3 Essential Rules For New Investors
The investing landscape can be extremely volatile, and changes year after year, but there is a lot to be said for investing in what you really know and understand. Considering the enormous number of products on offer, and the nature of the industry, it is not that simple to be simple, but it can certainly be done. First, we will take a look at the potential difficulties of understanding investments, and then we'll look at how new investors can invest safely, suitably and sensibly.
How Much Do We Really Understand?
One could argue that the only asset that is fully understandable is cash in the bank, or some form of fixed deposit. Here, you know exactly how much you will earn and that you will get your capital back. The problem is that you will be lucky to beat inflation, and simply leaving your money in cash is not the answer; it is just not a productive investment.
Moving a bit up the risk ladder, we get to bonds. Given the variety of bonds and bond funds, understanding what you get is also not necessarily that simple. Government bonds are fairly straightforward, but, again, they don't pay much. Municipal bonds pay a little more and are usually tax exempt, but are not going to satisfy the average investor's retirement needs. So to really earn anything, you need a variety of bonds, probably some corporate ones, plus, arguably some foreign ones. Yet, these start to become complex and more risky, depending on various factors relating to the issuing company or country. Likewise, bond funds may depend on a number of managerial and financial issues. (Learn more in the Bond Basics Tutorial.)
The same applies to stocks, mutual funds and so on. Even real estate funds have proven to be less reliable and straightforward than many people might think. Direct real estate purchases are more understandable in one sense – what you see is what you get. But then again, there can be unknowns relating to the market, taxation, the location, disclosure by the seller and so on.
Similarly, alternative investments, like hedge funds, can be extremely complex. Infrastructure, too, is without doubt a great idea in principle, but the nitty-gritty of investing in it is not such a sure thing. No matter how sound the principle of a particular investment, there is almost always someone or something out there that can make it go wrong. And as for certificates of deposit (CD), they are probably the hardest type of investment to understand. Given yield curves, expectations and potential early withdraw penalties, they may be the easiest to missell. (Analyzing a hedge fund will help you determine whether it's a good investment - and a good fit. Read Hedge Fund Due Diligence, for more.)
Tracker funds, on the other hand, are relatively simple to understand – you are indeed just "buying the market", but the markets themselves are not so easy to deal with and understand. Furthermore, the tracker market is becoming more sophisticated and complex. This all sounds very daunting. But in fact, one can still invest simply and understandably, at low cost and with a good, diversified portfolio that is likely to perform well over time.
How Can We Invest Sensibly, Suitably and Simply?
The above section certainly implies that we really know very little about a lot of asset classes and investments. Nonetheless, there are many ways of ensuring that you are investing in what you know. One can really invest in a straightforward manner, and understand what one is doing.
Many veteran investors have simple diversified portfolios, and look more at asset allocation. Spending hours performing regression analysis is not an option for many part-time investors. For example, Steven Goldberg, of Kiplinger, has said in his "Value Added Web Column" that: "Most people wish they didn't have to be investors," and that they "lead busy enough lives without having to worry about stocks, bonds and mutual funds." Goldberg therefore recommends sticking with index funds that simply mirror the market and only attempt to be average. He even argues that one only needs three index funds, one covering the U.S. equity market, another with international equities and the third tracking a bond index. (Use these rules to guide you on the road to financial freedom, check out The 10 Commandments Of Investing.)
Trackers are sometimes better than actively managed funds. Lower fees, low turnover and a combination of available investor education makes index investing extremely attractive. So, a really straightforward mix of these funds is transparent, cheap and does as good (or better) a job as more complex and expensive vehicles. Despite the above, to be fair, there are a lot of good managed funds out there. With a bit of effort, you can find reliable and understandable equity and bond funds with which you can relax.
A good piece of advice is to start searching through Investopedia.com's tutorial section, namely to start with simple investments and then expand and extend as you learn more. Specifically, mutual funds or exchange-traded funds are a good way to get going, and one can then move on to individual stocks, real estate and further down the line, even a sensible amount into resources or hedge funds.
It is interesting to note the book title, "How Buffett Does It: 24 Simple Investing Strategies from the World's Greatest Value Investor" (James Pardoe, McGraw-Hill, 2005), about the world's greatest pro. Buffett himself comments that Wall Street dislikes too much simplicity. The reason is that brokers make money out of complexity. But one does not have to fall for this.
Conclusions
The more you learn, the better. But above and beyond this, you can (and probably should) avoid investments that you do not even understand in principle. A small number of index funds seems a very good solution. (You might want to check out Getting Started In Stocks.)
Also, go on sound recommendations. If your parents-in-law have been investing for 20 years in some mixed fund which has served them well, there is a better chance that it will continue to do so. On the other hand, if you get a phone call from someone who you met in a pub last week and who wants to give you a hot tip as a "big favor", be more skeptical.
Likewise, there are many independent financial advisors around who get paid only for their time and not on commission. Their job is to understand what they recommend, without the pressure of having to sell to earn a commission. And make sure you diversify, not only into asset classes, but possibly into different banks and fund providers. Then, if something goes wrong that neither you nor anyone else seemed to understand after all, the losses are not so disastrous. Always bear in mind that too many bits and pieces also create complexity which can lead to errors.
