All journeys need a goal. But just setting a goal is not enough. You’ll need to plan how you’ll get there. Our minds are like a GPS system in that unless you specify where your destination is, you run the risk of wasting time going down the wrong path.
This module is going to help you figure out the goals you should have and the mindset that is necessary for succeeding in the stock market.
Successful investment planning begins much before you decide to invest in the stock market. Ensuring that you have a stable financial base before you invest in the market is essential since this will prevent you from making mistakes. For example, if you don’t have the cash to pay your bills, you’re going to be tempted to sell some of your investments before they have a chance to blossom fully.
Figuring out where your investment capital will come from is essential to the process. Let’s take a look at the kind of money you should be investing in the market.
At Freeman Publications, we adopt a long term approach. The rule of thumb we apply is that all money invested in the market should not be missed for at least 10 years.
To prepare a sound financial base for yourself, we recommend that none of the following should be invested in the markets:
- Your rainy day fund – 3-6 months’ worth of living expenses that you’ve saved up in case you or your partner lose your jobs. This money should not be invested under any circumstances. Your rainy day fund should be held in readily accessible cash.
- Tuition payments – Money that is needed to pay bills or your child’s tuition should not be invested in the markets.
- Down payments – Even if you’re planning on purchasing a home several years down the road, don’t rely on the stock market to generate enough money for a down payment.
The best way to begin investing in the market is via a tax free retirement account. Maximize your contributions to it, and if your employer offers a 401(k) with matching benefits, make full use of that as well. In short, do not rely on the market to make you money or to somehow generate money that you need to survive.
This may seem like a pessimistic outlook, but in reality, it works very well. By not having to rely on the market for money, you remove the feeling that you ‘have’ to make money. A lot of short term traders and speculators get caught up in this emotion and end up making fatal mistakes that lose them money.
Here is a typical “I have to make money” scenario. A person places a trade on a stock, expecting a quick bump in price. The trade doesn’t go their way, so they exit their position for a 10% loss. Losing money is tough to deal with mentally, and in their frustration, they open another position in a different stock. This trade goes against them as well, and they exit that position for another 10% loss.
Now their frustration turns to anger. So they place a third trade, this time for a bigger position than they usually would, in an attempt to recoup the losses from both trades 1 and 2. They’re telling themselves that because the last 2 trades went against them, this trade should go in their favor. Unfortunately for them, the market has no idea how their previous 1, 2, or 100 trades went, and the odds are no more in their favor than on trade number 1. This third trade goes against them as well, and they cash out for another 10% loss.
This isn’t a guide about trading, but from this example, it’s easy to see how the irrational nature of human beings cause short-term thinkers to lose money. If we extrapolate this behavior pattern over a more extended period, you can see why over 95% of day traders fail.
But no matter if you’re a short-term trader or long-term investor. The markets are highly emotional, and you will be caught up in their whirlwind at some point, no matter how rational you think you are. Therefore, it is best to minimize your chances of doing something emotional in the first place. This is so when the time does come; you won’t be at an emotional extreme that will cause you to do something unintelligent.
The next step in your journey is to figure out your risk appetite.
Asset Classes and Risk
The concept of risk management is highly misunderstood in the markets. When you speak to an average financial advisor, they’ll explain risk to you in two ways. The first is to use your age as a barometer for it. A common rule of thumb is to subtract your age from 100. Then use the resulting number as a measure of how much of your money should be invested in stocks.
For example, if you’re 40 years old, they’ll tell you to place 60% of your money in stocks and 40% in bonds. This is a nonsensical way to allocate money. The thought process behind this is that an older person needs to invest for income while a younger person should aim for price appreciation.
What happens is that every year, as you get older, you end up selling profitable stock investments and keep moving that money into new bond investments. The timeline for your bond investments keeps increasing while that of your stock investments keeps decreasing.
What if you find a profitable stock to invest in when you’re 60 years old but have already allocated 40% of your money to stocks? Should you simply let this opportunity slip? This makes no sense. The real determinant of whether a person needs to invest for income or capital gains is their financial situation, not their age. 60 year olds tend to have assets on hand, and if they have a secure income, why should they invest in bonds and fixed income?
The second manner in which risk is explained to investors is to use asset classes. You’re told that small-cap stocks (the shares of companies under $1 billion in size) are risky, and large cap ones are less risky. Bonds are less risky than stocks and options. This is an equally nonsensical manner of classifying risk.
