The short answer is YES.
But the short answer is insufficient. This is a very important question that could change your financial future in drastic ways. You should consider a lot of factors before going one way or another.
Before we go any further, here are a few reminders:
- Investing in the stock market can be risky and you can lose 100% of your investment - and in some cases more than 100%;
- Returns of a stock portfolio can be very high compared to other investments, this is usually tied to the relationship of Risk and Return (the higher the risk, the higher the potential return) which you should understand fully before investing;
- DYOR - Do Your Own Research. This article is not to be construed as investing advice and the author cannot be held responsible for any loss you may end-up with by investing in the stock market.
Who Should Invest in Stocks
If you are in heavy debt, you should focus on eliminating your debt before investing, especially the expensive debt. For example if you have trailing credit card debt, their interest rates are usually extremely high (~18%!) and it's very unlikely that your stock investments' returns will offset that. So It's wiser to pay that debt off before getting into stocks (or any type of investment). It's also worth mentioning that going into credit card debt (or any kind of debt) to invest in risky assets is a very bad idea. You may not be able to pay-off your debt and lose a lot of money (and time!).
If you have term debt however, like a mortgage on your home, it's OK to invest unless you have difficulties making ends meet.
Here's the general rule of thumb: you don't have any revolving debt (other than your credit card that you pay-off each month), you are able to keep at all times a balance on your checking account that is about one month's worth of your expenses and you have a well-funded rainy day stash (a savings account with 6 to 12 months worth of expenses). Any cash you can save on top of that can safely be invested in the stock market.
What this rule is trying to have you do is avoid having to sell stocks during a rough patch. As we'll see below, the recommended way to invest in stock for people that aren't professional traders is to play the long term game. Stocks will go up and down during the lifetime of your investment and you really should try not to be in a position where you are forced to sell your stocks when the market is down. That's why financial planners usually recommend having a rainy day stash.
Why The Stock Market
Investing in the stock market could be the best financial decision of your life. When done carefully, it is an amazing investment because there are very few investment vehicles that provide the returns stocks do with long term compounding. Albert Einstein is reputed to have said:
'Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.'
Here are a few reasons why the stock market is a great home for your money:
- You can start immediately, with very little money. Many stocks are priced under one hundred dollars and with some brokers providing fractional shares (ability to invest in a portion of a stock instead of having to buy the entire share), the barrier to entry is virtually nonexistent. Compare that with having to build a big-enough deposit to buy real-estate and you can see how with stocks you can get your money to work immediately;
- Returns. The stocks you invest in can grow and have a higher stock price over time but also, some stocks pay-out a dividend. The combination of these two factors can result in a return rate far higher than what you would get out of other investments. Looking at historical data, the S&P 500's annualized return (or CAGR for Compound Annual Growth Rate), including dividends, is close to 10%. Check out this handy calculator for more info.
- You get to own a piece of a company and indirectly of the economy. This may give you the right to vote on the company's important decisions, but more than that, the stock's success is tied to the success of the company. Sure, there may be a fair bit of volatility in a stock's price, but that shouldn't matter to the long term investor. If the company is solid, the stock should rise over time, no matter how irrational the market currents are.
- Your investment is protected against inflation. Because you get dividends that are a direct result of the company's profits and thus linked to the prices of the products sold, there is a direct correlation between your return on the stock and the inflation. Also, the overall returns of a well built stock portfolio should surpass the inflation rate - which is not always (or rarely) the case of savings accounts.
Where To Start
You have checked all the boxes and want to start investing in the stock market. Congratulations, you are part of a very small group of people actually making the leap.
In 2016, a survey of consumer finances made by the USA's Federal Reserve has found that less than 14% of Americans owned stocks and less than 2% owned bonds. Meanwhile, trends in the distribution of income and wealth continued to favor the top 1% of wealth percentile.
I for one was too afraid and uninformed to go forward with investing in stock, and for a long time kept my hard earned money in a savings account. Not smart.
To get you started on your investing journey, I will go through a few well established principles and best practices you should know and understand before investing in the stock market.
