Author: Matthew Cochrane | October 24, 2019
Change your life
The thought of investing your hard-earned money in the stock market, with no guarantee that it will grow or even that it won't decrease in value, can be daunting. After all, there are always concerns that the next recession is just around the corner or that the next major geopolitical event will disrupt business as usual. Even seasoned investors, myself included, can be rattled by headlines screaming about the trade war or the latest conflict in the Middle East.
That is why it is so important to keep a proper perspective. Since 1926, the year the S&P 500 index was conceived, the stock market has given investors an average annual return of 10%. While inflation eats into that, making the real return closer to 7% or 8%, the stock market has still created an incredible amount of wealth for investors over a period that includes the Great Depression, World War 2, the Cold War, terrorist attacks, and countless natural disasters. There are very few, if any, vehicles that allow American investors to create as much wealth as the stock market.
If you're ready to start investing, here are a few things you should know…
1. Think long-term
As we've already seen, stocks provide tremendous returns when averaged out over long periods of time. Over shorter periods, however, stocks can be tremendously volatile, losing value in any given year, which is why all money invested in stocks should be kept in the market for at least five years (and preferably decades). In short, the longer your money is in the stock market, the greater your chances of success. In The Motley Fool Investment Guide, Tom and David Gardner powerfully illustrate this concept with some telling statistics:
"Stocks can and will go down. Sometimes a lot. And sometimes the market will take years to recover and reach new highs. But the long-term prognosis is tremendous ... Holding periods of ten years resulted in positive returns 88 percent of the time. For twenty- and thirty-year holding periods, that number jumps to 100 percent."
2. The magic of compound interest
Few understand the powerful nature of compound interest, causing them to vastly underestimate the power of long-term gains that can be earned in the stock market. Compound interest simply means the interest earned on top of interest and is determined by three simple inputs: the amount of money you invest, your rate of return, and the length of time your money is invested. It is best illustrated by using an example.
If you invest $1,000 and earn an 8% annual return, your money will grow to $1,080 by the end of the year. Simple enough, right? But in the second year, it won't just be your original $1,000 growing, it will be your new sum of $1,080 growing by 8%. At the end of your second year, then, your money won't just grow by another $80, but by $86.40, giving you a total of $1,166.40. While this doesn't seem like a big difference, this soon begins to compound. At the end of the third year, the balance grows by $93.31 and on and on it goes, growing by more dollars each year it stays in the market. At this rate, by the end of 10 years, the original $1,000 sum will grow to $2,158.92. In 20 years, it will be $4,660.96 and, if invested for 30 years, it will grow to more than $10,000.
3. Getting ready
Armed with the knowledge that investing in the stock market should only be done with a time horizon measured in years, not months or weeks, there are two important things that would-be investors should do to prepare themselves.
The first is to pay off any high-interest debt. While money invested in the stock market can compound to create wealth, credit card debt can quickly compound as well, with the exact opposite effect on your net worth. Indeed, if only minimum payments are made on credit card debt, what once seemed like reasonable debt levels can quickly spiral out of control.
The second important thing before investing in the stock market is to create an emergency fund, money that is set aside to pay for the fun surprises life likes to throw our way. This is money that can be used for unexpected car repairs, a new refrigerator when the old one goes bust, or living expenses in the wake of a job loss. Generally, experts recommend having three to six months of expenses set aside depending on your job stability and family situation so you will not have to divert money from your investments when an unexpected bill comes your way.
4. Passive investing
Okay, you're ready to put the magic of compound interest to work for you by investing money in the stock market for a long time. Your high-interest debt is paid off and your emergency fund is fully funded. What's next? The answer might depend on your interest and time.
Investors who understand the benefits of investing but have little time or interest to study the market, will undoubtedly be best served by passive investing, putting money away each month into an index fund that tracks the entire stock market or index. For instance, an S&P 500 index fund is comprised of stocks from the 500 companies that make up the index. By investing in such an index, investors are given a low-cost option that offers instant diversification across sectors and companies and essentially guarantees to match the index's returns.
Again, the Gardner brothers do a magnificent job of summing up the benefits of passive investing in The Motley Fool Investment Guide, stating, "With passively managed funds, you get one-stop diversified market exposure, lower fees, zero research commitment, a full knowledge of what investments the fund is making (typically market-weighted long positions in a number of well-known stocks), and -- not to be underrated -- time to spend on other things."