The asset class of a stock does not indicate its risk. Let’s use an example. Let’s say you were Jeff Bezos back in 1995. You have had a good career in finance and have money saved up. You get the idea to start this company, let’s call it Amazon, and you have a clear vision of where you want it to go. You trust your abilities and know that you have the wherewithal to succeed.
However, your financial adviser tells you that starting Amazon (and by proxy, investing your money in it) is extremely risky. Mr. Bezos is 31 years old and should invest 69% of his money in stocks, with 60% of them in large cap stocks, 5% in mid caps and the rest in small caps. Amazon is a startup and is none of those. Let’s say Bezos loses his mind momentarily and decides to follow this advice.
Given that he’s worth approximately 124 billion dollars today, largely thanks to his ownership stake in Amazon, it’s safe to say that this would have been a hall of fame worthy mistake to make.
The same factors apply when analyzing small-cap companies (defined as a company with a market capitalization of less than $2 Billion) versus large-cap companies. The commonly held belief is that small-cap companies are riskier than large-cap companies. This might be true on a macro level but is not correct on an individual level. If you know a small- cap company inside and out, then it is a far better company to invest in than a large cap like ExxonMobil or Goldman Sachs, where even the CEOs likely don’t have a full clue as to where the company’s money is going.
If you’re unsure as to the extent of your expertise, it’s best to outsource it to capable managers who know what they’re doing. A financial adviser or your broker is not a capable manager. Instead, investing in index funds and ETFs or mutual funds is the way to go. Index funds and ETFs follow broad based indices in the market. By purchasing a single share of these funds, you can gain exposure to all of the underlying stocks in the fund and get to have your money managed by a professional money manager for low costs.
In addition to asset allocation, you need to evaluate your personal risk tolerance. Let’s take a look at some of the factors that will help you define your risk tolerance.
Risk Factor #1 – Time
How much time do you wish to devote to the markets? The more time you can devote to analyzing companies and figuring out how they do business, the more risk you will be able to bear since you’ll be able to spend more time mitigating it. This doesn’t mean you need to be glued to the markets 24/7 like most traders are. For long-term investors, this behavior is counterproductive.
However, you will need to spend more time monitoring the companies you invest in if you wish to absorb more risk. You will need to spend more time finding quality companies to invest in, and you will need to spend time thinking about how to exit your investments correctly.
If you wish to make your investments passive, then you cannot have too much of your portfolio in single companies and will need to diversify your portfolio so that the risk is spread out. We’ll be explaining more about proper diversification in module 5.
Factor #2 – Your Expertise
Everyone is good at evaluating some form of business. You might not think of yourself as being an expert or even a business person, but there are businesses out there that are extremely simple to figure out. There are an equal number of companies that are complicated.
If you wish to invest in a complicated business, you’ll need to spend more time evaluating it. You might find that even after spending a lot of time, the business makes no sense to you, and you’re unable to figure out its prospects. Therefore it’s far better to choose simple companies to invest in, especially when you first start out. You’re going to have a better grasp of their economics, and you’ll make better decisions as a result.
Just because a business is simple, does not mean it can’t make great returns. For example, in 2014, while trendy tech companies like Facebook, Netflix and GoPro dominated the financial news cycle, the best performing stock on the S&P 500 was Southwest Airlines, which grew more than 110% in a single year.
Additionally, you probably have far more experience in your own company’s sector than the average Wall Street analyst. It’s a good idea to begin with companies in that sector.
Even if you don’t have much experience in a sector, you are still a consumer of products. For example, let’s say you’re a coffee drinker, and you visit Starbucks every morning before work. If that location is always busy, it’s a good indicator, if it’s always empty, then it tells you the opposite story.
Let us be clear; understanding a company or using a company’s products is not the only reason to invest in a company. It is crucial to make this distinction because many new investors use this as their entire analysis. But it is a great place to start your research.
To give you a real life example our how being a consumer is a great place to begin your research. One of our best investments over the past few years has been McDonald’s. Our research process started when one of our team commented that they’d traveled to 30 different countries, and had never seen a McDonald’s location that wasn’t busy.
