Investing 101

Want to invest, but don’t know how? This blog post has everything you need to make a sound and sensible life-time decision that will change your financial life. The goal is to convince you to open a low-fee index fund account, invest what you can, and start earning 7% annually. In ten years, this means you double your investment. This strategy is so sound, you may already be unknowingly doing it through your retirement accounts.

Consider this the beginning of your investment journey, and know that time in the market is greater than timing the market. The key is to start early, ideally now!


Action Steps to Your First Investing Account

  1. Open an investment account, preferably with a robo-advisor. I use Betterment (my referral account: https://www.betterment.com/invite/muhanzhang) but Vanguard, Acorn, Wealthfront, etc. all work.
    • Most robo-advisors are just a pretty design for what is essentially Vanguard funds, just like most eyeglass and sunglass brands means your money in Luxottica’s pockets.
  2. Fill out your service provider’s questionnaire and go with their recommended distribution.
    • Note: To compare for those under 30, I invest 100% in stocks versus bonds.
  3. Deposit however much you wish to invest, and you’re done!
    1. Whether it’s $100, $1,000, or $10,000, the important thing is to start. As a lifelong habit, setting the infrastructure to invest today will make it so your money goes to a productive place by default when you have future savings.

If you’d like to be persuaded why these are the right steps to take, read on.


Context

Five years ago, I wrote an email to good friends with the subject line “The Next FrontierInvesting“. In it, I introduced the most critical fundamentals of investing that I had been researching, along with the theory and historical evidence to feel confident in making a decision. 

Subsequently, half a decade later, the takeaways from that email have remained true. In February of this year, the “Oracle of Omaha” Warren Buffet won a ten-year investing bet with a hedge fund, claiming he could outperform any fund they chose with his own choice of a large, low-fee index fund. The following quote, from his annual letter to Berkshire Hathaway, effectively sums up the rest of this post:

Buffett also sought to make it loud and clear that he doesn’t think the exorbitant fees that hedge funds charge are worth it.

Index funds, he argues, can outperform them anyway.

But many investors “experienced a lost decade,” he said. “Performance comes, performance goes. Fees never falter.”

This blog post is meant to be a turbocharged replacement of my “Investing 101” email from 2013. That email, which I have sent a couple of times each year, was written for friends who “know they want to start investing, but don’t know how.”

This topic, often being the first inquiry regarding money, seems a fitting topic for the first blog post of this site. 

Your Money or Your Life 

All investments follow the rule of risk versus reward. As the uncertainty of an investment increases, so too does the return demanded by the market of investors.

The question then becomes, how do you choose which investment to make? And at what time?

For most of us, our appetite for risk (and more importantly, hassle) is staid, at best. We want to make money, but also want to enjoy a comfortable quality of life: free from board meetings, cash flow analyses, articles on SeekingAlpha.com, etc.

In addition, while we want good returns, we are more afraid of losing what we have than “betting the house” and maybe, possibly dramatically increasing our wealth.

In essence, we know there’s “something right” to do, but we want that “something right” to fit our lifestyle, and not vice-versa.

A Random Walk Down Wall Street

In 1973, Burton Malkiel, a Princeton economist wrote the seminal book on investing, portfolio theory, and finance: “A Random Walk Down Wall Street.” Among many stunning conclusions, Malkiel concluded that no one, not hedge fund managers, private bankers, investment advisors, or anyone else with/without fancy credentials after their name, could consistently outperform market averages. In fact, the vast majority of investors would be better off investing in the entire economy (the quintessential portfolio from portfolio theory), something we can easily do via an index fund.

The insight draws on a truth we often like to forget: humans are animals. We have a very, very long list of mental biases, including but not limited to: confirmation bias, confusing correlation for causation, and falling for the sunk cost fallacy.

Concretely, this means that it’s highly likely for every time that certain individuals would outperform the market, those same individuals would also error more than the market. Buying too high (Bitcoin anytime in 2017), selling too low (the man who sold Victoria’s Secret for $1 million dollars when it later grew to $1 billion dollars in revenue by the early 90’s), holding too long (anyone who had a property or underwater home from 2008 to recently. That’s roughly a decade of growth and compounding interest lost due to an illiquid asset!)

What An Index Fund Does

Let’s use an example to try to help visualize this dynamic. In this example, we’re keeping the stock selections to U.S. based stocks.

Assume that you start off investing $10,000 in 2018. The capital is invested into every stock in the U.S., but for the sake of simplicity, let’s say it’s invested into four companies representing their sectors:

2018 Net Worth: $10k

  1. McDonalds (Food & Beverage), 2500 shares at $1 USD
  2. Facebook (Tech), 2500 shares at $1 USD
  3. Shell (Energy), 2500 shares at $1 USD
  4. Tesla (Automobiles), 2500 shares at $1 USD

After a year of investing, people stop caring about Facebook’s PR scandal. Tesla also figures out how to regularly make 6000+ cars for their Model 3’s. Their stocks rally and appreciate 20%. In the meantime, McDonald’s self serve kiosks haven’t saved them much money, and they can’t rebrand McCafe to be cool like Chipotle yet. They’re down 10%. Shell has a normal year.

2019 Net Worth (Pre Balancing): $10,750

  1. McDonalds, 2500 shares at $0.9 USD ($2250, 20.9%)
  2. Facebook, 2500 shares at $1.2 USD ($3000, 27.9%)
  3. Shell, 2500 shares at $1 USD ($2500, 23.2%)
  4. Tesla, 2500 shares at $1.2 USD ($3000, 27.9%)

This is where rebalancing comes in. At this point, the long term value investor would see that they’re disproportionately invested in Facebook and Tesla, so she would sell off enough and buy McDonalds and Shell to hit back to 25% distribution.

