12 Things You Must Absolutely Know Before Investing Again Part 1
“My money isn’t safe in the markets.”
That’s the conclusion a lot of people drew from the financial devastation of 2008. Stocks were sold as people watched their 401K turn into a 201K and worried about it becoming just a 101K. Some people may have gone to cash or lowered their monthly contributions to their savings accounts. Anything to lower their exposure to the markets.
But these days people are starting to become interested in investing again. They’ve seen their investment portfolios grow again for the first time in recent memory. The stock market has been booming for months, proving all those Wall Street bears and skeptical journalists wrong.
The one worry many investors have is that they might already be too late—they may have missed the rally. That fear has kept investors out of the market since the rally began. And it’s unfortunate because it presumes that you should only invest if you can correctly time the market. If that were true, pretty much no one would ever be able to prudently invest. There’s a word for people who buy at the lows and sell at the highs: Liars.
If you are thinking about getting back into the markets, now might be the perfect time to avoid many of the errors that trap investors and eat away at any gains in their portfolios. In short, this time you have the opportunity to do it right. So here is our guide to investing wisely. Twelve tips that will help you avoid some of the most common mistakes.
See 12 tips for investing >
Tip #1: Know Your Investing Costs
We’re going to start with the biggest error many investors make: they pay too much to invest. High costs of stockbrokers, financial advisers, tax consultants, and even mutual funds can completely destroy any gains in your investment portfolio. If you cannot figure out how to control your costs, you really might be better out not investing at all.
The entire business of Wall Street often seems organized to hide the costs of investing from you. The fees are often written in small print on your quarterly statements, and you probably will have a hard time understanding them. No one will ever ask you to approve each fee after it is carefully explained to you. You don’t have to initiate any boxes authorizing each fee you will be charged.
So here’s how to address this problem: if you can’t figure out what fees you are being charged, you should not use that service to invest. Whether it is a brokerage account in which you buy and sell individual stocks or a mutual fund that does this for you, if the fees are not transparent and understandable, avoid it.
Here are the four major sources of investing costs you should watch out for:
Brokerage Commissions. Every time you buy and sell a stock, your brokerage probably charges you a fee. Often these are flat fees, based on either the trade or the amount of stock purchased. Regardless of the way the fee is charged, the rule is the same: the lower the better.
Advisory Fees: Brokers and mutual funds will charge you a fractional amount based on the size of your portfolio. Often the number is small enough that you might not think it is a big deal to pay something as small as 2% but these costs add up quickly. In some flat years, that will eat away at all your market gains. In down years—and there are always down years—you’ll end up paying more than your earned. Together, the flat and down year fees can add up to more than the gains in a bull market.
Taxes: When your investment adviser tells you how much money you’ve made for the year by investing with him, he’s probably talking about pre-tax gains. But here’s the thing. You never get to pocket pre-tax gains. You pocket after-tax gains. That means you need to know how the tax system will treat the investments you make. And you need to anticipate what future developments in the tax code will be.
Inflation: This is the ultimate killer. If your investment gains don’t outpace inflation, you’re actually losing money in the long term as the value of your money gets eaten away.
Tip #2: Reduce Your Costs
Now that you know the costs that can tear into your portfolio, you need to find ways to reduce them. Here are five things you can do:
Invest in the lowest cost mutual and index funds available. This seems like a no-brainer. But many investors overlook it. Tiny fractions of a percent can make a big difference over the years.
Pay Attention To Changing Costs.
Just because you invested in a low-cost fund to start, doesn’t mean the costs stay low. New products and competitors may have been introduced, and your fees may have increased. The price of Wall Street’s freedom is your undying vigilance.
Pay Capital Gains Not Income Taxes On Investments.
An actively investing fund or a brokerage account with frequent sales generate a lot of high taxes on gains. You can reduce the cost of taxes by going with a passive fund that makes long-term investments. These pay lower capital gains taxes, instead of ordinary income taxes. But beware: there are some on Capitol Hill who would like to eliminate this benefit.
Invest Through A Retirement Account.
If you are saving for retirement, make sure that you are using an account that has legal tax advantages that allow you to avoid taxes now or in the future. This is a huge advantage. Most big employers will offer these accounts to you.
Buy Inflation Protected Treasuries.
