Things Every New Investor Should Know

Things Every New Investor Should Know explained by professional Forex trading experts the “ForexSQ” FX trading team. 

Things Every New Investor Should Know

Things to Keep In Mind as You Begin Your Journey to Financial Independence

Starting out on your path to investing success might seem overwhelming. There’s no need to fear. Millions upon millions of people have traveled the same road you are about to take, successfully navigating booms and busts, war and peace, major life events, and every other twist and turn life can throw at you. With patience, discipline, and a calm temperament, you can do the same. Here are a few things you want to keep in mind as you take your first steps.

1. The Earlier You Start Investing, the Easier It Is to Build Wealth Thanks to the Power of Compounding

You’ve probably heard this a million times already but it’s important that you truly internalize it in a way that changes your behavior and reorders your priorities: You can save much less money, and end up far richer if you begin investing early. The outcome differentials are truly staggering. For example, an 18-year-old who jumps straight into the workforce and saves $5,000 a year in a tax shelter such as a Roth IRA, earning long-term average rates of return, would end up retiring with $4,359,874. For a 38-year-old to achieve the same thing, he or she would need to save more than $36,000 per year.

This is the reason I write articles explaining how a recent college grad could end up with $4,426,000 by saving $111 per paycheck throughout his or her lifetime or detailing how to improve the quality of your life by using the time value of money formulas.

It goes back to the old saying: The best time to plant a tree was yesterday. The second best time is today.  Start planting.

2. No Matter What Anyone Else Tells You, There Are No Silver Bullets —​ Your Portfolio Should Be Tailored to Your Unique Life Circumstances, Objectives, Risk Tolerance, and Goals

People have a tendency to get emotionally over-involved in their holdings, sometimes going so far as to all but worship a specific legal structure, methodology, or even company.

I’ve mentioned it before in some of my other writings but you tend to spot it when they constantly repeat refrains such as, “This is the only stock you’ll ever need to buy”, “Buy these three index funds and ignore everything else,” or “International stocks are always better than domestic stocks”. It’s all nonsense.

Instead, think of it this way: Your investment portfolio has a job to do. That job is going to depend on upon your personal goals, objectives, resources, temperament, psychology profile, tax bracket, willingness to commit time, and even prejudices. (One famous economist remarked many generations ago that (and I’m paraphrasing here), given enough years, a portfolio begins to take on the imprint of the person constructing it.)

A wealthy, well-heeled former private banker capable of reading an income statementand balance sheet may want to collect a six-figure passive income from dividends, interest, and rents resulting from lovingly putting together a collection of blue chip stocks, gilt-edged bonds, and trophy commercial buildings. A young worker may want to buy the cheapest, most diversified, most tax-efficient basket of stocks he can through a low-cost index fund in his 401(k).

A widow who is scared of the stock market may want to acquire a portfolio of cash-generating rental houses with surplus funds parked in certificates of deposit.  None of them is wrong. None of them is better than the other. They are all different. The question is whether the portfolio, methodology, and holding structure are optimal for whatever task you are attempting to achieve.

3. You Will Experience Several 50 percent Drops In the Market Value of Your Portfolio Over an Ordinary Investment Lifetime. You Cannot Avoid Them. Learn to Deal With It.

Asset prices fluctuate all the time. Sometimes, these fluctuations are irrational (e.g., tulip bulbs in Holland). Sometimes, these fluctuations are caused by macroeconomic events (e.g., mass markdowns on securities due to investment banks hurling toward bankruptcy having to liquidate anything and everything they could as quickly as possible to raise cash even if they knew the assets were dirt cheap).

Real estate prices collapse then recover. As long as the portfolio you’ve built is constructed intelligently, and the underlying holdings are backed by real earning power and assets acquired at reasonable prices, it should be fine in the end.  It’s life.

Consider the stock market. Between April 1973 and October 1974, stocks fell 48 percent; between August 1987 and December 1987, it was 33.5 percent; from March 2000 to October 2002, it was 49.1 percent; from October 2007 to March 2009, the decline in equity prices was a truly breathtaking 56.8 percent. If you are a long-term investor with a reasonable life expectancy, you will experience this more than once. You will watch your $500,000 portfolio decline to $250,000 even if it is filled with the safest, most diversified stocks and bonds you can find. Maturity means accepting this. A lot of mistakes are made attempting to avoid it.

4. The Evidence Is Abundant, Overwhelming, and Crystal Clear: Most of You Will Experience Far Better Real-World Returns By Paying a Qualified Advisor to Work With You in Managing Your Financial Affairs Even If It Increases Your Expense Ratios

Before the rise of behavioral economics, it was generally assumed —​ incorrectly, as it turned out —​ that most people were rational when making financial decisions. Studies out of the academic, economic, and investment sectors over the past few decades have demonstrated how catastrophic this assumption turned out to be in terms of real-world outcomes for investors. Tragically, unless a person had the knowledge, experience, interest, temperament, and Spock-like ability to ignore the market fluctuations we just discussed, they tend to do extraordinarily foolish things, such as “chasing performance” (throwing money into what has recently increased in price) or selling otherwise high-quality holdings at rock-bottom prices during times of economic distress; e.g., selling shares of well-run, financially sound banks when they dropped 80 percent in value a few years ago before recovering in subsequent years.

One now-famous paper by mutual fund giant Morningstar showed that during periods when the stock market returned 9 percent, 10 percent, or 11 percent, the fund investors were earning 2 percent, 3 percent, and 4 percent because they had no idea what they were doing; constantly buying and selling, moving from this fund to that fund, not taking advantage of intelligent tax strategies as they committed a host of other transgressions. This led to an almost paradoxical outcome: Those investors who paid an advisor reasonable fees so there was a person doing the actual work for them, including holding their hand and bringing professionalism to a task that demands it, ended up experiencing far better real-world outcomes despite paying more.

