Getting started as an investor can be a daunting task. According to the 2022 Investopedia Financial Literacy Survey, 57% of US adults are invested, but only one in three say they have advanced investing skills. Getting started can be especially daunting if you’re a methodical person wary of beginning such an important endeavor before you’ve built up enough knowledge, expertise, and confidence.
In the meantime, creating a short list of everything a beginning investor should know inevitably runs the risk of excluding many important points. In fact, successful investors will vary widely about what they would put on their top ten list if they were pushed to repeat the exercise.
However, we do offer what we hope will be a useful checklist to help you get started as a successful investor. We have chosen to highlight important personal attitudes and overarching strategic frameworks that we believe will help you become an intelligent investor.
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The central theses
- Have a plan, prioritize saving, and know the power of compounding.
- Understand risk, diversification and asset allocation.
- Minimize investment costs.
- Learn classic strategies, be disciplined and think like an owner or lender.
- Never invest in anything you don’t fully understand.
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1. Have a financial plan
The first step to becoming a successful investor should start with a financial plan that includes goals and milestones. These goals and milestones include setting targets for saving specific amounts by specific dates.
For example, the goals in question might be having enough savings to make buying a home easier, paying for your children’s education, building an emergency fund, having enough to fund a business venture, or having enough to start a business venture finance a comfortable retirement.
While most people think about saving for retirement, an even more desirable goal would be to achieve financial independence as early as possible. One movement dedicated to this goal is Financial Independence, Retire Early (FIRE).
While it is possible to create a solid financial plan yourself, if you are new to the process you should seek professional help from someone such as a financial advisor or financial planner, preferably a Certified Financial Planner (CFP). . Finally, don’t hesitate. Try to have a plan as early in life as possible and keep it as a living document that will be updated regularly and in light of changing circumstances and goals.
The FIRE movement
The FIRE (Financial Independence, Retire Early) movement advocates rapid wealth accumulation well ahead of the traditional retirement age to give you more choices in life sooner.
2 . Make saving a priority
Before you can become an investor, you must have money to invest. For most people, that means setting aside a portion of every paycheck for savings. If your employer offers a savings plan like 401(k), this can be an attractive way to make saving automatic, especially if your employer covers all or part of your own contributions.
When creating your financial plan, you can consider other alternatives besides using employer-sponsored plans to make saving automatic. Wealth building typically involves aggressive saving followed by wise investments aimed at growing those savings.
Also, a key to saving aggressively is to live frugally and spend wisely. With that in mind, a wise addition to your financial plan would be to create a budget, track your spending closely, and regularly review whether your spending makes sense and is delivering adequate value. Various budgeting apps and budgeting software packages are available, or you can create your own spreadsheets.
3. Understand the power of compounding
Regular, systematic saving and investing, and starting this discipline as early as possible in life, will enable you to fully harness the power of compound interest to grow your wealth. The current protracted period of historically low interest rates has reduced the power of compounding to some extent, but it has also meant that starting savings and wealth building early has become more imperative as it will take longer for interest-bearing and dividend-paying assets to double in value than before, everything else the same.
4. Understand risks
Investment risk has many aspects, such as: B. bond default risk (the risk that the issuer will default on its obligation to pay interest or principal) and stock volatility (which can cause large, sudden increases or decreases in value). In addition, there is generally a trade-off between risk and reward, or between risk and reward. That said, the path to achieving greater returns on your investments often involves taking greater risks, including the risk of losing all or part of your investment.
As a crucial part of your planning process, you should determine your own risk tolerance. How much you are willing to lose should a potential investment fall in value, and how much sustained price volatility in your investments you can tolerate without causing undue worry, are important considerations in determining what type of investments are best for you are.
At the most basic level, investment risk includes the possibility of total loss. But there are many other aspects of risk and its measurement.
5. Understand diversification and asset allocation
Diversification and asset allocation are two closely related concepts that play an important role in both managing investment risk and optimizing investment returns. Broadly speaking, diversification means spreading your investment portfolio across a variety of investments in the hope that below-average returns or losses in some can be offset by above-average returns or gains in others. Likewise, asset allocation has similar goals, but with a focus on diversifying your portfolio across the major asset classes, such as stocks, bonds, and cash.
Again, your ongoing financial planning process should regularly review your diversification and asset allocation decisions.
6. Keep costs low
You cannot control the future returns on your investments, but you can control the costs. In addition, costs (e.g. transaction costs, investment management fees, account fees, etc.) can weigh heavily on investment performance. Likewise, to cite just one example for mutual funds, high costs do not guarantee better performance.
The Importance of Cost
Investment costs and fees are often a determining factor in investment results.
7. Understand classic investment strategies
Investment strategies that the beginning investor should fully understand include active versus passive investing, value versus growth investing, and income versus profit investing.
While smart investment managers can outperform the market, few do so consistently over the long term. This is leading some investment professionals to recommend low-cost passive investment strategies, mainly those using index funds that attempt to track the market.
In the equity investing arena, value investors favor stocks that appear relatively cheap relative to the market, as measured by metrics such as price-to-earnings (P/E) ratios, with the expectation that these stocks have upside potential and limited downside risk. Growth investors, on the other hand, see greater profit opportunities in stocks that are seeing rapid increases in sales and earnings, even if they’re relatively expensive.
Income investors seek a steady stream of dividends and interest, either because they need cash on hand at all times, or because they see it as a strategy that limits investment risk, or both. Variations on income investing include focusing on stocks that offer dividend growth.
For-profit investors largely disregard the income streams from their investments, instead looking for the investments that are likely to deliver the most price appreciation over the long term.
Classic investment strategies
Income vs Profits; Value vs Growth; Passive vs Active.
8. Be disciplined
When you actually invest for the long term according to a well thought out and well constructed financial plan, you remain disciplined. Try not to be upset or disturbed by temporary market volatility and panicked media coverage of the markets that might border on sensationalism. Also, always take the statements of market experts with caution unless they have long, independently verified track records of forecast accuracy. Few do.
9. Think like an owner or lender
Stocks are ownership interests in a company. Bonds represent loans that the investor makes to the issuer. If you intend to be a smart long-term investor rather than a short-term speculator, think like a potential business owner before you buy a stock, or like a potential lender before you buy a bond. Would you like to become a shareholder of this company or a creditor of this issuer?
10. If you don’t understand it, don’t invest in it
With the proliferation of complex and novel investment products and companies with complex and novel business models, beginners today are faced with a wide range of investment choices that they may not fully understand. A simple and wise rule of thumb is never make an investment that you don’t fully understand, especially in relation to the risks involved. A corollary is to be very careful when it comes to avoiding fads, many of which may not stand the test of time.
Avoid the unknown
Avoid investing that you don’t fully understand. They can pose great hidden dangers.
Addendum: A classic read
If there’s one book you should read as a new investor, it’s this one Extraordinary popular delusions and madness of the masses by Charles Mackay. Written by a Scottish journalist in 1841, it is a masterful early study of crowd psychology. The first three chapters, “The Mississippi Scheme,” “The South-Sea Bubble,” and “The Tulipomania,” all deal with financial madness that ended in disaster and foreshadows many of today’s financial schemes, bubbles, and manias. As a result, these chapters have been cited by a number of contemporary financial writers.