Financial Planning for Geeks

Investment Basics: How to Invest

- Investments

This month, I continue on the topic of investment basics.

A black-and-white drawing of a machine for printing papers in eight colors.
It's almost like printing your own money.

Now that I’ve defined some of the basic terms, asset classes, and account types, and I’ve talked about investor psychology, it’s time to examine the how. How can I help you get started with your long-term investing? What are some of my favorite pieces of advice?

Remember I’m talking about long-term investing here. This is the money you put away now to take care of your future self and your loved ones; it’s what you’ll live on after you stop working for money. These are the investments you need to beat inflation over time and sustain you for your entire life. Buckle up for a long, healthy life with LOTS of inflation…because there is every chance you’ll get it!

Let’s start with the fundamental steps you need to take to set up your long-term investments:

1.      Account types: First, you’ll need choose the account types you want to invest in. Will you choose a 401(k), IRA, Roth IRA, or some other kind of investment account? Will you maintain multiple account types? Your plans can change over time, but you’ll have to choose the initial containers to put your money in.

How do you decide? Well, if you have a plan available at work that’s a great place to start. Many employers will match your contributions or make contributions for you, depending on the account type. Be sure you are taking advantage of all the free money available to you. These employer-sponsored accounts generally have higher contribution limits, too, so you can put away more money every year.

If you don’t have an employer-sponsored plan, an IRA and / or Roth IRA is great, too. As with 401(k)s and other employer-sponsored plans, the value of the investments in these accounts is allowed to grow without being taxed, which means more wealth in your pocket when you stop working for money.

If you’re eligible to contribute to all of these account types and you have enough money to do it, that’s wonderful! If not, take a look at my post about account types and prioritize from there.

2.      Asset allocation: Next, you have to decide what goes in each account and in what proportion. The proportion of each asset class in your portfolio is called your asset allocation. For example, you might decide to own 90% stocks, 5% bonds, 4% real estate, and 1% cash in your long-term portfolio; that’s an asset allocation. It’s also one way to diversify your portfolio, because you invest in multiple asset classes at once.

The more stocks you have in your portfolio, the more volatility you will experience in terms of value fluctuations. You’ll see the value of your account go up and down more frequently and dramatically if you invest mostly in stocks. You’ll also see higher long-term returns. Volatility and return go hand in hand, so choose the asset classes in your portfolio to reflect how much volatility you want to take on and what return you want to target. Investopedia has a pretty good summary of different asset allocations and how they line up with your tolerance for volatility and target return.

3.      Investment choices: once you have your asset allocation set up, it’s time to choose the investments you want from each asset class. Depending on the account type you’re working with, you’ll have a variety of options available.

Fundamentally, you’ll be choosing between individual investments and funds. Individual investments are just like they sound: you’re buying ONE company’s stocks at a time, or ONE lender’s bonds. When you buy funds, you’re buying a pre-packaged bundle of many individual investments, like a fund made up of stocks from hundreds of different companies. Other funds even contain investments from multiple asset classes, like a Target-Date Fund for people who are retiring in 2052. A fund like that would include stocks, bonds, real estate, cash, and other asset classes. See my post about investment structures to learn more about this topic.

My friends, choosing individual stocks, bonds, and so forth is a full-time job. It is quite literally a full-time job for stockbrokers, analysts, and investment advisors who spend their every waking moment researching and tracking every facet of a particular market and putting together a portfolio. AND THEY STILL DON’T DO ANY BETTER THAN THE OVERALL BOND OR STOCK MARKET THEY ARE COVERING! Not over the long term, anyway. Why in the world would I or anyone else think we can do better?

It can also be hard to truly diversify if you buy individual investments, since you have to buy shares of every company you want and bonds from every lender you want, and so forth. If you have 200 companies with $800 share prices, you might not have enough money to properly diversify. Yes, you can buy fractional shares of stocks, but it’s a lot of work, and at this time you can’t really buy fractional shares of bonds. You might also be able to buy fractional shares of certain types of alternative investments, but it’s going to take you extra time and research to find those opportunities, vet them, and buy them.

My point here is that if you’re going to choose your own investments, it will be easier and you’re probably more likely to meet your investment goals if you buy funds of some type.

If all of this sounds like a lot of work and pressure, please feel free to hire a professional to help you. I highly recommend working with an advisor who does comprehensive financial planning, because they will take the time to understand your needs, goals, and attitudes and then help you decide on the appropriate investment strategy for you. Just remember that this person can’t be a stock picker for you, any more than you can, or the world’s top analyst can. If your potential advisor tries to sell you on achieving higher returns by working with them, run a mile.

OK, you may have picked up on the fact that I have some strong opinions about how this whole shebang needs to go. You’ve got me there. So here are a few of my favorite practices and principles to send you on your way:

1.      Do it. Yes, you need to take action to make long-term investing happen. I beg you not to rely on Social Security or an inheritance or the lottery…or anyone but yourself. That includes your beloved partner(s) and your sweet mama. Take ownership and control of your financial future because you cannot know what will happen between now and then.

