Investing is a scary topic, especially if you’re a student who’s never studied finance and don’t understand how investing works.
I believe that investing is the single most effective way to build wealth in your life, and I think that everyone should start investing as early as possible for the sake of their financial future.
The best part is that you don’t have to be a financial expert to start investing.
You do, however, need to have a basic understanding of some of the concepts surrounding the market and investing, so that you won’t make mistakes that may end up costing you thousands of dollars.
If you’re a student or recent graduate who knows nothing about investing, this post is for you.
In this post, I’ll share 5 concepts surrounding investing that I believe are extremely important, and will definitely help you make better investment decisions once you understand them.
For the purpose of this post, ‘investing in the market’ will refer to investing in equities such as stocks or stock ETFs.
Disclaimer: This post assumes that all the investments you have are sound investments like broad-based ETFs or strong and stable companies, and there is no fundamental change in the business/company.
1: BUSINESS CYCLES
If you’ve studied Economics before, you’re probably familiar with this.
A business cycle illustrates how the market fluctuates over a period of time and is usually depicted in a graph as shown below.
From this graph, you can observe 2 things:
- recessions and economic downturns are expected
- the market always goes up in the long run
What this means is that when markets start crashing, there’s no need to panic because we know it’s bound to happen eventually.
It also means that if we invest in the market long enough, we will almost always be guaranteed to earn money.
From these 2 observations, investing in the market doesn’t sound scary and almost seems like a sure-win way to earn money. Right?
However, there are 2 important conditions that must be met.
The first is that when markets crash, you must be able to tolerate seeing your investments plummet without selling them.
This means that whatever you do, don’t sell off your investments. Either do nothing or continue investing.
Next, you must be able to leave your money invested in the market long enough to generate returns.
A general guideline is to leave your money invested for at least 10 years. This means that you shouldn’t be investing any money you may potentially need in the next 10 years.
If you can satisfy both of these conditions, investing will multiply your money many times over throughout the course of your life with the power of compounding.
2: COMPOUND INTEREST
Compound interest is able to earn even more interest and is the “secret sauce” that makes investing a powerful vehicle for accumulating wealth.
Even Albert Einstein thinks so too.
To illustrate compounding with an example, let’s say you make a $10,000 investment that earns 5% per year. After the 1st year, you’ll earn $500, so now your investment is worth $10,500. After the 2nd year, you’ll earn $525, and after the 3rd year, you’ll earn $551.25.
Notice how the 5% you earn every year increases even though you only invested $10,000 in the first year?
This is compounding – when your return on investments is reinvested back into the investment so that the “compoundable” amount increases every year.
It’s like a snowball effect for money. The longer your money stays invested, the more it will ‘snowball’ into a huge amount.
This ties in nicely with the concept of business cycles – the longer you stay invested in the market, the more likely you are to generate returns AND the higher your potential gains will be.
This is why people say it’s not about timing the market, but time in the market.
If you understand this, you’ll realise that the earlier you start investing and the longer you remain invested, the more you stand to gain.
The best time to invest was years ago, the next best time is today.
P.S. Just in case you were wondering: Yes, this is the same compound interest that you learned in math back in secondary school – but your math teacher probably never mentioned that compound interest could be used to earn money this way. Why? Well, probably because it’s “not in syllabus”.
3: RISK & RETURN
When you make an investment, you take on some risk of not getting your money back. To be compensated for this, you expect to make a profit, and this is known as the return on investment.
People often say “high risk, high reward”. When it comes to investing, this is not quite true. The only time this is true is when comparing 2 individual investments. For example, comparing stocks to bonds.
Since bonds promise a fixed payment of interest at regular intervals, the risk you bear for investing in bonds is usually low, and the returns you expect to make from it are also low.
For stocks, there is no guarantee that you can get your money back since dividends may get slashed or the company may perform poorly, causing the stock price to drop. This makes stocks riskier than bonds.
As a result, the returns you expect to make from stocks have to be higher than those from bonds. Otherwise, it doesn’t make sense to take on a riskier investment.
At this point, maybe you’re thinking that investing in stocks isn’t as risky as it sounds because based on the business cycle, economies always go up in the long run.
This is not true.
The distinction is this: in the long run, the market as a whole always goes up, but individual stock prices may or may not.
In the market, there are always going to be winners – stocks that perform above average, and losers – stocks that perform below average.
The problem is that no one can be 100% sure which stocks will end up losing. So if you somehow only pick stock losers, you will lose a lot of money investing, and end up being a loser too.
However, this doesn’t mean that you should only invest in bonds and avoid stocks.
Returns from stocks can be much higher than returns from bonds. When you take into account the effect of compounding, stocks are like steroids for your money, and bonds are just meh.
