3 Things to Know Before Investing
Investing in the stock market has always been a tool for people to save and grow their wealth in the long run. Unfortunately, short-term bias and get rich quick attitude is a major obstacle to long-term investing success. Even if one tries to remain rational and think far ahead, the news outlets would not forget to mention someone making millions of dollars ‘YOLOing’ on stock options. These types of investment returns where someone makes 10x or 100x in a short period are extraordinary and rare. Not everyone will experience similar returns on their portfolio unless they invest in the long run. But we are humans, so when we hear about someone making a lot of money, we can’t help but try to see ourselves in their position, and by doing so we take similar risky bets, which most of the time do not pay off.
I think there are three important things that first-time investors must know as they might help with fighting against the short-term bias in markets.
1. Choose Active or Passive
In investing, there are many types of investors, whether it’s value investors, growth investors, contrarian, etc. But I would just lay my emphasis on active and passive investing. Active investing usually refers to doing your research and picking stocks on your own, while passive investing involves just investing in an index fund or something similar. Warren Buffett is a big proponent of index fund investing in the long run.
You might encounter some confusion on whether you should do passive investing or active investing. I would simplify the confusion. Before you begin investing ask yourself this question, “If the market returned 10%, so your money compounded 10% as well, but would you have any regrets if you had done active research but only compounded 8% yearly?”
It seems like a simple question, but it addresses the dilemma regarding passive and active. If you are fine doing your research and spending numerous hours on it, then active investing might not be a bad idea. But if you just want to maximize your returns and it’s hard for you to not regret the potential returns you missed out on by just sitting and investing in an index, then passive investing is a preferable option.
2. Past Returns Will Not Reflect Future Returns
This is a simple point to make, and everyone understands it, but few can appreciate it. The past returns in the market do nothing to predict future returns. This notion that stocks go up, in the long run, is true, but in the short run, when the market valuations deviate from historical averages, it will tend to correct itself. It is important to not expect that the market will always go up to double digits. The historical average yearly return is somewhat near 8%, and a period of high valuation is usually succeeded with a period of single-digit yearly returns for the next decade. I would recommend people to read “Irrational Exuberance” by Robert Shiller to understand the historical timeline of the markets.
3. Risks of Margin Trading
If you are new to investing, you probably heard the term margin trading when you tried signing up for a brokerage account. Margin investing is basically borrowing money from the brokerage to invest money in the markets. It seems a simple concept, just like as you borrow money to buy a house or a car. The risks associated with borrowing money to invest in the stock market is different than using the same for a house or a car. Mortgages or car loans are usually based on your income and ability to pay. As long as you’re paying your bills, you won’t have much problem with the lenders. But in a case of margin trading, the money you have to pay up depends on the market fluctuations. In good times when the market is up, margin trading helps you increase your return.
When the market goes down, or if your stock goes down, then you are required to put collateral (money) to satisfy margin requirements. This means you need to pay your brokerage to ensure that you have enough money in case your stock is losing money. The 1987 market crash is partially blamed to be cause by excess margin trading. So, just be careful with margin trading. It is an interesting way to increase returns. But remember there is no such thing as free lunch.
While these 3 points are not the only things you should keep in mind while investing, I think during this unusual time around the stock market, these 3 are more important to consider, especially for people who haven’t invested before and are hearing ‘success’ stories, whether it is from media or friends.
** This is not financial advice