I have to say, I love blogging so far. Musing on money has provided a very therapeutic and enjoyable analytic exercise. One of my coworkers asked if I trouble have finding topics to write about. I don’t. Since the personal finance world touches so many topics and plays such a prevalent role in my life, I simply write about whatever topic presents itself. Recently I’ve had a mish mash of investing questions and work-related investing issues. So this week I want to talk a little about investing.
When I was studying for the CFP exam, investing was the most intimidating of the six core financial planning topics – principles/fundamentals, insurance, investing, income tax, retirement, and estate planning. I found it so daunting because of the vast amounts of information that existed and how seemingly complex and intricate the investing universe seemed.
After reading several books and taking some investing courses, I’ve begun to really like the investing world. The more I read, the simpler investing became. Eventually, I developed a good sense what investment strategy appealed to me the most.
What is investing?
Investing, in short, involves putting money in an investment vehicle to hopefully appreciate for future use. In other words, you set aside $1 today in order to get $1.05 a year from now. (That’s a 5% return.) You can use all sorts of vehicles: stocks, bonds, mutual funds, money markets, real estate etc. And sometimes you can use one investing tool inside another. For example, most of you hold mutual funds inside your 401ks or 403Bs.
You invest to achieve financial goals like retiring, buying a house, or being able to make it through emergencies. You pick your investment vehicle depending on your goals and your taste for risk. Some investments provide little return: right now, most online savings accounts provide less than a 1% return on your money. Other investments give more of a return: stocks, in the past at least, have provided returns on your money of 8-12%. One thing you must remember: risk and reward are inextricably linked. They higher return you seek, the more of a chance you have of losing the money you invested. As we have seen with the most recent recession, you can sometimes lose a lot of money.
Investing overwhelms people, like me, when they first start learning. Most of you take Ben’s initial approach and let the nice guy who comes to your job handle it for you. Completely washing your hands of your investing decisions is a mistake. Hopefully by reading this blog and other resources, investing will become clearer and easier to follow.
My strategy: spread the risk and keep fees to a minimum
My investing strategy boils down to diversifying by buying across the whole investing market (thus reducing my risk as much as feasible) and keeping my expenses to a minimum. This theory lends itself to index fund investing, which has become quite the popular trend. And by investing in index funds, mutual funds that track specific indexes, I’m considered a passive investor.
Passive v. Active investing
Simply put, passive investing involves limited buying and selling of investments. Passive investors usually look for low costs and simple management. Active investors, on the other hand, try picking certain investments that will outperform the market. In order to do that, active investors engage in fundamental or technical analysis, research, market timing, and other techniques used to make sure they achieve the overall investment goal.
The Efficient Market Hypothesis
The Efficient Market Hypothesis provides the fundamental support for passive investing. This theory holds that a stock’s price incorporates all information known about it. And because the price incorporates all known information, picking stocks that will do better than the market becomes futile.
I will pause here to say I can’t cover the arguments for and against passive and active investing in this one post. Both sides claim to have a lot of research on their side; it’s only in reading more about these arguments that you really get a sense of which side makes sense to you. I will say that the Efficient Market Hypothesis makes most sense to me given the pervasiveness of information about stocks and companies and the speed at which we can disseminate that information.
The Four Pillars of Investing
For more information on these theories, you should read one of my favorite investing books of all time: The Four Pillars of Investing by William Bernstein. He expertly analyzes the theory, history, psychology and business of the investing in an easily understandable way.
A metaphor that Bernstein has forever ingrained in my mind involves the problem active investors face when competing against the other traders. He states:
“The problem is that you almost never know who those people are. If you could, you would find out that they have names like Fidelity, PIMCO, or Goldman Sachs. It’s like a game of tennis in which the players on the other side of the net are invisible. The bad news is most of the time, it’s the Williams sisters.”
In short, ordinary, small investors like you and I will never have enough knowledge, time, or money to beat expert fund managers or investors on a consistent basis. In addition, ample academic research suggests that even these fund managers and investors can’t beat the market on a consistent basis.
Given this uncertainty and low odds of actually beating the market, I feel most comfortable following it and gaining average returns. Gaining average returns, at a low cost, should provide the money I need for my future needs. I try to do this by investing in low-cost index funds. More on them tomorrow.