Invest Like a Professional part 01: The Basics

It has been almost a year since I started investing in the stock market. That means it has been almost a year since my entire outlook on my finances and future has radically transformed. I had once set a goal to be able to invest in the stock market by the time I turned 35. I used to think that investing was difficult to get into, required thousands of dollars up front, and was extremely risky. Luckily, I discovered how to invest with little risk and little money. My hope for you is that if you have not invested in the market that you do so in 2018. Or if you already are invested, that you learn more about it so you can make better, more informed choices for yourself.

This article is called “invest like a professional” and you need to fill in the blank that comes next. I invest like a professional teacher, because that is my profession. If you are a nurse, you are going to invest like a professional nurse. If you are a network engineer, you are going to invest like a professional network engineer. You are not going to become Bobby Axelrod. You might get a little rush when you watch Billions and think you want to do that, too. It would be cool. But you aren’t going to short a bunch of stocks and become rich. That’s Bobby’s profession. And it’s a TV show. Regular people invest their money, meaning they buy and hold equities for the long term. This is distinct from trading equities (like Bobby), which for a regular person is akin to gambling. If you want to be a day trader, set a small limit for yourself that you’d be willing to lose all of and head over to Robinhood, a free trading platform that is about to add in options trading. If you’re on a phone, use my link to sign up and we’ll both get a free share of stock.

Investing for the long term is what Warren Buffet recommends to his family and friends, and it’s what we’re going to concentrate on. And Buffet recommends two types of investment: government bonds and the S&P 500 index fund, which is a special type of mutual fund. So let’s break it down and find out what he is talking about so we can grow our wealth.

 

Why invest at all?

What I tell my students who sometimes struggle to grasp a future needing a retirement fund, is that the market is going to do what the market is going to do, so you might as well be a part of it and make some money. This is true. The economy has its cycles of expansion and recession, but overall, it grows bigger over time. Hopefully, you have the sense to understand that you are going to want more than the potential social security benefit when you are 67 years old (the age they’ll probably push retirement to by the time we get there). We don’t know if social security is going to be there. I don’t know if the teacher pension will have a different formula by that time. I want wealth built up in my own name that I can count on. In the second half in this series, I explain the mathematics of investing which for me is convincing enough. It goes something like this: invest just enough when you are young enough, and you could end up with hundreds of thousands or even a million dollars. And it’s all due to patience and letting the market do its thing.

What do I invest in?

Well, Warren Buffett tells us: government bonds and an index fund. Let’s spell out some terms associated with the market so we understand it just right. A stock is a fraction of ownership in a company. If you own 100 shares of Facebook, that means you own 100/10,260,000th of Facebook. Not a lot, but you’ll make some money as Facebook grows. A bond is a fraction of the debt of a company or government agency. When organizations need money they can borrow it in the form of a bond. Bonds do not yield as much money as stocks might, but they tend to be more secure, especially of they are government bonds. The US government always pays its debts. Bonds are less risky to invest in than stocks, but stocks can yield much more reward.

I used to think that when I finally was ready to invest in the stock market, that I’d have to pick some favorite companies and hope they continued to do well so I would share in the profits. But that’s where a mutual fund comes in to play.

What is a mutual fund?

A mutual fund is basically a group of people buying many different stocks and sharing the cost and profit. There is a person in charge, called the fund manager, who buys hundreds of different stocks or bonds or both even. And other people with less knowledge all give their money to the manager to buy a piece of the fund so that the manager can buy all those different stocks. Mutual funds can have different themes or foci. I have a small amount in my Charles Schwab account invested in a technology mutual fund. The fund is invested in many different technology stocks like Alphabet (Google’s parent company), Facebook, Microsoft, Cisco, etc. So rather than me buying all of those companies’ stocks on my own, I just invest once in this fund and the fund buys all of them. When those companies do well, the mutual fund does well, and I see the profits.

