How to Start Investing
Stocks
Stocks are fractional ownership rights in companies, not meaningless numbers bouncing around on the trading screen. First and foremost, choose your investing style: value or growth.
Value investors look to buy undervalued companies, searching for stocks that are currently trading in the market for a price lower than its intrinsic value.
"Trying to buy a dollar bill for 50 cents"
Growth investors look for the next Amazon or Apple, companies that will grow rapidly in the future,
"Searching for dollar bills that will become 2 dollars later on"
Investing in stocks requires a lot of emotional control. Many people identified Amazon as a fast-growing business with a strong competitive advantage and invested in 1998, but panic sold during the 2000 NASDAQ crash. Yikes. If you want to feel bad for those investors, simply take a look at Amazon’s stock price since 1997:
Despite the volatilities in the 2000s, Amazon proved its worth and dominated the e-commerce market in the following years, and those investors who panic sold missed out on the investment gains of a lifetime (as of this writing, each share of Amazon stock traded at $3,226).
Index / ETF
ETF (exchange traded funds) are essentially companies that are traded on the stock market. The only difference is that, while the purpose of a real company is to provide goods and services, an ETF’s only purpose is to make investments. By buying shares of ETF stock, you are buying pieces of an investment portfolio constructed by someone else.
Institutions like Dow Jones or Standard & Poors create lists of stocks (also known as an index), that are representations of the overall market. Dow 30 and S&P 500 are the most popular indexes.
An index fund is an ETF that buys stocks in a way that replicates one of these indexes. This is known as passive investing because of how little effort it takes, and serves as a decent option for people who don’t have the time or expertise for investing.
Because all S&P 500 ETFs are by definition replicas of the same index, there's no difference between who you buy the ETF from (Vanguard’s S&P 500 ETF is as good as a BlackRock or Charles Schwab S&P 500 ETF). As such, the only consideration are the fees, the lower the better
Mutual Fund
Mutual funds are similar to ETFs except these are often active investments, where the fund manager is picking individual stocks in an attempt to beat the broad indexes. There have been superstar mutual fund managers like Peter Lynch who made millionaires out of his investors, but the vast majority of managers fail to do better than the S&P 500.
When picking mutual funds, there are three crucial considerations:
Ask yourself, does the fund manager share your investment philosophy? If you are a growth investor, you wouldn’t invest in a value investing fund since your objectives would be misaligned.
Evaluate if the fund manager is skilled at investing. Take a look at the track record; if he or she’s been able to outperform the S&P 500 over the past 10 years or longer, that’s a great sign. If not, be very skeptical.
Look at the fees. Remember, a mutual fund with a 10% ROI charging 2% fees is worse than an ETF with a 9% ROI charging no fees. Refer back to our earlier discussion on fees for more details.
One thing to note about mutual fund managers: with enough monkeys flipping coins, at least some of them will get ten tails in a roll.
In the short term, it is impossible to tell apart who is skilled and who is simply lucky. Those fund managers that have posted spectacular returns over short periods of time (1 - 3 years) will almost always subsequently underperform the S&P 500; similarly, some of the best and most talented investors in history have had periods of brief underperformance followed by decades of brilliant returns.
Hedge Funds
These are only available to high net worth investors (that means, as of this writing, you must have $200K in annual income or $1,000,000 in net worth if single, or $300K in combined income or $2,000,000 in combined net worth if married).
These are similar to mutual funds but with near-unlimited flexibility in how they invest. For example, mutual funds can’t short stocks like hedge funds.
This flexibility has given hedge funds a notorious reputation as unethical people use them to take on irresponsible risks, gambling at the expense of investors and society. That said, a lot of hedge funds are also doing good by responsibly managing money for pension funds or school endowments.
Another characteristic of hedge funds is their ability to charge really high fees. Usually, the funds charge a percentage of total assets, plus a percentage of any investment profits, traditionally 2% and 20%, respectively ( called "2 & 20" in the industry). Today, those numbers are now closer to 1% and 15%, respectively. Those hedge funds offering truly superior investment returns have increased or kept their fees the same, while a lot of mediocre managers have had to lower fees in order to attract or retain investors.
While most of the criteria for picking mutual funds apply, because hedge funds have the potential to blow up (not in a good way), we recommend extreme caution.
Life Insurance
More and more insurance companies are offering products like UL, IUL, or VUL where your insurance policy doubles as an investment account. Some of these products can sound very enticing, such as the IUL which allows you to invest in the S&P 500 but guarantees a minimum ROI of 0% for any given year.
That sounds amazing because if you put in $100,000 and the market falls 50% tomorrow, you still have $100,000 instead of only $50,000.
When evaluating life insurance products, it is important to consider “what’s the catch?”. For example, an IUL might set a 12% ROI cap, which means when the market rises 20%, you may only gain 12%. This is the reason why despite sounding like an incredible offer, the average IUL has historically underperformed the S&P 500. Another catch is the myriad of fees that can quickly add up to erode away your total investment returns (trust me, insurance companies looove charging fees).
Annuity
An annuity is a product that promises to pay you a certain amount of money in the future in exchange for the money they charge you today. The benefit of these products is a guaranteed ROIs - you know what you can expect in the future, compared to investing in real estate or the stock market where there is an element of uncertainty.
The downside is that the ROI offered by these products after all their fees have been deducted can get pretty low. That means these products are almost always poor investments for young professionals who have a lifetime of investing ahead of them (remember, time is the enemy of a sh*tty ROI).
That said, if the market fell tomorrow, the ability for a 30 years old to wait for the following market recovery is much greater than that of a 55 years old getting close to retirement. For older folks, the trade-off between certainty and a lower ROI might make more sense as their focus is no longer on wealth growth but wealth preservation.
Summary
These are the most common types of investments you will encounter. Remember, investment is as much about patience as it is about finding a good stock or a good real estate deal.
Keep Warren Buffet's 20-Slots Rule in mind, do thorough research, and think carefully before making any investment. Once you’ve pulled the trigger, evaluate your investment regularly to see if your investment thesis is still correct, have the conviction to stand against the herd if you’re correct, but also have the rationality to change course if you’re wrong.
