The craziness surrounding the stock market is usually what turns beginners away from investing but last week, Reddit investors changed that. They caused chaos and proved that amateur investors can band together and take down richer, older investors. This show of force empowered young people to start investing in huge numbers.
While I love how invigorated the GameStop battle has gotten people about investing, I’m also worried that newbie investors will fall victim to predatory financial tactics. There is so much misinformation promoting get-rich-quick schemes and risk-free ways to make 1000% returns on platforms like TikTok.
If it were as easy to get rich as they make it seem, we would all be doing it.
If you’re new to investing, I’m going to tell you how to cut through the BS and invest the smart way. Your success with this method won’t happen overnight, but it will happen. If you’re ready to stop reading because I’m not telling you how to get rich fast, let me ask you this. Would you rather take a gamble on getting rich quick or get rich for sure? If you picked the second option, these are my tips for what to do as a beginner investing in stocks and when you should start investing.
When to Start Investing
A popular phrase in personal finance is ‘time in the market beats timing the market’. Time in the market means that the longer you leave your money invested in the stock market, the more money you’ll make. This is due to compound interest, what Warren Buffett calls the eighth wonder of the world.
He’s probably so fond of it because over 99% of his wealth was made after he turned 54. You read that right. If Warren Buffett had cashed out his investment portfolio to retire at 60, he never would have gotten super-rich and you probably wouldn’t know his name. He’s amassed so much wealth by lengthening the time he was invested in the market and letting compound interest work its magic.
Compound interest is so great because you earn interest on the interest you’ve already earned. This creates exponential growth in your investment portfolio, but it takes a while to see huge gains. That’s where the time in the market comes into play. The longer you leave your money invested, the more money you’ll make from compounding.
Timing the market, on the other hand, is fast-paced and means that you try to buy a stock when the price is at its lowest and sell it when it’s at its highest. This sounds simple, but if it were, the hedge funds would have seen their billion-dollar GameStop losses coming and been able to avoid them.
The problem with timing the market is that it is a short-term investing approach and it’s nearly impossible to predict what will happen with the stock market in the short-term. If everyone had predicted the 2008 stock market and housing crash, it could have been avoided, and no one would have lost money. The same is true of the huge stock market drop in March 2020 when the novel coronavirus got to the US. And the same is also true of GameStop’s stock price surge. If it were easy to predict these swings, we would all be making lots of money doing it. But it isn’t easy. It’s almost impossible. That’s why time in the market usually beats timing the market.
To get as much time in the market as you can, you need to start investing as early as possible. Before you start, though, you should have an emergency fund saved. Investing is risky, and all of the money you invest can be lost in the blink of an eye. If you lose your job and your investments tank, you’ll still need money to live off of. That’s where your emergency fund comes in handy. So save for an emergency fund first, then invest.
Choose an Investing Approach
Once you have your emergency fund saved and are ready to start investing, there are three investing strategies you can choose from. Trading, value investing, and long term passive investing. Each method has a different level of risk and requires a different level of effort to succeed. To choose the strategy that’s best for you, you’ll need to assess your risk tolerance and the amount of effort you’re willing to put into managing your portfolio.
To assess your risk tolerance, take this quiz.
To determine the amount of effort you’re willing to put into your investments, read more about the 3 investing strategies below and select the one that is best for you.
Trading is a type of active investing that is all about timing the market. The goal with trading is to buy a stock at its lowest price, hold it until the price increases to a certain amount, and then sell it at a profit. Some traders only hold a stock for minutes or hours before selling. It’s fast-paced and requires a ton of research.
Like I mentioned before, it is extremely difficult to predict how a stock’s price will move over the short term. That means there is a high potential to lose money with this strategy, so if you want to succeed at it, you’ll need to spend a lot of time researching stocks, market sectors, consumer habits, and more. Unless you thrive under high stress and want to dedicate most of your time to your investment portfolio, I wouldn’t advise trading.
Risk level: Very high
Time commitment: Very high
The second stock market investing approach you can take is value investing. This is the approach Warren Buffett uses.
Value investing is an investment strategy where you buy stock in a company that you think is undervalued and has unforeseen growth potential. A stock is undervalued when the price it is trading for on the stock market is less than the actual value of the company. Basically, the stock is trading at a discount. It’s just like when you buy something on sale at a store. You feel good about your purchase because you know you paid less for the item than it’s actually worth.