Long Term Investing Versus Day Trading
If we are being honest, there is very little chance a casual investor will produce the same returns as the pros. Traders are well trained, spend their entire day (and probably some nights) thinking and breathing "stock market". I know I'm not and you likely aren't either. They know how to read between the lines of a company's financial statements and have an excellent understanding of the sector they are trading in. They see the trends happening as they do and make the most gains before any casual investor even realizes there's a play. Yet, they sometimes screw-up and lose money.
What I'm saying is that we are tiny fish in a huge ocean and day trading should be left to the pros. Unless of course you are investing a considerable amount of your time to learn the ropes and you have enough disposable income to try your hand at day trading (you'll lose more than you earn until you get really good at it)...
Index Investing Versus Stock Picking
When you invest in stock, you might be tempted to pick a number of well known stocks or stocks that are being talked about in the media. It's natural to want to follow the hype and get in on what everybody else is buying. This strategy could work, especially if the timing is right, but that's not what stock picking is about. Stock pickers are value investors (the most famous of which would be Warren Buffet). The idea behind this strategy is to find "bargains", stocks that sell for a price that is well under their value or that have a potential for big value gains. Buffet is also known to look for stocks with a "moat", which is a metaphor for competitive advantage. There are a few formulas and rules of thumb that are used to pick stocks and we will cover this in more detail in another article, but the reality is that this takes some time to understand and master and it comes with more risk than index investing. That's why I do not recommend this as a main portfolio strategy.
Some may argue that index investing comes with less returns, but that really depends on how good you are at picking your stocks. There are so many parameters to consider when picking stocks that I believe it to be somewhat speculative.
On the other hand, index investing provides you with the market's returns. If you invest in an index fund, vehicles mimicking an index (like the S&P 500), you will get similar returns as the index's market, and those are already quite good compared to other types of investments (see above 10% of CAGR for the S&P 500). Quick quiz:
If you have $100 invested with a 10% annual return, how much will you have after 10 years? If you think it's $200, think again. The answer is closer to $268. That's the magic of compound interests.
By investing in index funds, you are diversifying your portfolio and by doing so, reducing your portfolio's exposure as your stock will go down only if enough of the underlying assets take a hit. Also, it's unlikely that an index fund's value would go to zero, whereas a stock could and that means you would lose 100% of your investment.
Mutual Funds VS ETFs
The two main ways of investing in index funds is through Mutual Funds and ETFs. The differences between these two vehicles are well documented all over the internet (see here for example) and so I'm going to focus on why I prefer ETFs.
Not all Mutual Funds and ETFs are tracking an index. Some are built to represent specific sectors or geographies.
Mutual Funds are actively managed. This means they have higher fees than passively managed ETFs. It has been said that beating the market has not been achieved consistently by one person or strategy (or only by a very select number of people) and so I prefer to invest in low-cost ETFs.
Some mutual funds have a very nice feature that will let them automatically reinvest the dividends generated by the underlying assets into the fund. This is really great as it compounds your dividends faster... but if you have invested in an ETF, nothing is holding you back from mimicking this behavior by manually reinvesting your dividends in the ETF. You usually only get dividends on a quarterly basis anyway. The advantage of doing it manually is that you could also use the dividend to invest in other assets, to diversify or partially rebalance your portfolio.
Taxes. In investing, it is crucially important to look at all fees and charges your portfolio may incur, because they add-up over time and can have a very strong impact on your overall returns. ETFs are usually taxed less than Mutual Funds, but you should check to make sure as this changes drastically depending on the investment and your fiscal jurisdiction.
Options, Shorts and Margin Accounts
Options trading is a means to bet on a stock's movement (up ro down) that you can buy from most brokerage accounts. You are basically betting that the price will be lower or higher than it is now and are contracting the right (but not obligation) to buy or sell the underlying stock (depending on the option you chose) at a certain price. It's speculative but the downside is limited (to the cost of the option contract).
Shorting a stock is however very risky as there are virtually no limits to how much you can lose. You need a margin account to be able to short a stock but that unfortunately is not very hard to obtain (because of the risks and complexity of hedging them properly, I feel there should be more control on who can use margin accounts, based on the actual financial literacy of the applicant).
