Warren Buffett, the legendary investor and one of the world’s wealthiest people, made his first stock purchase at 11 years old.
If you are like me, at the age of 11, I had no idea about investing or the stock market.
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The school system, unfortunately, does not emphasize personal finance. As a result, most people enter adulthood with limited knowledge about the world of finance. Further, along the way, people develop bad money habits that hinder financial progress.
Had you learned about money and investing earlier, the sooner you would reach financial independence. However, as the saying goes, the best time to plant a tree was 20 years ago; the second-best time is today.
And so today, this article will provide an investing guide to help you get started.
What is Investing?
In a broader sense, investing could mean spending time and money on self-improvement activities such as education, exercise, a good diet, etc.
In a financial sense, investing means allocating resources to assets that grow in value and produce an income or profit. Income (dividends or interest) and capital gains (the increase in asset value) determine the total return on an investment.
In essence, the main goal of investing is to buy assets at a low price and sell them at a high price (buy low, sell high).
Generally, the higher the risk involved in an investment, the greater the return will be, and vice versa. Good investors determine for themselves an acceptable balance between expected returns and their risk appetite.
5 Key Things to do before starting to invest
While you should start investing sooner than later, there are a few things to consider first. It is wise to take the following actions before building an investment portfolio.
1. Pay off all high-interest debts
According to Goldman Sachs data, the U.S. stocks had a 9.2% average return over the past 140 years. In some years, the return was much more significant, and in others, it was much lower. Whatever the case may be, it is essential to note that returns in the stock market are not guaranteed.
On the other hand, the average credit card interest rate is 15.97%, according to creditcards.com. And depending on your credit score, these interest rates could be as high as 26%. Interest on your credit card debt is guaranteed since you have to pay it.
Based on the numbers, it is evident that investing while carrying high-interest debts is a losing battle. The interest expense is much higher than what you could earn, on average, in the stock market. As such, before starting to invest, you should aim to get rid of all your high-interest debt.
Any loans with an interest rate higher than 6% are considered high-interest debts. Generally, most mortgages and student loans interest rates fall below this threshold.
2. Establish an emergency fund
An emergency fund is the money set aside to cover any unforeseen expenses. Emergencies may include a job loss, health expenses, car or house repairs, etc. Unexpected expenses can significantly upset your investment plans.
It is essential to have an emergency fund before starting to invest for the following reasons:
- To avoid the risk of having to sell your investments at a loss during a market downturn
- It helps you avoid getting into credit card debt to cater to the emergency
As a general rule of thumb, you should aim to have at least three to six months of living expenses in your emergency savings.
3. Build your financial literacy
While you can hire someone to manage your investments, you need to have sufficient knowledge to understand your unique financial situation.
Everybody’s financial roadmap will be different due to varying circumstances and personal preferences. It is crucial to understand what is best for you.
As the old saying goes, knowledge is power. It can help you to make more informed and confident financial decisions.
Ways to improve your financial literacy may include:
- Reading personal finance books, blogs, and podcasts
- Subscribing to financial newsletters
- Take financial literacy courses
4. Set financial goals & create a budget
Financial goals are the big-picture objectives that you set for your money and which, in turn, guide your actions. These may include:
- Establishing an emergency fund
- Paying off high-interest debts
- Saving for retirement
- Achieving financial independence early
- Buying a home
- Starting a business
Without financial goals and the consequent plan (a budget) to achieve them, you may end up feeling like money just seems to slip through your fingers.
A budget is simply a way to see your money inflows and thus plan for the outflows. It helps you prioritize your spending in a way that is in line with your overarching financial goals.
5. Get your emotions in check
Unfortunately, many investors tend to buy high and sell low. They do so when they make decisions based on emotion rather than rationale.
The result is that you may participate in the market downside and miss out when the markets rise back up. It is essential to distinguish paper losses from actual losses.
Paper loss: It is the unrealized loss when an asset’s current price is lower than the price you bought it at. A paper loss reverses when the asset price rises.
Actual loss: It is the realized loss when you sell an asset as a loss. An actual loss is permanent; you cannot reverse it.