A mutual fund helps decrease risk of buying individual stocks. If you just own Facebook, you count on the performance of Facebook. If Facebook does well, you are happy. But if Facebook performs poorly, you are losing money and you are sad. But stocks are volatile so Facebook is going to do poorly sometime. A mutual fund is made up of many stocks so one stock doing well can offset another stock doing poorly. The idea is that over the long term, all together, the stocks will increase in value.

A mutual fund also helps people invest in companies at a lower cost. If you were to buy your own shares of a company, you would need hundreds or even a thousand dollars. For just one share. On the day of this posting, Apple opened at $172.54 and Amazon opened at $1205.05! If you were starting to invest today, you’d need almost $1380 plus the cost of the trade. But to buy into a mutual fund through Charles Schwab, you need just $100. You can start low and start out with diverse investments.

If you have a 401(k), you are probably already invested in several mutual funds. Look into it.

What is an index fund?

An index fund is a special type of mutual fund. Unlike my technology fund, an index fund has certain companies that must be in them, so the manager doesn’t get to pick. An index is a group that an outside source tracks, to have a general sense of how the American economy is doing at any one time. You might have heard of the Dow Jones – it’s an index of 30 fabulous companies. A hundred years ago it was the gold standard for measuring the economy. But now there are other indices out there that can give a better sense of how the economy is doing. The S&P 500 is a group of about 500 large companies. There is also the Russell 2000 and the Russell 3000. The Russell 3000 covers almost all of the publicly traded companies in the American Market and the Russell 2000 are the 2000 smaller companies (called “small cap” – we can get into that terminology later). The last main index that people talk about is the total stock market index. Vanguard and Charles Schwab both offer a fund that covers the entire stock market.

The S&P 500 is the index that Warren Buffett likes but that doesn’t mean investing in another index is wrong. To be honest, they will perform very similarly in most cases. The S&P 500, or just “the S&P,” is the benchmark for market performance. In Billions, there are several scenes in which they discuss beating the S&P.  Beating the S&P means that your investments are doing better than the market as a whole. But, after you read the next section about expenses, you might think twice about what it means to “beat the market.”

The S&P 500 was the first investment I ever made on my own. And I started with just $100 and then I watched for a while. I checked my account and read the stock news for like a month before feeling less anxious. You can read all of this information and understand the math, understand the theory, but when it comes to your own money, the thought of losing it is terrifying. It can take some time to really internalize the ideas. I know how my anxiety can impact my choices, so I knew I would need this adjustment period, and if you need it, give it to yourself. Just take $100 and invest it and then watch what happens. Know that, yes, it could crash to $50 tomorrow, and be OK with that. You’ve spent $100 on something stupid before in your life. What you’ll find is that your money will go up just a little bit, then it’ll drop again. It’ll take about a year for it to change too much. Hopefully, you’ll become more comfortable and add another $100 investment the next month, and again the next month. Whatever you need to do to get comfortable with investing, do, but don’t wait another 5 or 10 years to get involved.

What is this going to cost me?

There are two main costs you want to think about when investing: the expense ratio and taxes. Nothing is free, but there are ways to minimize these costs or avoid them all together.

EXPENSE RATIO. When you are doing research and reading an overview, or the document call the “prospectus,” of any mutual fund, there will be an item called the “expense ratio.” This is how much it will cost you to invest in the fund. And when spending money, you of course want a lower number. An expense ratio of 1.24% seems low to a lot of people, but it’s not. That’s 1.24% of your money that will be taken out each year and given to the fund manager and other operating expense. The expense ratio can be subtracted off of your expected interest rate or rate of return. I use that number, 1.24%, because that’s the expense for the plan I am on in my 403(b). I am not happy about it, but when it comes to employer retirement funds, you don’t always get the best options. If I ever change jobs, I will move that money. In the meantime I have to accept that of my $1800 I invested last year, they’ll take about $22 from me. But, in my S&P 500 index fund over at Charles Schwab, I won’t have to pay so much. Index funds are great mutual funds because they represent the market and they don’t cost very much. Remember that an index fund doesn’t require active management so you don’t have to pay for someone to remove a losing company and pick a new one to replace it. At Charles Schwab, the expense ratio for the S&P is 0.03%. Yes, three one-hundredths of a percent. Yes, a tiny, tiny amount. If my 1800 were invested in that Schwab fund, the cost would be $0.54 which I much prefer. While $22 is not a lot of money, half a buck is way less of a not a lot of money. So look for the expense ratio when deciding where you want your money to go and grow. It grows more when it costs less.