There are lots of opinions about how to reduce your exposure to inflation. Some people will tell you to buy gold, which tends to go up when the value of money goes down. This isn’t practical for most investors. A far easier way is to put part of your portfolio into TIPS—short for Treasury Inflation Protected Securities. This won’t protect you if the government of the United States collapses or repudiates its debt. But if that happens you’ll have a lot more to worry about than the effect of inflation on your portfolio.
Tip #3: Expose Yourself To Upside Surprises
One thing we’ve learned is that the markets are unpredictable. Even studies that show gains in the broad market through history cannot tell us for certain what will happen in the future. In fact, there’s a lot of recent evidence that we’re underestimating the uncertainty of the future.
That’s a problem for investors because you cannot invest in the past. You can only invest now for gains you hope to make in the future. In short, you are always speculating on uncertain future events.
One way of handling the radical uncertainty of the future is to create upside exposure to really uncertain events. This means that you have to be willing to put some money down on one number on the roulette wheel. Don’t be a fool and make a huge bet and don’t do it completely randomly.
Here’s what you should do. Find an event that looks really unlikely in the future. Something everyone you ask tells you is almost certain not to happen. Make a small investment in that event happening. But be sure that the odds are against you.
Let’s use an example. Buying a lottery ticket for a dollar isn’t a good way of exposing yourself to the upside of winning because the initial investment of a dollar is too much for almost any imagine jackpot. But if you could buy that lottery ticket for a few pennies, it would make sense. The point is that risky bets are fine if the cost of making them is low enough.
Tip #4: Limit Your Exposure To Downside Surprises
Just as you should put a small (tiny!) portion of your portfolio in very risky investments, you should also have a large portion in something very, very safe. Treasuries are the typical answer for this. This will protect you against the market doing something really unexpected.
The size of your safety net should depend on how old you are (if you’re younger, you have longer to recover from a big loss), how much you expect to need to withdraw from your portfolio in the next few years (you need more safe investments if you are saving for a house or your kids college), how psychologically well-prepared you are to handle losses in your portfolio (what investment advisers call “risk tolerance”) and how likely you think unlikely events will be.
Nassim Taleb, the author of the Black Swan, thinks unlikely events are far more likely than anyone expects. So he advises that you avoid “conservative” stock and bond investing altogether and put something like 95% of your money in Treasuries. That’s pretty extreme. If you’re not as worried as Taleb, you might consider a smaller share.
Tip #5: Diversify
Everyone knows that they are supposed to diversify. But very few people understand how hard it is to really diversify. Here are some pointers on how to effectively diversify.
Asset Mix. You are not diversified if you own twenty stocks or even a hundred stocks but nothing else. You need a variety of assets classes—stocks, bonds, gold, Treasuries—to truly diversify.
Time preference. Your portfolio should also contain assets that you expect will appreciate along different timelines. This is important and widely overlooked. This will help you avoid having all your investments keyed to one time—a time when the market could be crashing.
Have More Than One Manager. The clients of Bernie Madoff believed they were diversified because they had so many different kinds of assets listed on their monthly statements. But many of them were exposed to a different kind of risk—the risk of getting ripped off by their asset manager. It’s not just outright thievery you need to worry about—investment managers can fail and take your portfolio with them.
In short, diversification needs to happen at every level.
Tip #6: Beware Of Your Own Riskiness
There’s another lesson made clear from the recent financial catastrophe. The sources of risk to your portfolio are not just what the market does, but how the market reacts to you.
Let’s take AIG as an example. It had insured billions of dollars of subprime mortgages, and it thought it would be safe because most of those would still be in the money even if the housing market tanked. So far, that’s still true. But what killed AIG was that as both the risk on those mortgages increased and the perception of the riskiness of AIG itself grew, it’s customers had the right to demand more money as collateral for the insurance policies they bought. AIG couldn’t afford to put up the collateral, which is why it went hat in hand to Uncle Sam.
AIG never considered the risk that its customers would demand more collateral. You shouldn’t be that dumb. While you aren’t selling derivatives, there are lots of ways you could find yourself squeezed into having to sell assets at the very worst time. If you don’t have enough cash on hand, you might find yourself having to sell stocks during a bear market to pay for your mortgage. If you bought in a margin account, you might get squeezed by your broker.
Overall, remember that you are exposed not just to your investments going up and down, but to other demands on your assets that could force you to sell investments when you don’t want to.