You can make money using this investing approach because at some point, the stock price should adjust to match the company’s true value. When the price rises to the correct level, you make money. It sounds simple enough, but there are a lot of unknown variables involved in valuing a stock.
To determine if a company is undervalued, you first need to do a deep dive into that company’s financial statements. I don’t just mean glance over them. I mean, you need to use them to calculate their price to earnings/book/sales ratios, EBITDA, several other metrics, and to estimate their growth. Then you need to use all of these metrics to determine if the company is undervalued and has good long-term growth potential. If it does, it could be a good investment, but much of your assessment is based on assumptions. Those assumptions may be correct, or they may not.
To get great at value investing like Warren Buffett has, you have to make correct assumptions. Again, if becoming a billionaire were as easy as calculating a few ratios, we would all be doing it. Finding ways to predict the unknown variables correctly is what Warren is fantastic at and why he’s been able to make so much money. Unfortunately, his methods and earnings are hard for most people to replicate.
Risk level: Moderately high
Time commitment: High
Passive investing is a long-term investing approach where investors try to receive the same return as the market instead of trying to beat it. Passive investors buy index funds and ETFs that track an underlying set of investments and hold them for decades. When a fund tracks an underlying basket of investments, it provides the same return as those underlying investments. For example, if you buy an index fund that tracks the S&P 500, your fund will perform the same way the S&P 500 is performing. No better and no worse.
The reason passive investors are content receiving the same return as the market is because historically, the stock market has always gone up over the long term. Therefore, if you buy a well-diversified fund that tracks the stock market and hold it for decades, you can expect to make money even if the market drops in the short term.
Because passive investing doesn’t require you to predict market swings, this investing style requires minimal effort. The only time you need to exert any effort is when you select your initial investment and when balancing your portfolio. While there’s never 100% certainty when it comes to investing in stocks, since historically the market has gone up over the long-term, the probability of making money with this strategy is much more certain than with the other two investing strategies we’ve discussed.
Risk level: Moderate
Time commitment: Low
Don’t Lose Easy Money
Taxes and fees will eat into your earnings substantially and quickly. Here’s how you can minimize your losses to them.
Avoid Short Term Capital Gains Tax
When you sell a stock, you have to report your earnings as income and pay taxes on those earnings. If you hold your investments for less than a year, your earnings will be taxed at the short-term capital gains tax rate. For most people, this rate is the same as their income tax rate and is around 20-30%. All of the Reddit investors might not know this yet, but they’re going to lose close to a third of their earnings to taxes.
Instead, if you hold your investments for over a year, your earnings will be taxed at the long-term capital gains tax rate, which is around 15%. That’s 5-15% more money in your pocket for holding your investment for a longer period. This is another reason many investors take a long term investing approach over a short-term one.
Invest in Funds with Low Expense Ratios
Fees are another thing that will eat heavily into your earnings. If you’re going to take a short term investing approach, you’ll need to avoid trading fees. Fortunately, many platforms offer low or no trading fees, so these should be easy to avoid.
Long-term investors, on the other hand, need to watch out for high expense ratios. The reason so many people are tricked into investing in funds with high expense ratios is because, by normal standards, high expense ratios don’t seem high. What I mean by this is that a 2% expense ratio seems low to a newbie investor, but it’s actually super high. When deciding what fund to invest in, go for ones with expense ratios less than .5%. This may seem trivial, but high expense ratios can end up costing you hundreds of thousands of dollars.
If a person invests $1,000/month for 30 years into a fund with a .25% expense ratio, they’ll pay a total of about $55,000 in fees and end up with around $1.15 million assuming they receive a 7% annual return. $55k in fees may already seem like a lot, but just wait until you see the dollar amount for investing in a 2% fund.
Instead, if they had invested their money in a fund with an expense ratio of 2% and received the same return, they would end up paying almost $376,000 in fees! That’s a loss of more than 6 times what the low expense ratio investor paid. Because of that, the high expense ratio investor winds up with less than $1 mill in their pocket.
When it comes to newbie investors, there’s no shortage of misguided information on the internet. Social media platforms have made spreading misinformation even easier for the financial predators looking to get-rich-quick themselves. The truth is that smart investing isn’t glamorous or quick. It’s about making sure you’re financially secure enough to start, staying invested long enough to let compound interest make you millions, and minimizing the money you lose to taxes and fees. While there’s no guarantee that you’ll make money investing in the stock market, if you do those things, I can [almost] guarantee you will.