Most people should avoid margin accounts like the plague (and by extension avoid shorting stocks). My rule of thumb is to never borrow money to invest in stock (or risky investments - or gambling), because the risk of losing 100% of your investment or more and being left with the debt is too high. Short selling is part of the speculative strategies that have given stock investing a bad rap, mostly because of the risk involved. Long term investing in low fee ETFs is a much safer, sounder approach.
We have covered a lot so far and you're ready to buy your fist ETF stock. What ETF should you invest in? There are over five thousand different ETFs trading as I write these lines and picking the right one can be overwhelming.
Keep these two aspects in mind:
- Low fees: look for ETF with the lowest fees (expense ratio) possible. As mentioned above, the tiniest fees and taxes taken out of your return adds up to a lot in the long term.
- Diversify: don't put all your eggs in the same basket. ETFs are already diversified to some extent but you can go a lot further by investing in different ETFs that focus on different markets and sectors.
Investing all your portfolio in VTI (Vanguard's Total Stock Market ETF see here) may not be the safest approach. Sure, if the stock market goes up for the duration of your investment, then it's a great option but go back up to the S&P 500 graph above and see how many recessions it has gone through... Wouldn't it be better to protect your downside? It can be achieved, to some extent, with diversification. It's not a fool proof, 100% success rate strategy and there will always be risk involved. It is however the most recommended strategy for passive investing.
A very common (too common) diversification is the 60/40: 60% stock and 40% bonds. Bonds are a more stable, fixed income investment that should be inversely correlated to the stock market. In other words, when the stocks go down, the bonds go up and vice versa... It's not always the case but it's a good start. Click here for more reading on stocks and bonds relation.
Another very famous portfolio diversification is the one recommended by Ray Dalio. If you don't know who that is, he's the founder of the world's biggest hedge fund. The portfolio allocation he recommended in a number of interviews is called the All Weather Portfolio and is supposed to be strong enough to brave all kinds of market conditions. It is composed of 30% Stocks, 40% Long Term Bonds, 15% Intermediate Term Bonds, 7.5% Gold and 7.5% Other Commodities. According to www.lazyportfolioetf.com it is supposed to be one of the best (highest returns) Medium Risk portfolios with a 10 year annualized return of 8.11% (when reinvesting dividends and rebalancing at the beginning of each year).
Other diversification approaches might consider investing in non-US markets, seeking other currencies (with non-USD stocks or bonds), etc. Be careful however to understand the risk and volatility associated to the investments you are considering (emerging markets for example being a lot more volatile) and make sure you are actually diversifying, for example:
- If investing in different sectors, make sure one's under-performance will not bring the other down with it;
- Make sure your ETFs are not exposed to the same underlying assets - you may be much more exposed to a certain stock (or sector) then you realize just because two or more of your ETFs are invested in them.
Finally, you should pick a portfolio that corresponds to your risk profile. If you are 10 years away from retirement or less, you should probably not have a big portion of your portfolio in stocks (probably not more than 10%) and should instead favor a low risk portfolio (with mostly fixed income assets). If on the other hand you are just starting in life and have more time to let the markets go up and down, you could have a more aggressive portfolio. Just make sure you won't need that money any time soon (especially when the markets are down).
We mentioned reinvesting dividends which is a strong way to grow your portfolio, but we didn't really go into the balancing or rebalancing of your portfolio. This is crucial for the long term investor.
Let's say you have decided to invest in ETFs and to diversify your portfolio in a smart and proven way (with historical data). Great! You go ahead and invest, all is nice and balanced and the world goes round.
After a while however, your portfolio is bound to go out of balance. Some ETFs will go up, some will go down. The theory behind rebalancing your portfolio is that you should, every 6 to 12 months, go back to your brokerage account and sell just enough of the assets that went up and buy just enough of the assets that went down, so that your portfolio is back to its initial balance.
For example, let's say you have decided to go with the All Weather Portfolio and have invested 30% of your assets in stock. One year later, the stock market has done so well that the value of your stocks represents now 45% of your portfolio. You should sell enough stocks to get their share back down to 30% of your portfolio and buy the other assets that are under their balanced allocation so as to get back to your initial balance. Do that once or twice a year and you're done!
Is it smart to sell the assets that perform well to buy those that don't?
