If you ask yourself how some of the most successful individuals reached their financial goals or wealth, some or most of you will say investing in the stock market got them there. As with everything in life, what you don't know will scare you and consequently, you avoid it. The stock market and all that it entails is one of those things that if you avoid it could be a costly mistake. Stories of wealth and ruin have been predicated with or without merit, I am trying to make it simple so that you can take advantage of it.
What is the Stock Market?
Stocks - Think of the stock market like an auction house where shares (part of the company) are sold and bought, these are called equities or stocks. You buy a certain stock thinking that it will increase in value over time (appreciate).
Bonds - When a company or a country gets a loan from a bank/investor for money to grow/spend, this debt will be repaid with interest (where the money is made) these are called bonds. Essentially a bond is a loan.
Those are the 2 major ways to make money in the stock market, there are more ways but for the sake of simplicity we will keep it this way.
What is compounding?
It is one of the financial wonders, it is interest earned from previous interest plus the principal. You need to use it in your advantage in order to grow your wealth "Make your money work for you".
Year 0 - $1000 invested at 5% rate.
Year 1 - $1000 + $50 (Interest earned) $1050 re-invested
Year 2 - $1050 + $52.50 (interest earned) $1102.50 re-invested
You can now start to see how money works for you. This is how the wealthy get wealthier.
Why should I invest in the stock Market?
The stock market historically has been one of only a handful ways to make money without having to work for it. Great wealths have been made off of it, for example Warren Buffett, if you do not know him just click here.
Don't take my word for it, lets explore.
Dating back to 1930 the stock market has been on an upward trend, lets examine this graph.
If you take a closer look it looks like a see-saw but in an overall upward trend. The gray areas are recessions, which if you are in one feels the world is ending but if you zoom out you get the entire picture. I know what you are thinking, the 1930's "Great Depression", which followed the 1918 pandemic, seems very similar to what we are going through right now, and yes you are right. However if you are near retirement (60's-70's) or if you need the money in the next 5 years you should not invest in the stock market. If you would have invested $100 dollars in the bottom of the 1932 market today that would have turned into $47,620.00, just think about it.
When should I invest in the stock market?
People sometimes wait for the stock market to go up before they invest, only to sell when the markets start crashing, this is called "Timing the Market". What I can tell you is usually this does not work.
The answer as to when should I invest in the stock market is NOW!!
What matters is Time in the market, meaning the more time you are in the market, the better.
But what if it drops tomorrow? It could certainly drop tomorrow, however remember you do not need the money in the next 5 years, so it is better for you to forget this money exist.
Also remember you do not actually "lose" the money. Yes, it goes down in value, BUT, if you do not sell, you have not lost any money. Decisions to sell made during panic never work out well.
Dollar cost averaging is a strategy used by many to try to manage the ups and downs of the market. What this means is, instead of investing a lump sum of money, you invest small amounts of money spaced over time. This way you spread your risk; one day it might be high, another might be low.
Historically when you compare, investing a lump sum of money is better than dollar cost averaging.
What is the expense ratio?
This is what you will pay for the management of whatever fund you invest in.
Pay close attention to this.
The higher the expense ratio, the more you pay - THE LESS MONEY IN YOUR POCKET !!!!
Lets explore 2 different funds:
Fund A has an expense ratio of 1%. If you invest $10,000.00; you will pay $100.00 per year.
Fund B has an expense ratio of 0.5%. If you invest $10,000.00 you will pay $50.00 per year.
Next time you pick a fund see what the Expense Ratio is. You might want to take a look at your 401k and analyze the expense ratio for the funds you have, TAKE CONTROL OF YOUR MONEY.
How do you make money in the stock market?
There are 2 main ways to make money in the stock market:
1- Appreciation, which is when your stock/bond goes up in price.
2- Dividends/Interest, these are payments given out in specified period of times to the Stockholder (you) or bondholder (you). Some are monthly others are quarterly.
What is allocation?
Allocation means spreading your investments across different asset classes to reduce the risk of losses when the market has a downturn. For the sake of simplicity we will just stick to Stocks and Bonds. But just be aware there are many ways to allocate your money.
What should my allocation be?
How much bonds and stocks should I own?
Widely used formula is 110-age = Percentage in stocks. The rationale behind this - as you grow older the tolerance risk for the swings of the stock market decreases, therefore you will, by default, own more bonds (Bonds are more stable but have less growth).
For example, let's analyze. Jim is 40 years of age. If we go by the above formula, he should have 70% stocks and 40% bonds.
On the other hand Karen is 70 years old. She should have 40% stocks and 70% bonds.
The reason this is done is to decrease your risk, in the case one of your fund loses value, the other funds usually hold their value. It is unusual for ALL funds to go down in value.
What fund should I invest in?
You should understand your investments. You should be able to explain your investment to your child.
I like simplicity, this is why I created this website to help people understand how the rich think.
To get started, I like to focus in just 2 funds. YES only 2 funds you need and you will make money.
(I do not have any vested interest in Vanguard, I just find they are investor friendly and CHEAP).
VTSAX this is an index fund representing the ENTIRE stock market, the expense ratio is 0.04% (super low, YAY!).
What this means is you actually will own small amounts of each company in the entire stock market. The amounts in each company will vary according to their size and the fund manager.
This would be a good place to own stocks.
VBTLX this is an index fund representing the entire bond market, the expense ratio is 0.03% (super cheap!!). This fund covers the entire bond market of the United States of America. Think about it as a big fund of "I owe you".
There it is. A very simple, yet very effective investment strategy.
Yes, it is this simple and cheap.
Once you get more experienced, then you can diversify a bit, and maybe, include international stocks VTIAX to cover a broad range of non-us stocks in the world.
Say you want to be part of the real estate market then you could invest in VGSIX which is an index fund that tracks domestic (US) equity real estate investments trusts (REIT's that buy buildings, hotels, manages and collects rents). However VGSIX is best left to a 401k/403b portfolio since it is not tax favorable.
Till next time.
Disclaimer - This blog is meant purely for educational discussion of finance. It contains only general information about financial matters. It is not financial advice, should not be treated as such.