Tuesday, January 16, 2007

Advice on Investing in Stocks - an Alternative Perspective

A lot of people spent their time obsessing about their investments in the stock market. They spend hundreds of dollars on Financial Planners to help them "balance" their portfolios properly. Some buy expensive newsletters that promise them they can beat the market. They research stocks and mutual fund returns to get the maximum gain. Others just throw their hands up and keep all their investments in safe Bond or fixed income funds and accept a low return due to fear of losing all their money. Websites like AllFinancialMatters have lots of traffic, yet few research how well JLP really has done before taking his advice.

I've tried to do this myself. Researching individual companies, buying into the MotleyFool advice or getting tips from the "gurus" I work with. My brother subscribes to a news letter that he claims helps him beat the market using timing techniques. He says he would have gotten a 30% return last year except for a couple of times he didn't follow the advice and so his total return was below the market average. His experience reflects the all too human nature each of us employs when investing. We use hunches (influenced by greed or fear) to try to overcome our own ignorance, suffering from the Illusion of Knowledge.

Now some people seem to be well qualified to give investment advice (like Warren Buffet). Mr Buffet is an extremely brilliant man (MBA from Wharton School of Business) who started investing at age 11. After getting multiple degrees he convinced friends and family to invest $105,000 along with his $100 which he turned into a fortune. Most of his fortune did not come from investing in the stock market (as many seem to believe) as much as it did by buying and managing companies that he turned around. So Mr Buffet is really more a businessman than an investor in my opinion.

And this is where I differ with the conventional wisdom. If you are intent on becoming wealthy, I think that it is a mistake to believe that just by investing in stocks, you will succeed. The stock market is inherently risky and in the short term there is no guarantee. Now if you start by putting money away at age 11, using dollar cost averaging and investing in index funds, you will most certainly get rich over your lifetime. As far as I can determine, pretty much every other strategy of investing in the stock market is akin to gambling (day trading, timing techniques, technical analysis, buying individual stocks). And statistically, gambling is a losers game. Individual companies fail at an astonishingly high rate and since you have no direct control over what goes on in those companies it is a gamble to buy them individually (you can just as easily invest everything into an Enron as a Microsoft).

Perhaps the biggest gamble people take is putting all their eggs into their job (Read 10 Reasons You Should Not Get a Job). Most don't even bother to put aside a percentage of their income into a 401k, they just hope that they will stay employed and perhaps they will receive a pension (becoming increasingly unlikely) or Social Security (young people - have more children - please!!).

Now, I am not a millionaire, but do have a lot of experience trying different ways to succeed, if you have read much of this blog. I have also had the opportunity to talk extensively with some of the wealthiest people in the country, as well as listened to seminars given by many multi-millionaire businessmen and women. So I feel I can offer some advice to at least myself (and my children), if not to you.

  • Invest in knowledge first and foremost. Get an education that will teach you how to succeed financially. If you desire to be an artist, that's fine, but it will be easier to paint if you have money and aren't forced to work 70 hour weeks at McDonald's. I think that a practical college education is about the only smart way to spend the enormous amount of money that a degree requires today. But college alone is not sufficient. Most professors don't know much about real financial success. Get around wealthy people and pick their brains. You will become financially like the people you associate with. So don't spend most of your time with broke people. Build extensive networks with successful people.
  • If you are young and unmarried, start a business first or intern with a successful business person willing to mentor you in the basics. The best investment is always in yourself. If you have financial commitments already, you will probably need the steady income of a job to get started. But don't spend your extra cash on non-essentials. Instead, start a side business and re-invest in that business to make it grow. Use the principles of the "E-Myth Revisited" to make your business autonomous. Unlike investing in the stock of a company, starting your own company gives you control. And even if you fail, you will have garnered tremendous knowledge of how business works and what to do the next time.
  • Always, always, always take 10% of your income and start saving it. Invest it into index funds. Don't waste a lot of time trying to beat the market. As you get closer to retirement you may want to move a percentage of the money into fixed return funds, but when young you should be investing for the long term. Some years you will lose money but by using dollar cost averaging you will grow your investments steadily over time. AND LEAVE THIS MONEY ALONE!
  • Diversify into real estate - see my post on why here. Real estate is one of the safest investments around as evidenced by interest rates banks charge.

So invest in the stock market, but don't become obsessive about it. Use a simple strategy like I outlined above. Spend more of your time investing in yourself, your business and real estate.


traineeinvestor said...

Like you, I am a fan of investing in real estate.

In terms of relative risk, my take is that a single piece of real estate is less risky than a single stock but a single piece of real estate is more risky than a diversified portfolio of stocks (such as an index fund). Of course, when you start using leverage, the risks go up in either case.

I have noticed that in some countries, banks will often lend up to 70-80% on investments in funds which is getting close to what they will lend on real estate.

Paul said...

Actually, statistically speaking the risk of owning a single piece of real estate is never worse than a stock portfolio. See my post with data here

If you have bought stock on margin you must cover margin calls if the price falls. If your real estate price drops you do not have to sell. Real estate has an extremely high recovery rate if the price ever does drop.