2019 Net Worth (Post Balancing): $10,750

  1. McDonalds, 2986 shares at $0.9 USD ($2687, 25%)
  2. Facebook, 2239 shares at $1.2 USD ($2687, 25%)
  3. Shell, 2687 shares at $1 USD ($2687, 25%)
  4. Tesla, 2239 shares at $1.2 USD ($2687, 25%)

What happens next year? Shell takes a hit as the installation of solar roofs has surprisingly high adoption (-15% to Shell), McDonalds buys Shake Shack and seem to have potential of becoming cool again (+5%), Tesla suddenly faces competition from Uber as their autonomous car division has early success (-10%) and Facebook successfully makes an online dating app though their market is reluctant to pay for it (+5%.)

2020 Net Worth (Pre Balancing): $10,344.98

  1. McDonalds, 2986 shares at $0.945 USD ($2821.77, 27.27%)
  2. Facebook, 2239 shares at $1.26 USD ($2821.14, 27.27%)
  3. Shell, 2687 shares at $0.85 USD ($2283.95, 22.07%)
  4. Tesla, 2239 shares at $1.08 USD ($2418.12, 23.37%)

Then, 2020 Net Worth (Post Balancing): $10,344.98

  1. McDonalds, 2737 shares at $0.945 USD ($2586.25, 25%)
  2. Facebook, 2052 shares at $1.26 USD ($2586.25, 25%)
  3. Shell, 3043 shares at $0.85 USD ($2586.25, 25%)
  4. Tesla, 2395 shares at $1.08 USD ($2586.25, 25%)

The important thing to remember is that while prices fluctuate, the shares do not. In this short 2 year example, even if you were to reset prices back to 2018 fictional prices, you’d still have 10,227 shares, so at $1 you’d still be winning.

In addition, while I chose four stocks to keep the math and balancing example simple, in reality your investing company will be simultaneously doing this across thousands of companies. That means you’ll be selling MoviePass stock when they started exploding to buy Experian for cheap when their passwords were stolen, Amazon starting Prime Wardrobe to buy Bank of America when they don’t sell enough mortgages for a quarter, MetLife highs when insurance claims were low to buy GM, etc.

This example also demonstrates that recessions are actually great opportunities to start investing, as that is when assets are underpriced and you can get more shares for your dollar. McDonalds dipping to $0.9 USD per share is what let you 16% more shares, which you then liquidated to buy more of Shell when it plummeted. When Shell (which represents the entire energy industry in this example) comes back up, you’ll then realize those gains to buy more underpriced assets.

Does this sound rational, tedious, and teetering on boring? That’s what John Bogle thought as well…

Low-Fee Index Funds

Two years after the publication of Malkiel’s “A Random Walk Down Wall Street”, John C. Bogle founded the Vanguard group. Today, Vanguard index funds are the gold standard of balanced investing. In 2017, the New York Times reported Vanguard growing their assets managed by $823 billion from 2014-2017, roughly 8.5 times more than all of their competition (roughly 4000 firms) combined. They’re so popular, you may already be investing through them – just check your provider for retirement investing at work.

How Vanguard distinguishes itself from thousands of its competitors in the mutual fund space was low fees. By integrating what we know from Malkiel (no individual or firm can consistently out-perform the market in the long run), Vanguard went one stop further in their business: since the majority of our trades will not meaningful move the needle on returns for investors, let’s cut the activity (and headcount,) save money on each of those trades, and pass those savings in the form of low fees to investors.

When you buy a index fund, you’re not choosing any particular company to win or lose. Instead, you’re betting that the index, generally some combination of all major economic activity across the globe, will become more valuable with time. Take that hypothesis and combine it with the savings in fees from the elimination of money managers and firms, and you’ve got the bedrock of a sound, investment strategy.

In Conclusion

Low-fee index funds are the gold standard of investing because they are:

  1. Dead simple
  2. Liquid (you can sell as little or as much to pay for college, a car, a wedding, etc.)
  3. Hassle free (no board meetings, maintenance, or obligations)
  4. Cost-efficient (as historically opposed to most mutual funds)
  5. Egalitarian and accessible to everyone (e.g. you don’t need to have a network of talent entrepreneurial friends to invest in)
  6. Built on time-tested principles, with strong returns averaging 7% compounding interest year after year in the long run (e.g. your money doubles every 10 years, which Buffet handily received with 128% return on top of 100% of his capital returned, versus the hedge fund.)

Intuitively, low-fee index funds also pass the common sense test: fundamentally, one should believe that things will be better tomorrow than today. While there are many valid, philosophical arguments for why the world is descending further into madness, most serious inquiry would be lead one to believe we are making tremendous progress on building societies for humans. For a more thorough argument, see Steven Pinker’s “Enlightment Now”, which makes this argument on the metrics of longevity, quality of health, freedom from physical danger, nutrition, and (apparently) 70 other charts.

Another more fundamental lesson we should withdraw from low-fee index funds is the importance of diversification. In addition to diversifying across firms, there are substantial advantages also to diversifying outside of the stock market. This includes certain real estate (a hard asset which the banks will loan you money to buy), private investment (in your own business, a friend’s business, or certain education for your career), and even philanthropy and the public good if we’re broadening the scope of investment and return (which this blog will humbly seek to do.)

Those topics will be explored more in depth on another day, but for those just starting out in the investment world, you can’t go wrong with throwing a few hundred bucks in a low-fee index fund.

Click to sign up with my referral code for Betterment. Even if you go with another service, let me know at mail@muhanzhang.com
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