Investing 101

Wow. We’re only two months into 2021, and the financial news has already made a splash. Enough hoopla has already been made about GameStop, but I do think there is one teachable moment in all of this. And that’s the buy/hold strategy. Yes, GameStop had colossal gains in a short amount of time. But with it came colossal loss. During its trading frenzy, GameStop went from $20 per share to $483 and then back down to around $40 now. For anyone who bought the stock for more than $40 (or today’s price), you’re probably worried because you’re thinking, what if it goes down further? On the other hand, if you were already invested in GameStop stock from January 1 until now, you’d still be at a gain. By focusing on the end result rather than day-to-day performance, you won’t be bothered so much by the ups and downs that all stocks inevitably endure. 

The best thing that came out of the GameStop experience is that it generated huge interest in the stock market. With recent news putting the stock market at the center of attention, this month’s topic will be especially relevant. Let’s take a look at what you need to know about investing.

Why is investing important? 

We are typically taught that we have to work for money, so naturally the only way to make more money is to work harder, right? Wrong. There is another way. We can also make more money by investing some of the money that we have made. If you ever wanted money to work for you, investing takes your seed money and grows it over time, resulting in what’s known as compound interest. Like plants, not every investment grows. But for those who spend a little time understanding how to invest, the payoff is well worth it. 

How do I get started with investing? 

Anyone can invest their money. I repeat, anyone. Most employers offer a retirement plan where the money you contribute can be invested. Children can use a parent’s brokerage account or start one of their own with an adult as custodian. Many college savings plans, or 529 plans, offer investment choices as well. If you have none of the above, you can get setup easily with a brokerage account of your own. While Robinhood has been making the most waves, there are other established names like Fidelity or Charles Schwab or TD Ameritrade for commission-free trading. 

When should I start investing? When should I stop? 

Ideally we can all start investing from the day we are born. If, like most people, that did not happen, then the next best option would be as soon as there is money to invest and the investment has to be for a long-term goal, like retirement or a big purchase. In case the buy/hold strategy was not clear earlier, don’t worry about timing the market. By remaining invested for the long-term, the end result is what matters, not what happens between today and tomorrow or next month. As for when to stop investing, you just might continue to be invested for as long as you live. After all, the best case scenario is that your money outlives you, rather than the other way around. However, if the money is for a finite goal, like a home purchase or college, then it makes sense to shift investments into something more stable like cash some time before or when you withdraw your money. 

What are the different types of investments? Which ones are best? 

Once you enter the world of investing, there is a plethora of investments you can choose from, with the most common being stocks, bonds, mutual funds, and commodities. Refer back to the Ace Academy article on Compound Interest or just do a Google search to learn about the various choices.

The second question is commonly asked in the financial industry. The truth is, no one can tell you with 100% certainty which investment will perform better or which stock to pick. There are times when a company’s stock may be doing spectacularly well in comparison to its own financials. How is that possible? It’s all up to investor mentality. Before you invest, take some time to study past performance or ask a financial advisor.

What are some smart strategies for new investors?

As mentioned before, investing comes with risk, the risk of loss. However, we can minimize risk with some simple tactics. We already discussed buy/hold strategy. Another strategy is diversification. Instead of putting all your money into one investment, why not spread it out, so one or more investments can perform well when the others don’t? One more tip is to use dollar-cost averaging instead of timing the market.

Although investing may seem like gambling, with a bit of education, you will be better off investing than gambling. So take your money, throw in a dash of diversification, add dollar-cost averaging along the way, bake for some time, and you’ve got a recipe for wealth!

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Diversification

Ever hear the saying, “Don’t put all your eggs in one basket?” Just like eggs, your money is fragile. If the basket drops or breaks, you’re out of luck. That is why you need diversification. Essentially, diversification means spreading your money (eggs) into more than one investment (basket). This way, if one of your investments loses money, at least you have other investments.

What “baskets” can you choose from? First, you need to decide on a type of investment for each basket. The types of investments can be exhausting and some types even offer derivatives, so let’s just keep it high-level: cash, stocks, bonds, real estate. We previously covered these types of investments in the lesson on Compound Interest. So many choices! With diversification, you don’t have to choose just one, in fact, you should spread your money across them all.

“Baskets” are not to be confused with accounts. You can have one account with many investments inside. For example, your retirement account may have a blend of stocks, bonds, and other investments.