That's a very common question and the answer is yes. Remember that your ETFs will go up and down in cycles. You could just keep the initial number of shares you invested in and never rebalance, but you would end up with lower returns. The great thing with rebalancing is that you actually cash-out on some of the gains when there are some and you have an opportunity to buy assets when they are on the cheap. A few months or years after rebalancing, when the markets are going in the other direction, you would make better returns because you would have more of the gaining assets and less of the losing ones.
Avoid unnecessary trading fees. When you rebalance, you are at least selling and buying once. If you have a broker that takes high fees for each transaction, you will be spending unnecessary cash every year! I recommend finding a broker that does not charge commissions on trades and has low fees for everything else.
Is Cash Trash?
You'll hear "Cash is trash" on many occasions and it really depends who you ask. Buffet will tell you it's good to have some cash on hand so that when the market crashes you can use your cash to buy cheap stocks when no one else is buying. Dalio's view is quite the opposite and he will argue that because of inflation and poor returns of money markets, you're losing too much money by holding cash.
I think the truth may reside somewhere in the middle. For most retail investors like you and me, in booming times it's good to have all invested and no cash (except the above mentioned rainy day stash). But when times seem like there could be a bubble ready to burst, it is a good idea to keep some cash on the side lines so you have some buying power during the "sales". The only question is: how confident are you on being able to time the crash? Most people are not able to time the market, and the effects of missing the best trading days can be disastrous on your overall returns. Read this for more.
My personal take on this is to follow your gut but cautiously. One fairly good indicator is to look at when Buffet is investing and when he's not. Try to stay informed on the overall economy so that you can get a rough sense of what is going on in the world, but don't fool yourself in thinking you'll be able to time a crash exactly. If you feel a crash coming, I wouldn't recommend keeping more than 10 to 15% of your investments in cash so that you are still in the market (for 85 to 90%) and can still profit from a surprise good trading day or two while you wait for a crash. I know some people close all their positions (sell all their stocks) and miss-out on all the gains while waiting for the crash (which can take months, even years to come). If you don't want to bother with all that, it's still OK to invest everything and weather the market's storms, especially if you're far from retirement. The long term investors should not worry about crashes as they know that if it goes down it will go up.
When To Invest
It should be clear by now that I wouldn't recommend ever selling your stocks, except for rebalancing your portfolio or if you have decided to live-off of your stocks (say you are retiring and are drawing-out 4% of your portfolio each year). It should be even clearer that you should never sell by fear when the market is crashing. Don't look at the markets if you can't stomach its volatility until it's time to rebalance.
But when to buy? It's recommended to invest a little every month instead of all at once. If you have a big pay-out once a year (say a sales bonus), then you might be exempt from this rule and could invest it all at once, but there is nothing holding you back from splitting the amount in 4 or 6 and investing the chunks every two weeks. That's up to you.
What's more interesting is the reason why investing over time is much better than all at once. It is called Dollar-Cost Averaging. It's a way to avoid having to time the market and worrying about putting your money in at the right price. The more volatile the assets, the better this is. The result of DCA is that you will end up having purchased the asset at an average price, which is far better than buying it at a high price. Here is a link for more information, with a nice real world example.
Investing in the stock market can be stressful and taking the leap of faith can be scary. The principles we have covered in this article are just a start but they should get your foot in the door of this very select club, in a way that does not put your entire life's savings at tremendous risk. Remember it's all a matter of risk versus potential reward and by following these principles, you should be maximizing the potential reward while keeping the risks reasonably low. Here are a few important reminders:
- Don't borrow to invest in risky assets. Pay-out your expensive debt before investing;
- Don't try to time the market. Don't try to trade like a pro unless you're a pro;
- Fees and taxes matter. A lot;
- Invest in ETFs, diversify by choosing the right portfolio allocation;
- Rebalance once or twice a year, don't fear the crashes;
- Don't keep too much cash on hand other than your rainy day stash;
- Invest every month if you can, you'll average at better prices.
If you want to break the above principles for fun, the gambling-like rush or in hopes of making a ton of money very quickly, I would suggest only doing so with money you know for sure you won't regret losing. You might want to make sure you have reached financial freedom before gambling away your hard earned money and make sure you understand the risks you take. Some plays can cost you much more than what you're willing to lose.