10/20/08

How to Start Investing

I've received a few emails recently from people who want to start investing but do not know where to begin. While this post is aimed at new investors, seasoned investors will hopefully get something out of it too.

Before you start investing, you need the following things:

  1. An emergency fund of at least $1,000 that you will continue putting money into regularly, so that this fund will be worth at least half a year's expenses as soon as possible.
  2. Health insurance and disability insurance.
  3. Little (or better yet, no) debt.
  4. Money that you won't need for at least 5 (or better yet, 10) years.
Once you have done 1 through 3, you are ready to start investing with #4. For many people this means $50 or $100 a month that can be set aside for investing. Perhaps you already have $500 or $1,000 ready to invest (that's #4 money).

How Do I Start Investing with $1000?

Getting Started

Before you go shopping for stocks, ETFs, or mutual funds, you have to figure out what asset mix is best for you. Your ideal asset allocation depends primarily on your age (or the time between now and when the money to be invested will be needed), goals, and risk tolerance. Your risk tolerance is, basically, the degree of losses you can bear before freaking out and selling everything. The greater the risk, the greater the potential gains and losses. The lower the risk, the lower the potential losses and gains. The closer you are to your goal, the less risk you should take.

Diversification among and between different asset classes lowers the risk and decreases the volatility of a portfolio. For example, owning 10 stocks should provide a smoother return than owning one stock. The one stock can go out of business. In a one stock portfolio this would result in a total loss. In a 10 stock portfolio, the other 9 stocks would still be worth something, so the loss wouldn't be nearly as great.

While owning a number of stocks is less risky than owning one stock, a ten (or twenty or thirty, etc) stock portfolio is not a diversified investment. This is because stocks as an asset class have a type of risk that cannot be mitigated by owning more stocks.

To be adequately diversified, then, you need to own more than one asset class. Different asset classes include stocks, bonds, commodities (e.g., agricultural products, precious metals, and petroleum), real estate, and cash. (Each of these asset classes can be diversified to a lesser or greater extent. For example, there are small cap, mid cap, and large cap stocks, as well as various economic sectors like financials, energy, consumer staples, etc. There are various kinds of bonds, both in terms of safety, duration, and tax consequences. There are many different kinds of real estate. Hotels, for instance, are different from residential homes and malls. Even cash can be held in different forms and locations--CDs, under the mattress, in a savings account, as a foreign currency, in bank A rather than bank B, etc.)

Asset allocation determines the portion of your portfolio that each asset class takes up. Your ideal asset allocation should help reach your goals with as little risk and portfolio volatility as possible.

Determine Your Risk Tolerance

The first step, therefore, is to determine your risk tolerance. There are a number of decent tests online (some are better than others). You should answer the questions as honestly as possible. The best ones I could find are listed below. If you know of or come across a better one, please leave a comment or email me.

MSN

Rutgers

ICIEF

Bankrate


Figure Out the Best Asset Allocation For You

Asset allocation is a topic that makes most people who are interested in personal finance salivate. There are generally two types of asset allocation:

Strategic or target asset allocation is a passive investment strategy that involves figuring out the appropriate mix of assets in your portfolio, and then sticking to it for the long run (changing it gradually to take on less risk as your time horizon gets shorter). Let's say your original asset mix is 50% stocks and 50% bonds, and a year after you start investing your portfolio's composition is 60% stocks and 40% bonds. If you're putting new money into the portfolio, with strategic asset allocation you would put money into bonds first, so that they would once again take up 50%. If you don't put in new money, on this strategy you would sell some of your stocks and purchase bonds with the proceeds, so that your asset mix would once again be 50% stocks and 50% bonds.

Tactical asset allocation involves trying to get a higher return by, for example, underweighting assets that you think will do poorly in the (near) future and overweighting assets that you think will outperform in the (near) future. That is, whereas in target allocation you leave your optimal asset mix alone (or change it over time to reduce risk as you approach your goal), with tactical allocation you are frequently adjusting your asset mix to make bets on the near term. So, for example, you can add more money to commodities and reduce your holdings in financials if you think the former will outperform while the latter will underperform.

As beginning investors should not be trying to time the market or otherwise increase their risk by being overly active in the management of their portfolios, I think the target allocation approach is the best one for beginners. Moreover, I think you should not sell anything that you buy. Rather, rebalance your portfolio (keep your asset mix on target) with new money, which you should be putting in regularly. This way, you will always buying more of the asset classes that are performing worst. The worse they perform, the more shares you'll buy, increasing your potential future returns (buy low, sell high). And by avoiding the assets that are doing well, you'll be less likely to buy more of them when they are too expensive.