2.      Own stocks. Lots of them. My friends, stocks are the most reliable way to beat inflation over the long term, and by the greatest amount. If you want to build wealth, buy stocks. Yes, we all know the past doesn’t predict the future, but stocks are the best bet we’ve got. Since people invented the idea of stocks, they’ve performed better than real estate, bonds, cash, gold, and any other asset class you’d like to throw on the table. Yes, even now that interest rates are going up.

3.      Diversify. I’m referring to your stock portfolio here, but if you hold other asset classes you will need to diversify them as well. To use stocks as an example, diversification means you hold a lot of different types of stock, like value and growth, international and domestic, small companies and larger companies, companies from different industries, and so forth. If you own other asset classes, make sure to diversify your investments in them, too. The point of this is to not have all of your eggs in one basket, because if any one basket fails so does that asset class.  

4.      Buy and hold investments for the long term. This is the single most boring, un-sexy piece of advice you’ll ever hear, and I promise you it’s one of the best. While your friends are crowing about making a killing on Company X or diving into the next hyped industry sliver, you will be plugging away with your same old thing. I beg you to be boring, patient, and disciplined because those principles are positively correlated with long-term investment returns. Chasing trends is highly correlated with hot air; in our heart of hearts, we know this. We know that friend isn’t telling us when their day trading fails miserably.

5.      Corollary to buy and hold: don’t try to time the market. No one knows when the markets are going to go up or down. I repeat: NO ONE KNOWS WHEN THE MARKETS ARE GOING TO GO UP OR DOWN. Sometimes people get lucky and “predict” it, and sometimes they do it twice. But no one can do it reliably over the long term. Not you, not me, not Big Shot Expert in the News Who Predicted the Downturn Last Time. When should you get started? Now. As soon as you have that first dollar to invest. Don't wait for the "right" time.

6.      Get on the Dollar Cost Averaging (DCA) train. Dollar cost averaging is just a strategy to help you stay disciplined. With DCA, you make your investment purchases on a regular schedule and with a set amount of money, so you can avoid the lure of trying to time the market. The other great thing about DCA is that, over the long term, you will achieve a lower cost per share than if you waited all year and dumped your money in at once. It’s like getting a nice little discount on your purchases over time. If you’re contributing to your 401(k) or other employer-sponsored account, you’re already doing DCA. Yay, you!

Of course, you will want to increase your regular investment amount when you have more available cash or when contribution limits go up, but once you set that amount, you’ll want to stick to it until the next time something like that happens. Set rules around it and follow them.

7.      Pay yourself first. This is another way to instill discipline into your investing. If you set up auto-withdrawals to go into your long-term investment accounts at regular intervals, it’s a lot easier to be consistent. It’s also an easy way to do DCA when your employer isn’t the one taking the money out of your check.

If your employer does offer a plan, though, automatic deductions from your paycheck are just another way to pay yourself first. You won’t notice the withdrawals as much as you might think, because employer-sponsored plan contributions are made before taxes are taken out of your check.

8.      Rebalance your investment portfolio at set intervals. Yes, this is another tip related to discipline. Rebalancing resets your portfolio to your chosen asset allocation; for example, 90% stocks and 10% bonds. If stocks have a huge run one year, you’ll want to sell some of them and buy bonds to get your allocation back to 90/10. This ensures you’re buying high and selling low, in a disciplined way. Sure, I’m thrilled if you have 100% stocks, but if you have other asset classes you’ll want to rebalance at least once a year. If you’re working with an advisor, they can help you do it. Just be sure to do it at the same time each year to preserve that discipline.

9.      Volatility is NOT the same as risk. You’ll see a lot of people confuse the two; they’ll refer to “risk tolerance” when they really mean “tolerance for volatility.” They might say you have high risk tolerance if you have a 100% stock portfolio, but what they really mean is you have a high tolerance for volatility. I have a whole post about the difference between risk and volatility here.

When people talk about risk in this context, they are usually talking about the risk of losing all of your money. If you have a properly diversified portfolio of stocks, the risk of losing all of your money is low. The real risks you face are due to longevity and inflation: there is every chance you will live past age 90 and, in the meantime, inflation will probably continue at some level. The longer you live, the more money you will need to cover expenses and the more inflation will eat away at the value of your investments. That’s why you can’t just put cash under your mattress. Well, those are two reasons not to put cash under your mattress. You can probably think of more.

10.      Turn off the hysteria. Please don’t listen to anything you hear about investing in the media (and that includes social media). A few of these people might mean well, but at the end of the day they are sharing their opinion with the world so they can get paid. Whether it’s by clicks or ad sales or whatever mechanism, investment news and analysis happen because investment writers get paid. That means they are motivated by the simple goal of getting your eyeballs on their content.

They will come up with the most apocalyptic headlines, the direst predictions, and the scariest examples of unsuspecting investors just like you who are now ruined because they didn’t listen. I wrote a post about Negativity Bias here, and it turns out that writers do this because we are psychologically inclined to consume bad news more than good. Please don’t be derailed from your disciplined, buy-and-hold strategy by clickbaiters. Just don’t read the stuff; it’s bad for your head.

Wow, it turns out I had more to say on the subject than I thought. I may be missing a few tips, but I hope this will be enough to get you started. Bon voyage!

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Penny Farthing

I, Penny Farthing (non-wizarding name Kerry Read ), actually have a day job in the world of finance. This blog came into being because of my deep and abiding love for geeks and Personal Finance.