It is normal to feel emotional with changes in the market, but it can be devastating to act on these emotions. Here are some reasons why investors make unwise investing decisions:
- Fear of Missing Out (FOMO): Many investors may purchase the hype in the market without adequately weighing the risks. Most often, when a stock is doing well, it is likely trading too high.
- Fear of losing everything: When there is a large swing in the market, many investors will sell off their investments, fearing further declines. However, markets typically recover and rise even higher than before.
You can master your emotions when it comes to investing by:
- Having a long-term investment horizon. In this way, short-term dips will not frighten you into selling off your assets too soon.
- Avoid checking your portfolio daily as this can trigger anxiety and the fear of losing everything.
- Adopt Warren Buffett’s philosophy: be fearful when others are greedy and greedy when others are fearful.
Basic Investing Terminology
Before you start investing, here are some basic terminology to keep in mind.
This is the value of the total assets you own minus the total liabilities you owe.
For instance, if you have $10,000 cash savings and a student loan of $20,000, your net worth is negative $10,000. It is negative because your liabilities exceed your assets.
You can grow your net worth by increasing your assets and decreasing your liabilities.
Represents a fractional ownership of a corporation. Units of a company’s stock are called shares and are generally traded on a stock exchange as the Toronto Stock Exchange (TSX).
Owning a company’s shares allows you to vote in shareholder meetings, share in a company’s profits (dividends), and sell your position when you wish.
The main reason that companies issue shares is to raise money for their business activities.
These are units of a company’s debt. Bonds are another way for companies to raise money for their business ventures.
Essentially, by owning a bond, you become a company’s creditor as the company owes you. For extending this loan, the company will pay you a fixed interest rate (coupon) periodically.
Generally, bonds have a lower risk than stocks. Conversely, bonds have a lower return than stocks.
Exchange-Traded Funds (ETFs)
They are a basket of securities (such as stocks, bonds or commodities) traded on the stock exchange.
An ETF may track a particular index such as the S&P 500. It could also include securities from a particular industry or sector.
ETFs provide diversification as they include securities from various industries.
It is a professionally managed investment fund that pools money from many investors to buy various securities.
Unlike ETFs that you can buy and sell when the stock markets are open, you can only trade mutual funds once a day.
The professional management of mutual funds leads them to have higher expense ratios than ETFs.
These are a special case of mutual funds. However, they are designed to track a specific index and therefore require very little management.
As a result, index funds tend to have very low expense ratios and outperform traditional mutual funds.
Real Estate Investment Trust (REIT)
It is a publicly-traded company that owns and manages income-producing real estate.
REITs offer real estate exposure without putting down a large investment as you would to buy such property directly.
An investment in REITs also offer passive income through regular dividend distributions. However, REITs do not have much potential for capital growth, as they have to distribute most of their profits to investors.
Ways to invest in the stock market
Investing in the stock market is surprisingly quite easy today. All you need to do is open an account, choose a broker, and start making investments. There are three main ways to start investing, depending on your preferences.
DIY Investor: Online/Discount Brokers
An online stock broker allows you to research, select securities, and decide when to buy or sell investments. You can trade various securities such as stocks, bonds, mutual funds, EFTs, etc. without an advisor or trading agent’s assistance.
Self-directed investors that do not require much guidance or analysis prefer online brokers as they tend to have the lowest fees. The financial world regards online brokers as discount brokers due to the low cost. The cost-savings from ultra-low commissions provide for a greater return.
If you have the time and interest to know more about investing, you should consider this option. Anybody can learn how to manage a personal investment portfolio.
There are plenty of online brokers. The best discount brokers in Canada include Qtrade Investor, Questrade, TD Direct Investing, National Bank Direct Brokerage, Scotia iTrade, etc.
Some of the best discount brokers in the U.S. include Fidelity Investments, TD Ameritrade, Charles Schwab, Interactive Brokers, E*TRADE, etc.
Hands-off Investor: Hire a financial advisor
Human financial advisors provide the highest level of service. An advisors’ offerings may include: creating a customized financial plan, executing trades, providing savings, budgeting, insurance, and tax strategies, etc.
