Intermediate level of reading – this post includes a modest level of jargon that may or may not be explained in greater detail. Beginners should get familiar with the topics even if they don’t fully understand them [use Wikipedia to help fill in gaps].
Day trading is so cool and sexy, but are you really making any money? Depending on who you are and how lucky you’ve been this year, then maybe or maybe not. There are numerous factors that go into determining the share price of a stock, and figuring out what will impact the price in any given direction on any given day is near impossible. Generally speaking, share prices follow a random walk pattern from day to day meaning that from day to day prices fluctuate up and down randomly. Long term prices show a definite direction, but even week to week and month to month there is little logic in the movements of prices and, without 20/20 backwards looking vision, you won’t understand why a price shift did what it did.
A common and frequent saying in investing circles is, “past performance doesn’t predict future performance,” and this is legally a required statement in all fund prospectuses that you receive when you buy a mutual or (better) an index fund. What this means is that what happened yesterday says nothing about what will happen tomorrow. Now, I admit that this is a very simplistic statement that doesn’t always fit reality, but it follows what’s call the Efficient Market Theory/Hypothesis (EMT) that for all intents and purposes is the rule of law in investing. This being that market prices are based on all available public information the instant they’re known, so when you read about a new product in the Wall Street Journal, you’re too late to make money off that specific event because the benefit (or cost) is already priced into the stock. For the most part, this is how you should think about investing, and except for basically two people our of billions (usually Warren Buffet and Peter Lynch are named), few have figured out a way to beat EMT and make lots of money off of short term trading, although Warren Buffet is still a huge advocate of buy and hold.
So two paragraphs in, if it’s near impossible to make money off of day trading (after all costs including taxes and transaction costs) and EMT is king, what can you control in your investments? How do you make money in this investing game? Well, it’s actually not that complex (I’ll cross my fingers that you agree) and there are really three factors that you directly control and two factors that you indirectly control. You directly control the amount of time you hold an investment and the taxes and transaction costs that you eventually pay on that investment. Because you directly control these three factors (and they relate to one another), these should be at the top of your list of investment concerns. The two indirect factors that you control are risk and return of an investment. These are indirect because these are controlled by the company and the markets they operate in, so you indirectly control these factors through your purchases.
If you don’t want to know anything more, then buy index funds and hold until you need the money back (hopefully 10, 20 or more years from now). Your mantra should be, “buy and hold – forever.” Not very sexy, but it will make you wealthier than day trading and without the high risks. That’s a simple plan, and that’s what I’ll basically end up writing about for the rest of this post and into future posts, but this is one of the best ways to make yourself a millionaire (hyping much?), and if you want to understand why this is superior, then keep reading.
You can definitely go into great depth on almost any small or large topic with investing, but I want to keep this somewhat simple and removed from complexity. As I state in other posts, the current financial industry makes money from complexity and confusing you, so bare with me if it doesn’t seem so, but investing and making money really is simple and easy. In the end, you’re investment strategy will look like this: 50% invested in fund X, 20% in fund Y, 20% in fund Z, and 10% invested in fund D, or possibly 100% in fund A that’s similar to all those, and hold for 5, 10, 20+ years. To get us there, all we’re concerned with are time, taxes and transaction costs, and risk and return.
Time, taxes, and transaction costs. It’s easy understanding how you control time, but you may not understand why. It’s easy understanding why you control taxes and transaction costs, but not exactly how you’d do that. Both are actually simple. Time is the number 1 most important factor in your investment strategy. This is thanks to compound interest, which means the money you make off of an investment additionally makes money for you. If you buy a stake in an index fund for $1,000 and its value grows 10%, then you now have $1,100. The next 10% gain on that initial $1,000 investment is now making money off the first 10% that your investment accrued, and you now have $1,210 worth of stock. The longer you hold this investment, the more that will accumulate, compounding itself more over time. This is the key to getting wealth from investing, and if you keep buying and selling your investments, then you’re not giving them time to compound.
Also, time plays a major role in the taxes and transaction costs that you pay. The less taxes and transaction costs you pay, the more money you have (duh!). For taxes, if you sell your investments before a year’s time, then you pay taxes on your interest earned as income. If you hold for at least a year, then you pay taxes at a lower rate as capital gains, money earned. Additionally, if this money is in a retirement account like a Roth IRA or a 401(k), then you can lower your taxes even more if done right. I’ll cover that another time, but the general rule is that the more often you buy and sell, the more often you pay taxes and give away your wealth to the government when you didn’t need to. Also, the more often you buy and sell, the more often you’re paying transaction costs, money wasted. Hence, buy and hold.
Of course, the money earned depends on the return of the investment. This is typically what drives most people, and drives them in the wrong direction. Always chasing a return, or a higher return, causes a person to ignore the risks involved (which include the risks of paying higher taxes and transaction costs). Risk and return are related, though, like the other factors above. Generally, the higher the risk the higher the return, so the riskier the stock you buy, the more money it COULD make you. It could also lose you money, or it wouldn’t be considered risky. On a scale of riskiness of investment we have fixed income such as bonds as the least risky and equity being stock as the more risky. Hence you’ll get a better return from stocks than bonds, but that doesn’t mean you should own all stocks in your portfolio.
Since most people can’t handle the day to day volatility, or risk, in stocks, it’s advised you hold a combination of stocks and bonds. This is called diversification and allows you to maintain a level of return while reducing the level of risk. You can also diversify within bonds and stocks by holding low risk and return treasury bills, or T-bills, along with higher risk and return investment grade bonds, and in stocks by holding less risky modest return large capitalization stocks, large cap, along with riskier better return small value stocks. The reason you are diversified is that the return from a large cap stock are less correlated with small value stocks and will likely lose money when a small value makes money and vice versus. Also, bonds tend to be even less correlated in their gains and losses to stock. What you get is a smoother middle ground where the gains and losses somewhat balance each other out and you’re able to make a return while reducing of the risk of loss.
Understanding time, taxes and transactions costs, and risk and return gives you the first understanding for building a well diversified money making portfolio. You’ll use these as you understand each for your own specific situation in developing your investment strategy, which tells you what you should you own and for how long you should own it. If you can understand these five factors, then you know pretty much all you need to know, and you can sit back and relax while your investments make you money.