Three Steps to Take Before Starting Investing

As most people know, investing is a smart thing to do. While you go out to work for the day, you’re happy knowing that over time, your money is working for you too.

Especially with uncertainty over the future of state pensions, investing is a subject that is becoming more important for financial security and freedom going into retirement ages. According to Andrew Craig in his book How to Own the World, anyone under the age of 50 should assume that the government will be in so much debt by the time you retire, that they will no longer be able to offer you a state pension.

But before you jump in with two feet, what are a few things you should make sure of before you start your investment journey?

Pay Off Any Non-Student/Mortgage Loan Debt

There’s no point investing until you have paid off any debt that isn’t from your student loan or mortgage. The reason being is that some types of debt such as credit card debt have high rates of interest. This means that even if you are making a solid 10% return on your investments, you will be paying 20%+ interest rates on your debt – basically placing yourself on the wrong side of compound interest.

Build An Emergency Fund

The last thing you want to do is have to sell your investments because you lost your job or an unexpected expense came up, so before you start investing make sure you have a comfortable amount of cash in a savings account as a security blanket. Selling off your investments can increase your investment fees, but it also encourages you create a habit of doing it in the future too, which can lower your investment returns for years to come. Six months to a year’s worth of expenses should be ample in an emergency fund.

Create An Investment Plan

It’s not wise to just wing it when it comes to investing. Figure out which investment vehicles you want to put your hard-earned money into, and decide what your psychological risk tolerance is. The key is to create a plan and have the discipline to stick to it. Decide the frequency and the amount you will be investing, and how diversified you want to be – whether to buy stocks, bonds, commodities, real estate, precious metals or even cryptocurrency. A lot of new investors will dabble in certain investments, and withdraw their money as soon as any losses appear. The investor that has a solid plan will be able to ride out any market uncertainties because they have already rehearsed beforehand what they would do in that situation.

The Permanent Portfolio: How to Invest Without Losing

The biggest fear people have when thinking about investing is that they don’t want to lose any money. If you were to do some number-crunching: if you lose 30% of your investment, you need a subsequent 42% gain to recoup your losses. If you were invested into the S&P 500 in 2008 when it lost 50% of its value, you would need a 100% increase to get back to where you were. Seems a little unfair right? But that’s why it’s called the break-even fallacy. This phenomenon is probably why Warren Buffett’s number one rule of investing is simply: “Don’t lose.”

Now that we know how important it is not to lose while investing long-term, how do we go about it?

In How to Own the World, author Andrew Craig outlines a simple portfolio that has only five losing years in the last 37, the worst being only 5.3%. The portfolio even had a positive year in 2008, the same year where the whole world was in financial crisis. The portfolio had an average 7.5% annual gain over the last 37 years.

It might not seem a lot to average 7.5% per year, but putting $100/month in this kind of investment would bring you $17,957.60 after 10 years, $55,500.52 after 20 years, $134,428.85 after 30 years, and $300,363.77 after 40 years. If you just kept the cash you would have amounted to $48,000 in that time. Even worse, if you spent that extra $100/month you’d have $0 after 40 years.

This asset allocation was created by Harry Browne – his idea being that if you owned a diverse range of assets, you should always have something that performs well.

The allocation is:

  • 25% stocks
  • 25% long-term US bonds
  • 25% gold
  • 25% cash

The reason why this combination works so well in managing risk is that these asset classes thrive in different market conditions. Gold is a good bet in times of inflation, while stocks grow in line with economic growth. Bonds are useful to own in times of lower than expected inflation or lower than expected economic growth. Cash gives you liquidity, no fees, an albeit small interest rate, and stability when the others lose value.

The advantage of this type of portfolio is the simplicity – you will only need to buy into two or three different funds and rebalance periodically. Even better, you won’t have to manage your emotions as much because there will be much fewer losing years than with most other types of investment portfolio.

Ronald Read: The World’s Most Unexpected Millionaire

On June 2nd 2014, a 92-year-old man died in Vermont. His name was Ronald Read, and he was a retired janitor and gas station attendant. His favorite hobbies included wood-chopping and stamp-collecting. He grew up having to hitchhike to school, and served in the US military during World War II. He liked drinking coffee, and English muffins with peanut butter.

Soon after he died, Read’s name was all over the news headlines. In his will, he left $2 million to his two stepchildren and gave $6 million to his local hospital and library. Where on Earth did a retired janitor and gas station attendant get all that money from? He had lived frugally, and purchased blue-chip stocks throughout his working life. And then he waited, reinvested his dividends and watched his portfolio grow. By the time he died, the value of his holdings amounted to more than $8 million. Read went from janitor, to gas station attendant, to the greatest philanthropist his town had ever produced.

This story just demonstrates that wealth-building comes more from saving and investing than on income. Forming the habit of paying yourself first, and funding investment and savings before paying for expenses is probably one of the most valuable skills I have learned in the last few years. Many people postpone saving and investing for when their income rises to a particular level, but in reality when earnings increase it’s much easier just to spend the equivalent increase in money instead of growing wealth.

