Intro to Investing: The Golden Principles

You've decided to take the plunge. After reading many articles, you've finally been convinced that you're missing out by not investing. With great trepidation, you're now just a few clicks away from making your first investment in the stock market. 

Boom. 5 shares of Facebook stock. 

The rush. The relief. And then...the growing sense of dread. What's going on? The stock price takes a plunge, and continues to plunge day after day. You've already lost $100 in less than a week. Oh man, I could lose everything. In a panic, the "sell" button is simply too tempting. You sell out, and now you're down $114 including commissions to finish off the week. 

Hopefully the above story doesn't sound too familiar. But like most novice investors, I've also experienced some significant losses. There will always be gains and losses when investing in the market, but losses like the one mentioned above can certainly be avoided. Contrary to common belief, being a successful investor does not require some astounding intellect or deep knowledge of the markets. For the typical investor, his or her greatest advantages will be time and discipline. By applying the following principles, an average person can outperform an average hedge fund manager:

1) Know your timeline
2) Diversify
3) Apply Dollar-Cost Averaging
4) Remain disciplined

1) Know your timeline
First, you must know your timeline. Are you investing for the long haul? Or do you need cash for a down payment in the next 2 months? With a longer timeline, it makes sense to be invested in equities. On a shorter timeline, a certificate of deposit, treasury ETF, or high yield savings account would be the better choice. If you invest in the stock market with a very short horizon, you run the risk of loss that cannot be recovered by the time you need the cash.

2) Diversify
In my first year of investing, I had over 20% returns from investing in just 3 high-growth tech companies. After a tech downturn, I found myself lagging the market, and barely breaking even. Since then, I’ve realized the importance of diversification. It’s easy to get an inflated sense of confidence after outperforming the market for some stretch of time, but it is oftentimes not replicable over the long haul. It’s by no surprise that one of the most famous and successful investors in history, Warren Buffett, advises people to "consistently buy an S&P 500 low-cost index fund.” In brief, buying index funds or index ETFs allows you to be invested in hundreds of companies instead of just one. In general, a person who invests $10,000 in an index of 500+ companies will easily outperform a person who invests the same amount in a single stock over the long haul. Even great (or seemingly great) companies can implode or fail to adapt to new market conditions (Sears, Blockbuster, Yahoo, GE just to name a few). Being invested in an index like the S&P 500 provides diversification that mitigates the risk of any one company’s struggles destroying your entire portfolio.

Moreover, the US market has continued its climb year after year. Of course, there are some years that experience bear markets, but overall, the US market is consistently growing in value, and doubling on average every 7 years. There are certainly ways to get substantially more yield than simply investing in total market indices, but those methods come with significant risk, and demand substantial time and consideration. For the passive investor (someone that primarily purchases larger index funds and maintains a buy-and-hold approach), the best combination of yield, risk, and time is likely investing in total market ETFs.

3) Apply Dollar-Cost Averaging
It’s impossible to perfectly time the market. It is generally unwise to suddenly invest a very large sum all at once, thinking that you may have caught the bottom. Even general trends in the market can suddenly change based on different events or circumstance. As a recent example, the Fed’s commentary on interest rates being far from neutral sent the market crashing for nearly all of October. Instead of trying to perfectly time a downswing to buy everything, or an upswing to sell everything, it’s better to simply buy consistently over time (your 401K plan basically already does this for you). Buy a little more when the market is tanking, and a little less when the market reaches new all-time highs.

Imagine that you need to buy jugs of water for drinking and cooking (this is actually a reality in some places in the world. Hah, I digress). Say that these jugs of water occasionally jump in price, but also occasionally go on sale. You always need at least some water to survive, so you buy it consistently. During times the price jumps up, you hold off a little and buy less. During times it’s on sale, you pick up a bit more. Dollar-cost averaging in purchasing index ETFs follows the same principle.

Again, this follows the old adage of “buy low, sell high”, with the added caveat that you cannot perfectly predict market movements. So determine a plan and stick to it, whether that means buying once a week or once every other week in some fixed dollar amount (unless there are large rallies or selloffs in the interim). In doing so, your dollar-cost average will be lower, and your return will potentially be a bit higher than the market.

As a real world example, here is the YTD chart for ITOT, which follows the S&P 1500 index.

Screen Shot 2018-11-01 at 2.01.52 PM.png

Person A does not apply dollar-cost averaging. Person B and C both apply dollar-cost averaging. However, Person C is a bit more opportunistic, and buys more shares during market panic, and buys fewer shares when the market seems to border on all-time highs.

Screen Shot 2018-11-01 at 2.34.18 PM.png

In this example, Person A, after seeing a two day drop at the end of January, decides to go all-in. He bets on a market rally to bring the total market to new heights. Person B applies dollar-cost averaging in a purely flat-line manner. Person C pays a little closer attention to the market, and decides to buy a little more aggressively on the downswings, and a little less on the upswings.

Over time, Person C will almost always end up with the lowest average cost. Person A may look a little foolish in hindsight, but many people do fall into this kind of mentality.

4) Remain disciplined
The market is a fickle beast that often does not move according to our expectations. It will undoubtedly be tempting to sell and just get out when people are panicking and the market is crashing. At the same time, when the market is reaching new highs, it may be tempting to think that you have to get in now and not miss out. However, do not be fooled into taking any drastic measures, or succumbing to these temptations. Even brilliant people have lost an incredible amount from their investments due to falling for these temptations. In general, any strategy that likens to “get rich quick” is likely to set you up for huge loss. Stick with the plan.

-Ezekiel Emunah

Disclosure: I am/we are long ITOT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. 

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