There are many resources asset allocation, some of which are listed below.

About.com

CNN Money

IPERS

Seeking Alpha

Wikipedia

To see it in action, check out my model portfolio, which at the time of writing is down almost 28%, but is currently outperforming the S&P 500 by 1%.

The most important decision you'll make is about what portion of your portfolio is devoted to stocks, bonds, and cash, and as your portfolio grows, commodities and real estate.

With stocks (and to a certain extent bonds) you also have to decide what portion should be allocated to domestic companies and what portion should be invested in foreign companies. Traditionally, most financial professionals advocated keeping foreign stocks to a small portion of your stock portfolio (20% was around the maximum). Today there is a growing body of experts advising that you devote as much as 55% of the stock portion of your portfolio to foreign stocks. They argue that future growth will come from abroad. As you think about this, you should consider that many (particularly large cap) US companies derive significant portions of their sales from abroad while many foreign companies derive significant portions of their sales from the United States.

Here are some examples of asset allocations based on risk tolerance:

Aggressive
80-90% stocks
10-20% bonds

Aggressive/Moderate
70% stocks
20% bonds
5% real estate
5% commodities

Moderate
65% stocks
20% bonds
10% commodities
5% real estate

Balanced
51% stocks
34% bonds
7% commodities
5% real estate
3% cash (CDs, money market, high yield savings)

Conservative
20% stocks
65% bonds
3% commodities
5% real estate
7% cash (CDs, money market, high yield savings)

Deciding How You Will Invest

Once you've figured out your risk tolerance and ideal asset allocation, you have to decide which route you want to take: doing it on your own, or leaving it to a financial professional. These are not mutually exclusive. You can combine the two approaches. An important factor to consider here is costs.

There are three general types of ETFs and mutual funds:

1. ones that are based on a broad index (e.g., entire stock market, S&P 500, all stocks except US, all bond index, total real estate, etc),

2. ones that are based on more specific sectors, asset types, or valuations (e.g., health care stocks, short term treasury bonds, high yield corporate bonds, small cap value, health care real estate investment trusts, etc), and

3. ones that are based on a target allocation (e.g., starts out with 80% stocks and 20% bonds, and gradually reduces the portion of stocks and increases bonds). These are usually called Target Date Funds (and are based on the approximate date you want to retire). They are worth considering if your ideal asset allocation matches theirs.


ETFs

Doing it yourself, at least at the beginning involves purchasing Exchange Traded Funds (ETFs). These are baskets of stocks and/or bonds that you can buy like regular stocks through a broker. Most ETFs are index based, and are thus passively managed. That is, their managers do not engage in stock picking. ETFs are a very easy and inexpensive way to get instant diversification.

The costs associated with ETFs are generally of two types: commission fees you pay your broker, and the management fees taken by the company that manages the ETF. To a certain extent, both these costs can be controlled by you by choosing a low cost broker and picking the lowest cost ETFs. Broker commission costs run from $0 to $30 a trade and above. ETF management costs run from 0.06% to as much as 2% or above, with most in a range of 0.2% to 0.6%.

If you opt for the ETF approach, I suggest you stick with those in categories 1 or 3.

Here is an example of a very simple low fee ETF portfolio made of ETFs like those in category 1:

40% US stocks (VTI)
30% International stocks (VEU)
30% Bonds (BND)

If you started out with $1,000, you'd put $400 into VTI, $300 into VEU, and $300 into BND.

Mutual Funds

Leaving your portfolio to a professional involves purchasing mutual funds. They come in pretty much the same varieties as the ETFs mentioned above. Except for the mutual funds that are index based (and are thus passively managed), mutual fund managers try to beat the market. That is, they try to select stocks and bonds that will do better than their benchmark index (usually the S&P 500 for stocks and the Lehman total bond index for bonds). This means two things: much higher costs than ETFs and index mutual funds, and the risk that the mutual fund manager is not very good. As most actively managed mutual funds underperform the market and charge higher fees than passive mutual funds and ETFs, you should stay away from them.

The best mutual funds for you to consider are those that are index based (category 1 above) and those in category 3 that are passively managed. Look for funds that charge no transaction fees and as little management fees as possible.

