Investing Essentials – A Primer

Investing Essentials
A Primer

Essentials-Basics-Fundamentals

Dedicated to those investors trying to make sense of it all

Introduction

Who is writing this primer? I am a self-taught investor who began by learning the basics from other knowledgeable, dedicated investors. I have now been enthusiastically studying investing for 12 years. My mission here is to pass along what I have learned, and hopefully to ultimately help you become a wise investor. It turns out that all of the investing research I’ve studied ends up with the same essential recommendations for the average investor, and this is what the primer is all about. I’ve also included some insight into what I’ve observed about average investors from 12 years participating on investment forums.

The Guide Will Enable You To:
Implement the six essentials of investing
Understand and manage risk
Evaluate and select mutual funds
Recognize and control the devastating effects of cost
Develop and write an Investment Policy Statement
Recognize and avoid behavioral mistakes
Evaluate and choose an Investment Advisor
Locate a large collection of reference material

You may read the book by simply scrolling down through the text, or you can go directly to a specific chapter by clicking on the chapter links.

CHAPTER 1: The Essentials
CHAPTER 2: Understanding Risk and Asset Allocation
CHAPTER 3: How Diversification Works
CHAPTER 4: Diversifying A Portfolio With Asset Classes
CHAPTER 5: Costs are a BIG DEAL
CHAPTER 6: Building Your Portfolio – A look at the Options
CHAPTER 7: Rebalancing
CHAPTER 8: Formalize Your Investment Plan
CHAPTER 9: Behavioral mistakes
CHAPTER 10: On Your Own Or Hire An Advisor
CHAPTER 11: Final thoughts and References

FORWARD

In the past thirty years, there has been a dramatic shift in retirement funding. We have moved from defined benefit plans to defined contribution plans. The difference is in the past an employee could go to work for a company and remain there for an entire working career, and on retirement receive a monthly pension and health benefits, and no worries about the future. Now, for most workers, the responsibility for a secure retirement is entirely up to the employee. Under the old system you did not have to worry about accumulating or managing a large amount of money to secure your retirement, now you do. This is a formidable challenge for workers who now must become not just investors, but smart investors.

Unfortunately, our educational system has not kept pace with the changes in retirement funding. Investing fundamentals are not taught at the high school level as they should be, and even college does not address investing fundamentals unless you take an economics course. When it comes to knowing what to do, you’re pretty much on your own.

Depending on where you work, your defined contribution plan might be called a 401(k), 403(b), 457, or something else. The numbers refer to the part of the IRS code that covers the plan regulations. Although your employer may match all or part of your contribution amount, you probably won’t receive the information you need to get the most out of your retirement plan. Education on the plan level and from the oversight agencies has been painfully lacking. What little education you might get comes from those selling the product.

Many plans are provided by insurance companies that charge very high fees and offer poor fund choices. Others have more reasonable fees and better choices, but that doesn’t help much if you don’t know the difference. Beside company related plans, you also have IRAs, Roth IRAs and taxable accounts for accumulating assets. The challenge before you is clear: you must make retirement savings a top priority and take charge of your future by becoming an educated investor.

A General Perspective on Saving and Investing for Retirement
While this book is about investing, a few comments about saving are in order because the two are so closely tied together. Before you can invest, you have to save. Your investment money can come from money you have put aside in your savings account, or it can bypass that and simply go directly to an investment from your wages. Saving is the real key to future wealth. No one is going to make you save, but no one is going to hand you a nice check every month after you retire either.

For some of you, serious saving may require a new perspective. Think for a minute about why you work. The answer is easy because the goals are readily apparent – you work so you can provide the necessities for yourself and your family, and earn enough to enjoy a better life.

Now, you have to add another goal that isn’t quite as apparent: saving for a better life when you stop working. Saving for something so far away doesn’t seem too important because more immediate goals appear to take priority. But preparing for that time is a very big part of your job now. You can’t afford to ignore it.

Where do you think your income will come from after retirement? It will come from the money you have saved and the money you have invested. You have to save (pay yourself enough while you’re working) to be able to support yourself after you no longer receive a check from someone else. Want to pay yourself well and enjoy a comfortable retirement? Then you have to continuously save and invest a portion of your earnings. With each paycheck, pay yourself first. Do it automatically and you won’t even miss it.

How much will you need for your retirement nest egg? The general guideline is that you need to set aside 25 times the amount you plan to withdraw each year. This amount has a high probability of lasting 30 years without depleting the original principle.

