Principles of Investing: The Basics
First of all, before you start thinking about investing, you should be debt free. The reason? The average investor might be able to earn 5%-6% per annum (and this is if you invest correctly), but the cost of interest is usually higher than this.
If you still have debt, read this article instead.
What this article will do, is to lay out 5 simple points about investing. It will explain to you why you should invest, how to invest and how to not screw up.
1. Setting Expectations Correctly
Wait. Before all those gasps of collective surprise, 5%-6% of returns only? My friend, you read it correctly.
While some of you might snob away at this paltry amount, do note that it is the averaged return over multiple market cycles; i.e. periods of bear markets and terrible returns. In addition, I’m adding on a 2% p.a. discount because humans on average, are terrible investors.
While we like think of ourselves as above average, the truth is; this is like university, even if you went in as a straight A student, somebody has to take the Cs and Ds. Not everybody can be above average, and you are essentially competing in the same market as the top investment professionals in the world.
2. Compounding is magic
So what if it’s just 5% or 6%?
Well. If you contribute just $1000 a month from the age of 24 onwards, by the time you hit 60, even on a 5% return you will have $1.5 million.
What if you started later at say 35 years old? How would that look? Like this:
Essentially, by starting just 10 years later (which is pretty short in the 40-year investment horizon), your ending portfolio will end up half of what it could be.
3. Keep your costs as low as possible
Most investment plans in Singapore charge huge amounts of fees while underperforming the market. To me, this is really the fastest road to wealth erosion.
Taking the same example in point #2, we invest $1000 every month. However, if we are charged a 2% annual management fee, our wealth will look like this:
While 2% may not sound like a lot, the mechanics of compounding ensures that over a 40-year horizon, you are left with only half your money.
4. Most stocks are losers
Yep. You read it correctly. Most stocks lose value and by buying them you lose value.
However, stock returns also exhibit a fat tail characteristic. There are a few stocks that win and they win BIG.
If you miss these stocks, your returns are highly likely to be below average.
Peter Lynch terms this as his “ten-baggers”. However, let’s be honest; you are highly unlike to be able to be pick out these exact stocks while avoiding the bad ones.
5. Your likelihood of outperforming is low
Most money managers fail to outperform the index. The probability that an individual can do so is extremely low.
Also, unless you have more than a million dollars (in which, please disregard any advice from me because odds are, you are probably more well informed than me), there is little value in outperformance.
Let’s say that you manage to outperform the index by 200 basis points (on the same level of risk which is impressive), your net gain on 1 million is only… 20,000.
What is the effort required for that? Top money managers pore through vast amounts of reading material on a daily basis with an army of analyst to help them coordinate and decipher information.
20,000 for so much effort. You would be better off driving an Uber on the weekends or concentrating more at work.
The effort to reward ratio just does not make sense.
From this article, you should understand these few things:
- Investment returns on average are going to be about 5% – 6% on a nicely well-diversified portfolio. Anyone promising sky-high returns either requires you to take an inordinate amount of risk or are charlatans. Because, if it was so good, why would they offer it to you instead of hogging it themselves?
- Start investing early because time matters
- Keep investment costs as low as possible
- Be diversified because you don’t know who the winners are
- Forget about outperforming the index
With these information, what can we do?
The easiest way we can obtain diversified equity exposure at a low cost is through ETFs.
Readers, the above sentence is the most important sentence of this whole article. Read it, re-read it and tell the next person that tries to sell you a unit trust that you want to buy an ETF instead.
In the next article, you will find out what an ETF is and why it is good for you (Hint: Costs are low and it provides a diversified return)
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