TAXES. One of two certainties in life. When and how much tax you pay depends on the account you choose and when you spend the money. If you choose a tax-deferred account, which would be most retirement plans, you don’t have to pay any taxes on the money or the growth until you draw the money out in retirement. So imagine you take out $40,000 in your first year of retirement. If it’s just you and you take only the standard deduction, you’ll be in the 12% tax bracket. You’ll pay the federal and state taxes on this money just like you would if it was money for your job.

If you choose a Roth IRA, that means you pay tax when the money comes through your paycheck and then you invest the money. The money grows and grows and grows. Forty years go by and now you want to take it out. No taxes for you. Enjoy your $40,000 in your first year of retirement. Even if your portfolio grows to $1,000,000 you don’t have to pay any tax.

If you set up an account like I have at Charles Schwab, often called a taxable account, you pay taxes on money when it comes through your check before you invest it. Then, you pay taxes again when you earn money on the investment. This is one reason why saving for retirement is such a great idea! You avoid taxes. But saving for retirement isn’t the only financial task you have. Some people use the stock market for other ventures like saving for a house or a business. The amount you pay in taxes for a taxable account depends on how long you hold the investment. If you hold an investment for less than one year, you pay the same tax rate you do for your income. So, say I sold my S&P 500 index shares. My statement says I made about $30 in 2017. It hasn’t yet been 365 days, so if I sell, that $30 would basically just be added to my regular income and all together I’d be taxed in the 12% bracket. But say I wait until the end of February so that I hold the shares for over 365 days. Now my investment is long term and I have to pay capital gains tax instead of ordinary income tax. Since my taxable income is less than $38,600, I would pay 0% capital gains tax. If I get to a point when my taxable income goes over $38,600 I would pay 15% capital gains tax on my long term investments. I have no expectation that I would ever be in the 20% rate for capital gains; I’d need to have a taxable income over $425,800! Clearly, my advantage would be to hold my investments for longer than a year.

What are the risks?

There is always going to be risk involved when you invest in the stock market. Investing in a new company is extremely risky. You have no idea how it will actually do in the coming years. You can’t predict the future. It’s less risky to invest in a mutual fund. It’s not risky at all to save your money. Savings accounts are perfectly secure. They are FDIC insured up to $250,000. But it will not grow very much, and it won’t grow enough to beat the rate of inflation we experience. An investment account does not have insurance. You are owning fractions of a company which has to figure out how to operate successfully. You’ll share in the success, hopefully. But you’ll also share in the failures. Mutual funds help you avoid risk because one company can do poorly but be offset by another company doing well. Usually, poor performance of one company is offset by the success of several other companies in the fund. Investing in an index is like investing in the American economy which is why you should do it. The economy has been growing for the last 9 years.

Yes, the economy has been growing, but be ready for it to stop. When it dips and crashes, so will your account. Just assume it is going to happen. But don’t sell your shares. Don’t freak out. After the crash, the economy will begin to expand again. Just hold on, use your cash reserves to make it through the tough times. Your account will eventually rebound to a higher level than before the crash. We can dive into this more later, but know that every investor is exposed to the same risk so you are not alone. You just have to be smart and remember that the economy cycles just like the seasons. Expect the downs as much as you expect the ups.

Read part 2 of this post if want to understand the mathematics of investing. If you are on the fence about investing, I highly recommend reading this post. Seeing what your future holds will convince you to invest.

 

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