.
Let’s say you successfully predicted that the stock of company X will skyrocket once some event happens. Or let’s not be that abstract… I’ll use a better example! Let’s say that you HODLd a Bitcoin you bought for 2000$ until mid December 2017 and sold it for 10x returns. Let’s even say that you had two!
So what did you end up with? You ended up with a ROI (return of investment) that anyone would admire, in the form of not-insignificant sum of money, but not enough to retire on. And you sit there with 40k in profits and no idea how to invest them or how to repeat the process. And then you realize… You need a long-term vehicle that will drive your success consistently and continuously! Welcome to the world of investing.
So, what now?
You still have the question unanswered – how do the FIRE community, among other investors, assume the market returns for granted? We’re slowly getting there… But before you understand how we invest in the market itself, you need to understand what the market is.
The next post in the Become an Investor series will cover the two most common financial instruments that you need to understand in order to start investing – stocks and bonds.
Until then, the only thing you need to remember is what investing is (allocating resources in something we understand and expect to grow to realize profits in the future) and how it’s different than other types of asset allocations.
See you in part 2.
Next Become an Investor Post: Introduction to Stocks and Bonds
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