5. Active investing
Investors who have the time and possess a genuine interest in studying businesses might want to consider active investing, picking individual stocks or ETFs in an attempt to "beat the market." Many investors who engage in picking sectors and individual companies are wagering that the companies they select will provide greater returns going forward than investing in the broader index as a whole.
Picking sectors or individual companies can be successfully accomplished by studying companies and choosing only the very best to invest in. A portfolio made up of some of the stock market's best stocks, such as Apple Inc (NASDAQ:AAPL), Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL), and Netflix (NASDAQ:NFLX) would have provided spectacular returns over the past decade. It is also possible to beat the market by investing in ETFs (exchange-traded funds) that track specific sectors, such as technology, or even narrow investing themes, such as fintech or 5G.
Of course, while the promise of beating the market might be alluring, there are more risks involved too. Certain sectors can quickly fall out of favor, as when the dot-com bubble popped in 2000, and individual companies can go bankrupt. In contrast, while the S&P 500 index experiences many down years, there is usually a sector or two that outperforms and helps buoy returns, making it virtually impossible for the entire index to go bankrupt.
Finally, choosing passive or active investing does not have to be a binary choice. Many investors allocate a certain percentage of their portfolio to index funds and dedicate the rest to individual companies or sectors that interest them.
6. Dollar-cost averaging
One of the biggest questions as you start your investing journey is when to make your investments. Should you buy when the market is at all-time high levels? Should you buy only after a market correction, when stocks dip at least 10% from a 52-week high? One popular solution to this dilemma is dollar-cost averaging.
Dollar-cost averaging is investing equal dollar amounts at regular intervals of time. For instance, an investor who wanted to invest $12,000 into an S&P 500 index fund in any given year, would simply invest $1,000 at the beginning of each month. This way investors aren't trying to time the market, an often fruitless endeavor, but are buying at a range of values at pre-determined intervals.
Whether investors choose to invest passively or actively, it is important to diversify. This goes back to the maxim to not place all your eggs in one basket. By spreading out their portfolios across several investments, investors effectively de-risk their portfolios, making them much less susceptible to long-term, negative returns.
It should be pointed out that passive investors that are dollar-cost averaging into an index fund every month have already accomplished this. Investors in an S&P 500 index fund are spreading out their dollars across 500 large, domestic companies.
For active investors selecting individual equities, there is no right answer on how many stocks to own. In a 1998 lecture, none other than Warren Buffett declared, "If you can identify six wonderful businesses, that is all of the diversification you need." Others might feel more comfortable investing in 20 companies or more, carefully selecting companies from different sectors.
8. Value investing
Choosing whether to invest actively or passively is hardly the only consideration beginning investors will have to make. For investors who decide to actively invest, choosing individual stocks in an effort to beat the S&P 500 index or control for risks, one strategy that has proven to be particularly effective is value investing.
Value investors attempt to determine the intrinsic value of an asset, the true intrinsic worth of an object, and buy it at a substantial discount. The gap between the intrinsic value and the current price is referred to as the margin of safety, and the greater the margin of safety, the greater value the asset is currently selling for.
9. Growth investing
While some of history's greatest investors have famously followed a strict adherence to the principles of value investing, others have enjoyed great success with growth investing. While growth investors still keep stock valuations in mind, they are usually more interested in the growth opportunities ahead for companies, making them more willing to pay higher multiples now for stocks.
Growth investors often identify stocks by looking at their total addressable markets (TAM), the size of the potential market for specific products and services could eventually be. They often favor smaller companies over larger companies, because it is often relatively easier for smaller companies to grow sales by double-digit percentages than it is for larger companies.
Finally, growth investors also like their companies to exhibit optionality, or second and third "tricks," they can introduce to spur further growth. For example, over a decade ago, who would have predicted that Amazon.com's cloud business, Amazon Web Services, would be its most important line of business? That optionality, however, spurred the company into much faster and greater growth than could ever have been achieved solely through its e-commerce business.
Just take the first step
While beginning investors are faced with a myriad of choices, the most important decision is to just get started. There will always be naysayers, saying that this is not an ideal time to start investing. But until you start putting your own money away, the magic of compounding cannot begin to work for you, making each passing year impossible to redeem. While it is important to understand the differences between active and passive investing or growth and value investing, understanding that investing that first dollar as soon as you can is the most important thing for beginning investors to know.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Matthew Cochrane owns shares of Alphabet (A shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, and Netflix. The Motley Fool has the following options: short January 2020 $155 calls on Apple and long January 2020 $150 calls on Apple and recommends the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.