Factor #3 – Emotional Risk Tolerance
Let’s say you’ve invested a sum of money in the market. You promptly see that the stock has declined by 30%. What do you do? What are your emotions at that moment going to be like? Will you have the confidence and discipline to act rationally despite this huge dip?
People don’t take the time to ask themselves if they’re willing to lose more than half of their investment on paper before it ever makes them a single cent before investing. Instead, everyone dreams of stock prices soaring and doubling their money in a matter of months.
This can happen and does happen in the markets quite a lot. However, you cannot expect constant rises without experiencing dips. How much of a dip are you willing to stomach? Your investment in a single stock is far more likely to see a serious dip than the entire market will.
If the entire market, or an index fund that tracks the market, dips by a lot, you can rest assured that it will bounce back unless something truly catastrophic happens. It is unlikely that all of these companies are going to disappear overnight and for the markets to remain at zero forever. However, a single business can go bankrupt overnight.
Therefore, evaluate how much of a loss on paper you’re willing to stomach and adjust your investments accordingly. If you’re only willing to accept a 10-15% loss on paper in your investment, then sticking to index funds and ETFs is your best choice. If you’re going to invest in individual stocks, be prepared to stomach a loss of at least 30% on paper. On paper is the operative phrase here, because you don’t realize a loss until you sell your stock.
Initial Investment Amounts
We typically advise people to invest at least $5,000 in the markets when starting out. This means $5,000 in total investments, not $5,000 per company.
This is because to capture meaningful gains; your investment amount needs to be somewhat significant. Turning a $100 investment into $1 million is an unrealistic scenario. Turning $1,000 into $1 million is unlikely, but still achievable. Turning $10,000 into $1 million is completely possible with the right company. With smart investments, turning $100,000 into $1 million is expected. Those numbers might sound unrealistic, but you have to remember the power of compound interest. With a 9.69% rate of a return (the market average) it takes 26 years for $100,000 to turn into $1 million. With a 15% rate of return, it only takes 17 years. With a 20% rate of return, it only takes 13 years.
The way to get compounding to work for you is to invest a large sum of money and then have it grow rapidly. Let’s look at this via an example. Let’s say there are two investors A and B. A invests $1,000 in the market and B invests $5,000. Both of them earn modest 7% gains over the course of 30 years. What is the value of their portfolios at the end of the 30 year period?
A’s portfolio has grown to $7,612 while B’s portfolio has grown to $38,061. The amount by which B’s portfolio has grown is $33,061 which is far more than the paltry $6,612 that A has witnessed. This is why it is important to capture the power of compounding by investing a larger amount of money.
However, this doesn’t mean that you should hoard your money until it reaches $1 million and only invest then. You need to give it time to grow as well. This is why we recommend a minimum amount of $5,000. From the above example, you can see that even this modest amount grows to quite a significant sum over 30 years.
If you don’t have $5,000 but are determined to make a start, then go ahead. Providing you do proper research, investing in stocks is nearly always a superior option to just holding cash. If you only have a small amount to invest, it’s essential to choose the right investing platform, because you don’t want massive commissions to eat away at your potential profits.
How to Place Orders
If you already have a brokerage account, then you can go straight to module 3. However, if you do not, we’ve included a short guide for opening your first brokerage account.
With the rise in comparison websites, it can be overwhelming to choose an investing platform. We’ll simplify the process for you. For new investors, there are 3 major factors which matter most when selecting a platform to use.
- The commission structure (how much you have to pay each time you buy or sell a stock)
- What financial instruments you can buy (stocks/bonds/mutual funds/ETFs)
- How user-friendly the platform is
Based on the factors above, for new investors in the United States, we recommend the Robinhood platform. The most significant selling point of Robinhood is that it is commission-free for buying and selling common stocks. Zero commission is important because if you are only investing small amounts, fixed commissions on each buy or sell order can put a significant dent into your potential profits.
More experienced investors will likely favor other platforms like E*Trade, TD Ameritrade or Charles Schwab. Each of them have their pros and cons, so we advise you to do your research and pick the one best suited to your situation.
For those readers outside the US, a simple Google search for “Best investing platform in [your country]” will let you compare your options.
Read Books to Learn The Right Investment Mindset
A large part of successful investing is about Mindset. So I read many mindset books.
Recently, I read Rich Dad Poor Dad and found it quite interesting.
Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy.
The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.
He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).
It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).
Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.