The reason why “high risk, high reward” doesn’t hold in investing is that a significant amount of risk can be reduced without compromising on returns.
This is done through diversification, and it allows you to get high returns while reducing your total risk.
Diversification has an extremely important role to play in investing because it directly affects the amount of risk you bear as well as the returns you can potentially make on your investments.
Just as every kid should have a diverse stash of candy, every investor should have a diverse portfolio of investments.
There are 2 main layers of diversification: between asset classes and within asset classes.
Diversification Between Asset Classes
An asset class is a group of investment types that have similar behaviours and are affected by the same economic factors.
Diversifying across asset classes can reduce the volatility of your portfolio, thereby reducing the risk you bear as an investor.
This is possible because investments across different asset classes may be negatively correlated, while investments in the same asset class tend to be positively correlated.
For example, there is a negative correlation between stocks and bonds. During a market crash, stock prices fall drastically. In contrast, bond prices tend to go up in a market crash.
By owning both stocks and bonds, the fluctuation in the value of your portfolio is greatly reduced.
So if your risk appetite is small and you can’t bear large fluctuations in the market, diversifying among asset classes is a useful strategy to keep you sane while you invest.
Diversification Within Asset Classes
It is also possible to diversify within an asset class.
Let’s take stocks for example. As mentioned earlier, there are always going to be winners and losers in the market.
Since the market is an aggregate of all the winners and losers, 50% of stocks will end up being losers. That’s a lot.
If you pick just 1 stock to invest in, there’s a good chance that you picked a loser.
As you invest in more stocks, the more likely you are to get an equal spread of winners and losers. What you end up with is the market return – which always goes up in the long run.
But it’s not as simple as just investing in more stocks. In the economy, there are many different sectors, and companies in the same sector tend to perform similarly to one another.
If you pick many different stocks in the same sector, you end up with the average return of that sector, which is different from the market return – so it may not always go up in the long run.
Instead, the sector you picked may consist of many losing stocks, resulting in below-average returns. You don’t want that.
The more stocks you own across different sectors, the more your portfolio resembles the market portfolio, and the more likely you are to capture the growth in the market while reducing your risk in stocks.
5: PAPER LOSSES
A paper loss literally means a loss ‘on paper’.
In investing, this refers to a loss in net worth due to a fall in the prices of your investments. It’s a loss that you have experienced, but you haven’t done anything about it.
One of the most common occurrences of paper losses is during a market crash. The prices of most stocks drop, and anyone with investments in stocks will likely experience a decrease in the value of their portfolio.
Then people are afraid that their investments will drop even further, so they sell off their investments to ‘cut their losses’.
This is the biggest mistake anyone can make.
By selling off their investments, they have converted their paper losses into realised losses.
A realised loss is when you convert the loss on your investments into cash by selling them – so you receive less cash than what you paid for the investments.
As mentioned earlier in business cycles, markets fluctuate and the value of an investment will decrease and increase periodically.
By selling your investment at a loss, you are cutting it off before it has a chance to rebound and produce returns, and you have guaranteed yourself to lose money on that investment.
As Warren Buffet said, “Rule #1: Never lose money. Rule #2: Never forget Rule #1.” Listen to Warren Buffet, and don’t lose money.
Instead, if you hold on to your investment, it will probably recover its value in a few years’ time, and then continue to generate returns for you – so you end up experiencing gains instead of losses.
The problem is that many people don’t distinguish between a paper loss and a realised loss.
When they experience paper losses worth tens of thousands of dollars, they believe they have lost money and perceive them as realised losses, causing them to sell their investments to cut losses and realise the loss.
The fact is that a paper loss is merely a loss on paper – you haven’t actually lost any money yet, because the money you seem to have lost can be recovered when the economy recovers.
So if this ever happens to you, just remember this: no money is actually lost until you sell.
- The longer you invest, the more likely you are to earn money
- The earlier you invest, the more money you can earn
- The more diversified you are, the less risk you bear
- Never sell when your investments are down
Hopefully, this post has given you a basic understanding of important concepts when it comes to investing.
If you’re a student or a recent graduate with no investments yet, I highly encourage you to start your investing journey ASAP.
The saying “time is money” has never been truer, and allowing more time for your money to grow will literally earn you more money in the future due to compound interest.
Even if you only have a few hundred dollars to invest, you should still do it.
Spending time in the market will allow you to experience market volatility and learn from any mistakes that you make so that you’ll be better prepared for the future when you have more money to invest.
You can check out this post for an introductory guide to ETFs.
Of course, only make your first investment after doing your due diligence and gaining the necessary knowledge. I’ll have a future post about how to get started with investing, so stay tuned!