There’s more to diversification than deciding what type of investment to place your money in. Diversification extends to the sector you’re investing in as well. Let’s use stocks, which carry a lot of variety. You could invest in telecommunications, medicine, entertainment, finance, and the list goes on. So instead of choosing just one sector, invest your money in different sectors to allow for the best outcome if one or more of your sectors hits a rough patch.

If you are an employee of a publicly traded company on the stock market, your company might give the option to purchase company stock at a discount or they may offer company stock as one of the choices for investing within the 401(k) plan or you can simply choose to invest in the stock in your own brokerage account. It’s tempting because it’s an easy choice. Be very careful when choosing to put money into company stock. While it’s fine to invest in the company you work for, after all it’s a show of pride and support for your work, you don’t want to place a lot of “stock” in one place (couldn’t help the pun!). Think of it this way. What if the company takes a tumble on the stock market and as a result, lays off a bunch of employees, including you? Now you’ve lost both your salary and savings, if you invested your savings in company stock. So again, while it’s ok to invest in your company, limit your investments there, and remember to diversify!

Diversification is a timeless strategy that you can use for investing, but it becomes particularly useful when markets are taking a dip. That is because you may see a lot of your investments lose money, but if you diversify, some investments may trend the other direction, up. It’s important to diversify your investments across as many possible areas, so that you can brave the roller coaster of investing like a pro!

Homework: Choose 3 stocks from different sectors to follow over the course of one week. How did they perform compared to each other? If they all lost money, expand your stock selection to 10 stocks the following week. Was there one sector that did better than the others?

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The Secret To Smart Investing

The old adage “Buy Low, Sell High” works great … if you have a crystal ball for every investment you make. In reality, no one can predict with absolute certainty the best time to buy or sell an investment. How do you know that a stock is at its lowest price when you buy? How can you tell that a stock price won’t climb higher after you sell? Stop stressing over things you cannot control. That is why you should remove one word from your investment vocabulary: timing.

Now replace that word with something else: dollar-cost averaging.

Dollar-cost averaging is a method of investing the same amount of money on a consistent basis, so that your overall price tag ends up an average rather than the highest point or the lowest point on the scale. Why does this work in your favor? Because you are investing the same amount of money each time, you’re buying more shares when the price is low. That’s smart! You managed to scoop up a good deal. And when the investment price goes up? You naturally buy less shares with the same amount of money.

Think of it like your favorite pair of pants. When they’re on sale, maybe you buy more than one pair. But when they go back to retail price, you stick to just buying one pair. The difference between investing and buying clothes is that with investments, nothing will advertise that they are on sale. That’s where dollar-cost averaging helps you out. This method automatically buys more at a low price.

How do you get started? Chances are if you have a 401(k), you’re already dollar-cost averaging. That is because you already apply the same amount on a regular basis to an investment. But you can do the same without a 401(k). If you have a sum of money, rather than investing it all at one time, consider dollar-cost averaging instead. Let’s use a sample stock purchase to illustrate this strategy.

Dollar-Cost Averaging Example

Investment Amount: $300 per month

Shares of Stock Purchased:

  • January @ $10 / share = 30 shares
    • Average price @ $10.00 / share ($300 paid for 30 shares)
  • February @ $15 / share = 20 shares
    • Average price @ $12.00 / share ($600 paid for 50 shares)
  • March @ $20 / share = 15 shares
    • Average price @ $13.85 / share ($900 paid for 65 shares)
  • April @ $16 / share = 18.75 shares
    • Average price @ $14.33 / share ($1,200 paid for 83.75 shares)
  • May @ $15 / share = 20 shares
    • Average price @ $14.46 / share ($1,500 paid for 103.75 shares)
  • June @ $20 / share = 15 shares
    • Average price @ $15.16 / share ($1,800 paid for 118.75 shares)

Remember when we talked about timing? Can you predict what the price of the stock will be next? You can try to guess, but would you bet all your money on it? Now you understand why timing the market is not such a great idea.

As you notice in the example, the actual price of the stock took a bumpy ride, sometimes jumping $5 up or down between months. But thanks to dollar-cost averaging, you enjoyed a much smoother ride, with the biggest swing being a $2 difference in average price between January and February. Most people cannot pay every second of attention to investing, let alone stomach the bumpy ride. Dollar-cost averaging makes for a much smoother ride. If you were on a roller coaster, wouldn’t you want one with smooth turns, rather than jagged cliffs? That is why smart investors choose dollar-cost averaging!

Homework: Make dollar-cost averaging a new year’s resolution, whether it be through a 401(k) or an investment account. Consider tracking the average price paid per share every month for the next 6 months to see how dollar-cost averaging works.

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