Invest Like An Idiot
The recent run-up of Reddit endorsed meme stocks has brought the stock market to the forefront of the conversation. I have put together five nontechnical investment strategies to help the novice investor create long term wealth.
Preamble
Investing is an activity in which an economic actor purchases an asset in order to attain financial gain. Investing your money is not something to take lightly or whimsically, and should always be met with sound decision making and long term planning. The stock market isn’t there to make a quick buck (though it certainly can), but rather to provide a medium in which people and corporations can attain mutual benefit through community investment. When you purchase a stock, you are buying a portion of the company, albeit a small one. The company, on the other hand, uses this inflow of cash to finance business ventures, pay off debt, or invest in research and development, among other things. As a young person in today’s technology-enabled world, it is easier to invest in stocks than ever before. Low to no brokerage fees, partial share purchasing, and being able to literally invest from your phone have made owning assets easier than ever. Stocks, compared to other assets and securities, are fairly easy to understand, have a low barrier to entry, and provide relatively high returns. Below I have constructed a list of five strategies to follow in order to, with as little technical analysis as possible, construct a stable and sound portfolio for long term wealth creation.
1. Diversify, Diversify, Diversify…
Remember when your parents told you never to put all your eggs in one basket? Well, the same logic applies when constructing a stable and balanced financial portfolio. Initially, it may seem fruitful to pour all of your investment money into a company you really like such as Apple, Tesla, Coca-Cola, or Proctor and Gamble. These are certainly good companies with solid fundamentals, but a monolithic portfolio exposes one to higher potential risk. Some of Wall Street’s most beloved equities have crashed and burned due to asymmetric information between companies and investors. While publicly traded companies are required to release a myriad of financial statements and reports to showcase their performance year over year, one can never completely hedge against unknown risks. These risks can include corruption, foul play, or simple fraud which, once exposed, may significantly drive down the value of your holdings. Furthermore, a number of extrinsic factors may drastically affect the value of a company, such as natural disasters, unforeseen regulations, or key personnel loss.
To put this hypothesis of diversification to the test, I created a graph comparing the five-year performance of seven exchange-traded funds (ETFs). An ETF is a collection of stocks chosen by financial professionals that can be openly traded on an exchange. There are ETFs of all kinds, such as industry-specific ETFs, general ETFs, and even innovation ETFs. Below I compare the performance of a general ETF (S&P 500) versus industry-specific ETFs in technology, healthcare, energy, financials, and utilities.
In the graphic above, the S&P 500 certainly wasn’t the best performer of the bunch, simultaneously, it was not the worst; this is the key benefit of diversifying across industries. Technology may have been the highest performer, but we can also observe its relative higher volatility, particularly in its sharp decline at the beginning stages of the COVID-19 pandemic. Other sectors lagged behind such as Energy and Financials. While I certainly do not recommend scrapping industry-specific ETFs for the S&P, it is beneficial to diversify your portfolio in order to take advantage of the high yield of certain industries, and the low volatility of others.
The main purpose of this article is to provide a swift and simple methodology for investing in stocks, but equities are only the beginning of asset ownership and wealth retention tools. Other financial instruments such as bonds, high-yielding savings accounts, real estate, art, and precious metals are all forms of investment and provide varying levels of risk, return, and difficulty. As you get older and gather more wealth, the barrier of entry into more capital intensive asset classes (such as real estate) decreases. Allowing you to take advantage of assets that are less volatile and provide a higher fixed yield. Stocks are one of the key components to wealth-building, yet as time goes on, it becomes increasingly important to hedge against systemic risks to the stock market by investing in fixed income securities. So, while you may spend your younger years diversifying your stock portfolio, you may wish to begin to diversify across asset classes as you build your complete financial portfolio.
2. Invest in What You Know
This is a simple and nontechnical tip, but it can drastically improve your decision-making process when it comes to your portfolio. A simple spray and pray strategy for purchasing stocks is not going to cut it; there are thousands and thousands of stocks on the market. So, while I want to keep this as low effort as possible, there is going to need to be some level of research when shaping your portfolio. Knowing why your investment is valuable is absolutely vital. Don’t just trust my word for it, this tip comes directly from legendary billionaire investor Warren Buffet:
Buffet recommends that investors remain in their “circle of competence” in which one is able to understand the value proposition of the equities they’re investing in. Not knowing what you’re investing in is essentially indistinguishable from gambling, and Wall Street ain’t in Vegas. The key to sidestepping bubbles, avoiding catastrophic losses, and protecting against adverse volatility is making responsible and long term investment decisions.
3. Weight Individual Stocks Against ETFs
Now, we have been talking a lot about investing in ETFs, but what about individual stocks? While individual stocks may experience periods of particularly high growth they can be one of the riskiest and volatile equities in which to invest. That being said, it is difficult to deny the value proposition of some of the Street’s most notorious stocks such as FAANG (Facebook, Apple, Amazon, Netflix, and Google). When investing in individual stocks, an investor may protect their portfolio from negative price volatility by weighing their individual investment against an ETF within the same industry.
For example, instead of investing $100 a month into Tesla, one could invest $40 into Tesla and $60 into an electric vehicle ETF such as $DRIV. By doing so, an investor can still invest in a particular sector while partially hedging against the risk of that single stock failing. In the chart below, I compare the 5-year performance of three ETFs (S&P 500, Vanguard Financial, and Invesco QQQ Trust) with five holdings from each fund. As the charts illustrate, the funds themselves are never the highest performers, yet they are never the worst performers and tend to be less volatile than the individual stocks.
4. Dollar Cost Average
An untrained investor may see a stock make unprecedented gains in a short period of time and rush to pour their money into it at the height of its value. While it may seem logical to invest in a stock that has experienced remarkably high returns, this method is often counterintuitive and typically results in swift losses as the equity decreases in value to correct its atypical rise. In The Intelligent Investor (another Warren Buffet recommendation) Benjamin Graham touches on this very concept:
“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable price… The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down.”
A wise man once told me that “volatility is a two-way street.” If an investor is holding a portfolio of sound stocks, she should not be discouraged when facing negative volatility; she should rather recognize such an event as a potential opportunity to purchase shares at a discounted price.
For a passive investor, short-term market fluctuations will not be a point of profit, rather profit will arise from the long-term holding. When looking to invest, Graham provides further wisdom:
“On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value.”
Graham introduces the initial concept of dollar cost averaging. For a passive investor, short term fluctuations are more dangerous than fruitful. Purchasing a stock when it is highly valued, perhaps overvalued, may expose the investor to an adverse buying opportunity. Conversely, not purchasing enough shares during a significant decline in the price of a stock may result in lost gains and the investor purchasing shares at a later date when the price may be less favorable. To hedge against these fluctuations, it may prove advantageous to average the cost of your purchases by spreading them out over many weeks or months, perhaps increasing the magnitude of the purchases during significant price declines and decreasing during price inclines.
5. Wield the Power of Compound Interest
Finally and most importantly is to take advantage of compound growth. As a young person with a relatively small amount of capital, it will be very difficult to monetize your short term stock gains for clothes, food, or other purchases. Rather view investing as a long term venture, in which you not only safeguard the money you have, but you use that money to build onto itself. The value of investment compounds itself as the years go on, meaning the longer you invest, the more you’ll have in the end. Based on a return of 8% year over year, if you invest $1000 at age 20 and $1000 at age 40, by the time you are 60 your first investment will be worth $21,700 while your second investment will only be worth $4,700. That’s a difference of $17,000! As you can see, compound interest is an extremely powerful wealth-building tool that can exponentially grow your initial investment.