Typically, advisors have extensive investing knowledge and can guide you to make better financial decisions. They manage your portfolio, so you never have to worry about it falling through the cracks when life gets busy.
With the high level of service comes high fees and commissions. This path to investing is the most expensive.
A Robo-advisor is a hybrid between doing it all on your own and receiving full financial advice.
Robo-advisors use algorithms to determine the best investments that suit your risk profile and preferences. They typically invest in various ETFs.
A Robo-advisor will select and manage your portfolio, including services such as portfolio rebalancing and tax-loss harvesting. However, it will not assist you in making future long-term plans as a human advisor can.
One of the main advantages of Robo-advisors is lower fees as compared to human advisors.
Types of Investment Accounts
There are two main types of accounts that you can use for investing purposes. These include tax-advantaged accounts and non-tax advantaged accounts.
- Tax-Advantaged Accounts
- Registered Retirement Savings Plan (RRSP): This is a retirement account in Canada designed to save for investment. Income earned within an RRSP is exempt from tax until the time of withdrawal. Further, you would contribute to an RRSP with pre-tax dollars providing you with an immediate tax break. There is an annual limit to the amount you can contribute to an RRSP.
The equivalent of an RRSP in the U.S. is the 401(K).
- Tax-Free Savings Account (TFSA): Income earned within a TFSA is exempt from tax, even when you withdraw it. You would contribute to a TFSA with after-tax dollars. As such, the tax benefit is deferred until you earn an income in the account. There is an annual limit to the amount you can contribute to a TFSA.
- Non-Tax-Advantaged Accounts
- Ordinary Brokerage Account: This an account that is not tax-sheltered in any way. Therefore, any income or profits realized within this account will be taxed according to income type.
Since there is a limit to the amount you can contribute to tax-advantaged accounts, you need to strategically allocate investments according to different income types.
Generally, you should use taxable accounts for income that is inherently taxed favourable such as capital gains.
Common Investing Mistakes to Avoid
Letting your emotions decide
Unfortunately, fear and greed are often the driving forces behind many investment decisions. As discussed early, the Fear of missing out or losing everything can lead to reactionary and devastating choices.
Be aware of these emotions and try to make rational investment decisions. If you are particularly prone to making emotional decisions, you may want to consider using a Robo-advisor or a Human financial advisor.
Putting all your eggs in one basket
Diversification helps to reduce your exposure to any single investment. For instance, in addition to picking various companies, your portfolio should also include companies in different industries and markets.
Typically, when one industry faces a downturn, other sectors may still be performing well.
Having a diversified investment strategy ensures that your entire portfolio will not be at risk if one asset performs poorly.
Attempting to time the market
No one can successfully know how the markets will behave on any given day. Market-timers to try to predict the best times to get in and out of the market.
For example, when attempting to time the market, an investor may try to guess when the market will “bottom out” during a downturn. While waiting, the market could make a sudden recovery leading to missed opportunities.
Experts advise that you should consistently invest in the market and avoid trying to time it. Long-term buy and hold strategies tend to outperform timing the market.
As the saying goes, time in the market beats timing the market.
Investing in companies/assets you don’t understand
Emotional investing often leads to investing in assets that you do not understand. Typically, many investors will buy investments based on the “hot” stocks of the moment. For instance, even with minimal understanding, many rushed into cryptocurrencies such as Bitcoin.
Unfortunately, when a stock becomes a mainstream news item, it has typically reached its peak at that point.
When buying individual stocks, choose your assets based on the companies’ fundamentals, such as financial performance and management quality, not hype.
Investing money you cannot afford to lose
Putting money that you cannot afford to risk makes for a very stressful investing experience. You will have an emotional rollercoaster watching the ebbs and flows of the stock market.
Further, you can end up making poor choices that you would otherwise not have made.
Be sure to build an emergency fund before starting to invest. Further, only invest money that you do not need in the short-term.
If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.
“Success is not final; failure is not fatal: It is the courage to continue that counts.” — Winston S. Churchill
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