In other words, classic economics had it wrong, including some of the high-priests of low-cost investing, such as Princeton-educated economist John Bogle, who founded Vanguard: An investor’s return was not the result of gross returns minus costs with financial advisors and registered investment advisors extracting value. Instead, they earned those fees, often in spades because a typical investor could end up with much higher returns because the advisor held their hand and changed their behavior. Human irrationality meant that the theoretical perfect was, in fact, detrimental. Continuing to insist upon it is intellectual malpractice.

To their credit, Bogle’s enterprise, Vanguard, has recently acquiesced to this reality, albeit quietly in a way that has gone unnoticed (though I suspect, won’t be in another decade). The well-known, low-cost asset management company has roughly 1/3rd of the money under its supervision in actively managed funds with the remaining 2/3rds in passive index funds. The latter are famous (or, if you believe the whistleblower lawsuit from its former tax attorney in the news lately claiming the company has dodged roughly $35 billion in taxes, infamous) for charging between 0.05 percent and 1 percent annual expense ratios. Sure, some of them have their problems (which are not Vanguard’s fault) such as quiet methodology changes that would make past performance impossible to replicate and potentially painful embedded capital gains, but overall, they’re among the best in the industry. In theory, it should be easy for a person who was willing to deal with the trade-offs to regularly buy it, staying the course for an entire career until retirement approached.

Seeing how incapable investors were at that task —​ “staying the course” —​ Vanguard has launched its own advisory service that will manage the client’s portfolio of Vanguard funds in exchange for an additional 0.30 percent per annum on top of the underlying fund expenses. That means, depending on the specific underlying fund selected, the effective fees on all levels might amount to anywhere between 0.35 percent and 1.26 percent (trust fund accounts are a bit different with the effective fees on a $500,000 trust amounting to somewhere around 1.57 percent per annum). According to Vanguard’s own publications, the firm estimates this could lead to as much as a 3 percent per annum increase in the actual real-world compounding rate enjoyed by the investor, with half of that coming from having someone to serve as an emotional coach during economic, political, and financial maelstroms. Over 10, 25, or 50+ years, that is a staggering amount of extra wealth despite theoretically higher fees that “took” hundreds of thousands, or even millions, of dollars in lost compounding; the mythical wealth that never would have materialized due to operator error.

5. Tax and Asset Protection Strategies Can Make a Huge Difference in Your Income, Net Worth, and Ability to Pay Your Bills

It is entirely possible for the exact same investor, with the exact same saving and spending habits, with the exact same portfolio of stocks, bonds, mutual funds, real estate, and other securities, to end up with wildly different ending wealth amounts depending upon how he or she structured the holdings. From simple techniques such as asset placement and taking advantage of a Traditional or Roth IRAto more advanced concepts such as using a family limited partnership liquidity discount estimate to reduce gift taxes, it is worth the time, effort, and trouble to make sure you understand the rules, regulations, and laws, using them to your maximum benefit.

For example, if you are experiencing extreme financial stress, it may be a terrible mistake to try and pay your bills with money in your retirement plan. Depending upon the type of account you have, you may be entitled to unlimited bankruptcy protection of the assets within its protective confines. Consulting with a bankruptcy attorney would be the most intelligent course of action because you might end up richer by declaring bankruptcy, starting over, and walking out of the courthouse with most, or all, of your retirement plan assets still intact, compounding for you as it pumps out dividends, interest, and rents.

6. There Are Only Three Approaches to Acquiring Assets for Your Portfolio

In the final analysis, there are only three approaches an investor can take to acquiring assets for his or her portfolio. I wrote about this in-depth on my personal blog but the short version is:

  • Systematic Purchases: Regularly buying or selling a collection of assets over time regardless of valuation under the hope that time will even out the good times and the bad times. Many people have grown wealth this way. This is the “Defensive Investor” in Benjamin Graham’s work; the person who doesn’t want to think much about his or her portfolio but let diversification, low-cost, long-term passive ownership, and time work its magic.
  • Valuation: Buying or selling based upon price relative to the conservatively estimated intrinsic value of a firm. This requires significant knowledge of everything from business and accounting to finance and economics and basically causes you to evaluate assets as if you were a private buyer. Many people have grown wealthy this way. This is the “Enterprising Investor” in Benjamin Graham’s work; the person who wants to control risk, enjoy a margin of safety, and know there is substance (real earnings and assets sufficient relative to the price paid) for each and every position in the portfolio so if we go into another 1929-1933 or 1973-1974, they can sleep well without worrying. At the end of the day, the entire financial system rests upon this method because prices can only deviate from underlying reality for so long. Almost all high-profile investors who have good long-term records fall into this camp, including those who have become spokesmen for the first approach; e.g., since we already mentioned his firm, John Bogle, the founder Vanguard, quietly liquidating a massive percentage of his personal equity holdings during the dot-com boom because the earnings yields on the underlying stocks had become pathetic relative to the yield available on Treasury bonds at the time.
  • Market Timing: Buying or selling based upon what you think the stock market or economy is going to do in the foreseeable future. Market timing is a form of speculation. A few people have gotten rich off of it but it’s not sustainable.

If you are a layman, stick to the first method. If you become an expert, stick to the second method. Anyone with common sense should largely avoid the third method though it sells wells and makes for interesting cocktail party talk.

Things Every New Investor Should Know Conclusion

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