Here is an example of a very simple low fee mutual fund portfolio:

40% US stocks VTSMX
30% International stocks VGTSX
30% Bonds VBMFX

In choosing this strategy, you're essentially going the do it yourself route. In doing it yourself, you may ask, what's better, ETFs or mutual funds?

The answer to this question depends on costs and how much money you're investing. ETFs have no purchase minimums, and typically have lower management fees, but you incur broker commissions every time you buy them. Unless you have a broker that allows you to buy fractional shares, you will not be able to buy an exact dollar amount worth of an ETF. (For instance, suppose you want to invest $500 into VTI. As I'm writing, it's trading at $48.66 a share. If your broker doesn't let you buy fractional shares, you can only buy 10 shares of VTI with your $500. This leaves $13.40, which is not put to work in the way you want.)

No transaction fee index mutual funds typically have purchase minimums (the lowest I've seen is $500 initial investment and $50 subsequent investment; the ones listed above each require a $3,000 initial investment), and slightly higher fees. However, once you've made your initial purchase you can invest smaller amounts (usually $50 or $100) whenever you want. You get to buy fractional shares, so the full amount of your money is put to work. Depending on how often you want to invest and how much your broker charges you to buy ETFs, mutual funds, even with their higher management fees, may be more cost effective for you.

Choosing a Broker

You should choose your broker based on:

  1. commission costs.
  2. availability of fractional share purchases (especially if you're starting out with a small amount of money).
  3. if you want to go with the mutual fund approach, make sure the mutual funds you want to buy are available through your broker (be sure to check if it's cheaper/easier to buy directly from the mutual fund company).
  4. availability of dividend reinvestment.
Essentially, your choice of broker should boil down to the availability of the mutual funds or ETFs you want to buy, and the costs involved in buying them. Try to find a broker that does not charge you account maintenance, minimum balance, or inactivity fees. Site layout, order execution, and trading tools should take a back seat when you're starting out. (These things matter, of course, but you don't really need them when you're starting out. If you later decide to be a day trader or something, you can always open an account with another broker if you're unsatisfied with your cheap broker).

Some brokers you may want to consider:

My Suggestion

If you decide to go with the ETF approach, I suggest Sharebuilder or SogoTrade. Both have low commission fees, and no minimum balance or inactivity fees. They also allow you to put all your money to work by letting you purchase fractional shares. If you don't care about fractional shares and have $2,500 ready to go, check out Zecco. At the time of writing (10/21/08), they offer 10 free trades a month when your account value is $2,500 or over (this may change at any time, however). (Note that if you intend to invest in an IRA or Roth IRA, avoid Sharebuilder and Zecco, as they charge annual custodial fees for retirement accounts. At the time of writing SogoTrade does not offer an IRA.)

If you pay commissions for ETFs, try to limit your commission to 1% of your trade. For example, if you pay $4 a trade, try to invest at least $400 (or $404, including the commission charge).

If you choose to go with broad index mutual funds, choose the ones with the lowest costs.

With either approach, once you begin investing, continue to do so regularly. As long as you have #4 money (money you don't need for a while), keep putting it in on a fixed schedule (once a week, once a month, etc) no matter what is happening in the market. You should be buying when people are jumping out of windows screaming the sky is falling, when everyone is optimistic about the future and thinks stocks are the best thing ever, and at any time in between. As long as you have #4 money, stick to your schedule.

Should people's attitudes and economic circumstances affect you, remember that there is more reason to stop putting money in regularly when people are optimistic than when they can't bear to look at their brokerage account statements. Always try to maintain your asset allocation when you invest new money--this means buying more of the assets that are doing worst. With an index ETF or index mutual fund portfolio, you should never sell anything.

If you opt to go with an ETF or mutual fund of the #3 variety (target date funds), pick the one that most closely matches your ideal asset allocation and that has the lowest costs. Be aware that most target date mutual funds are funds of funds. That is, their holdings are other mutual funds. As those other mutual funds are usually actively managed, remember the risk that the managers of those funds may not be very good. If you go with the #3 variety mutual fund, try to find one that has no transaction fees, low management fees, and is index based.

Individual Stocks

You may be thinking what role individual stocks (or bonds, etc) play. You should consider these as potential portfolio boosters that are to be used sparingly. The bulk of your investment money should be in index funds. Individual stocks should make up a small fraction of your portfolio. Use them only to boost returns. Consider them as side bets.

The best time to invest is whenever you have money that you don't need for at least five years. If this is your situation, get to it.