It also shows that pretty much anyone in the Western world can achieve this level of wealth, insofar as they live long enough and stay disciplined enough. The capability of the compound effect in investing is so powerful, but only when enough time is given to the compounding process. $82.6 billion of 90-year-old Warren Buffett’s $85.6 billion net worth came after his 65th birthday. And that’s not because he got way better at investing after 65, it’s just the absurdity of the compound effect.

The Intelligent Investor: Insights From Benjamin Graham

“Don’t tell me what you think, tell me what you have in your portfolio.”

Nassim Nicholas Taleb

I recently read The Intelligent Investor by the legendary value investor Benjamin Graham. Known as the most complete guide to investing ever written, his wisdom has stood the test of time. His legacy lives on not only in this book, but in his students such as the mighty Warren Buffett.

The book is extensive and can be tough to digest at times, but it was well worth reading and I learned a lot.

One of the key lessons I learned is that you cannot sensibly become an enterprising investor unless you are willing to read a company’s annual report. An enterprising investor is one that picks specific stocks and buys them for a price that they deem is good value. The only way they can do that reliably is by perusing through several years’ worth of annual reports with a fine-toothed comb, looking for information to judge whether the company is undervalued or overvalued in the stock market. Even then they could still be wrong and end up losing money.

The good news is that I can become what’s termed a “defensive investor”. It doesn’t sound nearly as cool, and there’s no longer the possibility of bragging to your friends about picking winning stocks, but it is much less risky and takes much less time. Defensive investors usually buy a combination of low-cost index funds (groups of stocks that follow the entire market such as The Dow Jones Industrial Index or the Standard & Poors 500 Index) and bonds from governments and companies.

I was 15 years old the first time I was introduced to the idea of the stock market in my Statistics class in school. We were asked to go on the Internet and pretend we were investing in some stocks. I looked on the Dow Jones list and I remember just choosing the companies that had the green numbers next to them – the stock price was going up. If a stock price was going up, I could sell the stock a week later and win the competition of getting the highest profit in my class. But I was in for a shock.

The next week, I logged back in to find that not only had I not got the highest profit in the class, I had lost money! Unfortunately this is the reality for many wannabe traders who don’t do their homework.

That formative experience gave me a couple of conclusions – The stock market doesn’t extrapolate well, and I don’t understand the stock market. But there’s no shame in that, very few people do. No person on Earth knows what the market will do next.

One of the biggest lessons in The Intelligent Investor is the importance of not losing money. It takes a lot more time to recoup losses than it does to increase the investment by the same amount. People that lost 90%+ of their money when the dot-com bubble burst in 2000 still would not have been able to break-even over 20 years since. So how can you be in the market as a defensive investor but lose as little as possible?

Graham recommends a combination of bonds and index funds in a 50-50 split. If the investor is feeling bullish (optimistic) about the market, he can go up to a maximum of 75% index funds. If he is feeling bearish (pessimistic), he can increase the bonds proportion up to 75% instead. The diversification of the bonds and having shares in all the companies in an index such as the S & P 500 will shelter the investor from undue losses.

In March 2020 the stock market dropped significantly and the market value of my investments dropped several thousand dollars. With a global pandemic looming and plenty of uncertainty, I took most of my invested money out of the market. I had turned an “unrealized” paper loss into a “realized” loss. This turned out to be a big mistake, as I missed the gains I could have had on the subsequent recovery of the market to an even higher level than before.

The biggest lesson I learned from that experience is that my risk tolerance wasn’t as high as I thought it was, and it had changed over the years as my investment fund got larger. I had sensed this in the back of my mind for months on end, but I didn’t do anything about it because the market was steadily going up at the time.

Another lesson was that the more often I check my investments, the worse decisions I will make. I use a robo-investing app that rebalances my portfolio and gives me the option to automate my contributions to my fund, so there’s no real reason I should be logging in if I don’t need to. Checking investments frequently is the equivalent to appraising your house all the time, even if you don’t plan to ever sell it.

Another important thing to consider is how much money do I need in savings before I put money into investments instead? Money in savings accounts will track the rate of inflation at best, and at worst it could be losing value if inflation rates happen to be high. Over the long-term, money invested will beat the rate of inflation and will be worth more when you eventually decide to use it. This doesn’t mean that all spare money should go into investments. If you are saving for a deposit on a house, it’s better off in a savings account. Emergency funds (12-24 months of expenses) should also be in savings in case of a loss of job or a sudden large expense.

One insight The Intelligent Investor brought to me was that everyone that invests is obsessed with beating the market. But what’s actually important is asking: “Do I have enough money for my life goals?” It can be so easy to get lost in the numbers and forget what you’re actually wanting in life.

Since starting to use a robo-investing app over the last couple of years, I have noticed that it is way more fun to save and invest. Even if (or should I say when?) I end up losing a significant proportion of my portfolio again, I can be grateful in years to come that I took the conscious decision to take responsibility of my finances.