Chapter 1 – Investing Essentials

CHAPTER 1

Investing Essentials

There are many directions an investor can take when risking assets for higher returns, but for most of us who are simply trying to get from point A to point B (retirement), the really efficient, and least hazardous directions are actually few and simple.

Defining our goal
Investing: Money committed or property acquired for future income. A trade off between risk and reward while aiming for incremental gain and preservation of the invested amount (principal). Investing means investing in businesses, both in the U.S. and internationally. It is, by definition, a long term commitment to share in the successes of companies in businesses for profit.
Speculation: Aims at high gain or heavy loss.
Gambling:
Betting (wagering) that must result either in a gain or a loss. Gambling is neither risk taking in the sense of speculation (assumption of substantial short term risk) nor investing (acquiring property or assets for the securing long-term capital gains.

This primer focuses on sensible investing. Using a driving analogy: investing is not about speed, it’s about mileage. And over longer periods of time, the strategy proposed in the primer will provide you with higher than average returns without large commitments of time or study. The fundamentals are relevant whether you use actively managed funds or index funds.

Legendary investor Benjamin Graham felt that investors fell into two groups, aggressive or “enterprising’ investors and “defensive” investors. The two groups are distinguished by the amount of intelligent effort they are able to devote to working on their investments. Professionals–doctors for example–are in the defensive group, and so are the vast majority of individual investors. An example of an enterprising investor is Warren Buffett. Buffett, a disciple of Graham’s, began his career by reading the 10,000 pages of Moody’s stock manuals–twice. The lesson: know want kind of investor you are. Buffett, in turn, recommends the average investor simply invest in index funds.

Making Sense of Investing – Wall Street Marketing is NOT the Answer
It is understandable that beginners find the subject of investing daunting and confusing. But in addition to newer investors, there are also millions of people who have been investing for years and they still have an uneasy sense that they may be on the wrong road. Where do you start? Are there guidelines? There is an overwhelming amount of information out there, but knowing which advice will take us to our destination, and which puts us on a road that leads over a cliff, is the question this book will answer.

What’s traditionally been drummed into our heads is that investing is very complicated and should only be attempted by professionals or with the aid of very expensive and risky strategies and software programs. Don’t buy it. Investing doesn’t need to be complicated, and in fact should not be complicated. The portfolio selection method, as we will call it, provides investing with structure. It enables average investors to implement the method step-by-step. The so-called ‘know-how’ of a Wall Street analyst isn’t needed. In fact, their record of picking winning stocks and mutual funds in advance is dismal. Wall Street and the media’s self serving advice, ofter called “investment pornography,” should usually be avoided. According to research firm First Call/Thompson financial, at the peak of the bull market in March 2000, less than 1% all recommendations on stocks issued by Wall Street brokerages and investment banks were to sell.

If investing really is so easy, then why haven’t you heard of the portfolio selection method before? Because it is to Wall Street’s advantage to make people think that investing is complicated. Wherever money is involved, there are people who want a share of your money. Every dollar Wall Street takes from your investments is one less dollar for your family. It’s as simple as that. Unfortunately, it is extremely difficult to find someone from a large, mainstream investment firm that will level with you on your best investment options. Employees in large brokerage firms need to sell you expensive products that will make the firm a profit because that is how they keep their jobs. And they are rewarded by how much money they take in. So, what you really need to learn is what Wall Street doesn’t want you to know–which also happens to be the title of a very good book by Larry Swedroe.

Here are the six investing essentials necessary to put you on the road to investing success.
1. Understand risk and correctly develop an asset allocation that manages that risk. Asset Allocation is simply the percentages of your money you plan to place (allocate) into stocks, bonds and cash. It determines most of your investing risk.
2. Diversify your holdings. Diversifying means placing some money in different kinds of investments in order to spread the risk.
3. Keep costs as low as possible. Whatever you spend on buying and maintaining your investments comes directly out of the returns you receive. Costs are the second major reason for unnecessary losses.
4. Rebalance your portfolio when necessary. Rebalancing is simply readjusting your allocation percentages back to where you originally set them so you can maintain your chosen exposure to risk.
5.
Formalize your investment plan. Developing a plan and then writing it down is a way of
demonstrating your commitment and clarifying your objective. It also serves as a compass to insure you stay on course.
6. Understand and avoid common behavioral mistakes, which can account for most of your unnecessary losses. Successful investing is about discipline and behaving correctly.

The following chapters will explain what the essentials are and how they work with each other to create a portfolio with maximum benefit. For those who like the technical stuff, here are two links offering an excellent introduction to the portfolio selection method.
http://travismorien.com/invest_FAQ/content/view/221/58/
http://www.moneychimp.com/articles/risk/riskintro.htm

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