This is where investing comes in. To accumulate what is needed is going to require higher returns than you can get by simply saving your money in a bank. Investing in the stock market has provided those higher returns. In addition, you want to start as early as possible in order to have the power of compounding those returns work for you.

The stock market has provided higher returns than savings accounts and bonds, but the reason is there is more risk involved. And the risk does show up—Investing is a bumpy road. Individual companies can go bankrupt and the stock market as a whole can crash as it has done several times. Also, the stock market can go a decade or more without providing the expected higher returns. It is important to understand this so you can make intelligent decisions about how much of your savings you are willing to expose to stock market risks.

The probability that the businesses you buy will reward you in the future is high. The value of all companies (the stock market) has an upward slope over time, but no one can guarantee the market or your investments will provide what they have in the past. On the other hand, you have to take some market risk to have a good chance of reaching your goals. The need to have enough money for retirement offsets the risk you have to take. Remember, you’ll need to accumulate total assets of about 25 times what you intend to withdraw in retirement. So, if you want to retire with an income of $40,000 a year at age 62, you need to accumulate one million dollars (today’s dollars).

Assuming an average annual return of 8%, here is what you need to save each month starting at different ages in order to draw down that $40,000/year. Note that the 8% used is an attempt to represent a portfolio of approximately 75% stocks and 25% bonds. Since future market returns are unknown, the 8% and the associated savings/investing rates should be viewed only as an example. Actual returns will vary.

Beginning at age 22, you’ll need to save $300 per month.
Wait ’til age 32, and you’ll need to save $670 per month.
At age 42, you’ll have to save $1,800 per month.

The catch is you can’t get an 8% return on your money if you put it into a savings account. In the above example, if you start saving at age 22 but only earn a savings account rate of return, instead of $300, you’ll have to set aside $1,000 per month. That’s over 3 times more than if you invest some of your savings in the stock market. Also notice that waiting until age 32 requires you to save more than double the amount of age 22. Waiting until 42 requires six times the amount. These big increases are due to the power of compounding investment returns over longer time periods.

But no one actually receives all of what the market returns because you lose what you pay in costs. You can’t control what the market returns, but you can control costs and there is a proven relationship between the costs you pay and the returns you get. If you pay 1% higher costs, you lose 1% in returns. And over time, that 1% can cost you more than $200,000. The example demonstrates four things:

    1. The need to take some stock market risk.
    2. The big advantage of time and starting to save at a young age.
    3. The power of compounding returns.
    4. The relentless stranglehold costs have on returns.

Nothing can be guaranteed—risk is real. Smart investors do not forget this, and that is why they use every means at their disposal to minimize the elements of risk by investing in the most efficient way. The idea is to get the maximum return for the amount of risk taken and each dollar spent. Or actually, for each dollar unspent. That is what this book is all about.

The secret to investing and achieving higher than average returns is simply the elimination of mistakes most investors make. The stock market provides returns everyone hears about, but the truth is that investors as a group net substantially less than those returns. With the aid of this guide, you will learn how to protect yourself from throwing away returns due to behavioral mistakes, unnecessary costs, and the more serious risk of bad advice. If you are considering an advisor, or already have one, you should find chapter 10 on evaluating and choosing an advisor very helpful.

The investment guide begins with an examination of the risks associated with investing. Then we move on to creating an investment portfolio that targets your goals and matches your desired risk exposure. Chapter 8 covers the differences between active funds and index funds and how to use them in the most effective and efficient ways. Chapter 9 takes a close look at behavioral problems. Throughout the guide you will find many links to additional information that you may want to explore. The final chapter provides many additional links and references in the final chapter.

No matter if you manage your own investments or decide to hand the job to someone else, understanding essential investing principles is a must. With this book as your guide, you will gain the knowledge needed to learn and apply these essentials.

Taylor Larimore, Dean of the Vanguard Diehards as Money Magazine has named him, and one of the three authors of “The Bogleheads’ Guide to Investing”, has summed up the secret of successful investing in one concise sentence: The best way to beat the average investor, professional or otherwise, is to save regularly, avoid mistakes, keep your costs low (including taxes), diversify, and stay the course. The sentence is a true investing “gem.”

Best wishes as you begin your journey along the pathway to investing success!

Thanks to the Bogleheads for helping me make some sense of it all. Special thanks to Taylor Larimore and Mel Lindauer for their tireless assistance to others. And thanks to Rick Ferri, Bill Schultheis, Larry Swedroe, and all authors and contributors who are giving us the investing education we never had, and never knew about.

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