8 Things Every Beginning Investor Should Know
1. Investment Costs Count
When it comes time to allocate money, investment costs are of the utmost importance. Many first time investors will pick an actively managed mutual fund with the best-looking brochure and sales pitch. Usually, these funds are packed with expense ratios over 1% of assets. For an inexperienced investor, 1% might not seem like much to pay in return for somebody else investing his money. However, these investment costs eat away at an investors’ money and when compounded, take a large percentage of potential returns out of the investors pocket and into the hands of the investment management company.
Think of your investment account as a glass of water. In order to reach your financial goals, you will need to fill the glass to the top. Investment costs can be illustrated as a hole in the side of each glass. The larger the costs of owning a fund, the bigger the hole in the glass is. When the glass is getting filled with contributions and gains, there is a percentage that is going out the door to the investment management company. The purpose of this analogy is to illustrate that in order to reach one’s financial goals, one is going to either have to contribute more money to make up for the extra costs incurred or are going to have to achieve outsized investment gains from their current portfolio. As history indicates, the former is a more likely scenario, and one that can cost investors thousands of dollars over time.
2. You Don’t Always Get What You Pay For
There is a common belief that when it comes to investment management, the higher the expense ratio a mutual fund has, the more skilled the manager is. This is simply not true and this misconception has helped the financial industry reap great riches from unknowing investors.
Actively managed mutual funds almost always have higher expense ratios than index funds. While it certainly is nice to believe that a Harvard educated portfolio manager will have no problem outperforming an index fund over a long period of time, it is very rare when it happens. You will never see an index fund ranked in the top 10 mutual funds in Forbes or Fortune, but over the course of 15 years or more, they historically have achieved better returns than the majority of actively managed funds. Food for thought: The Vanguard 500 index fund outperformed 60% of actively managed mutual funds over the past 10 years.
High management fees also come with funds that involve exotic investment strategies, but that do not always pay off. For example, hedge funds increased in popularity in the early to mid-2000s. Many of the pioneers of hedge funds were able to achieve great returns for their initial investors. The early success the funds inspired numerous imitators to follow suit. The management costs were the same, if not higher, but the results were less than stellar.
3. Not All Investment Advisers Are Created Equal
There is another belief that all investment advisers are equally knowledgeable. While there are many excellent advisers that have a client’s best interests in mind, there are many more that do not behave ethically. Perhaps the most important question to ask a potential financial adviser is how they will get compensated. There are a few different types of investment advisers: fee-only, fee-based, and commission based.
To beginning investors, fee-only financial advisers seem like the most costly. These advisers charge a set rate, typically $100 or more an hour in exchange for their financial expertise. Ironically, though they initially appear to be the most expensive, fee-only investment advisers are usually the cheapest. Fee-only advisers make money regardless of whether or not an investor actually takes the adviser’s advice. The fact that fee-only investment advisers get paid regardless if you take his or her advice allows them to make impartial and unbiased investment recommendations.
Fee-based financial advisers are different from their fee-only counterparts because they get paid a percentage of an investor’s assets. This allows them to make unbiased recommendations, but an investor usually ends up paying dearly for their services. A typical fee-based adviser charges at least 1% of assets annually, which would be $2,000 on a $200,000 portfolio. Just to reiterate the last point, the percentage of assets is charged every year, a pretty steep price to pay for financial advice.
Commission based financial advisers are to be avoided at all costs. While many of them are probably decent people simply trying to earn a living, they are harmful to an investor’s financial well being. The reason being is that they will not have your best interests in mind. Commission based advisers are salespeople who push financial products and get paid a commission on the products sold. Many times these advisers will either try to put clients in actively managed mutual funds with high expense ratios or even try to sell them variable annuities or insurance products loaded with high costs and hidden fees. Using a commission based financial adviser is akin to committing financial suicide.
4. Individual Stocks are For People That Know What They’re Doing
Many beginning investors are intrigued by the possibility to build their portfolio by buying individual stocks. While it certainly is exciting to research and purchase stocks, it is very difficult to beat the market averages over an extended period of time. Legendary investors Warren Buffett the CEO of Berkshire Hathaway and Peter Lynch, the former portfolio manager for Fidelity’s Magellan Fund, were able to consistently beat the market. While it certainly ambitious to believe that their feats can be matched, beginning investors are better off investing in low cost mutual funds. In fact, in Berkshire Hathaway’s 1996 letter to shareholders, Warren Buffett writes:
Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees
and expenses) delivered by the great majority of investment professionals.
When the greatest investor of all time is saying that beginning investors should own index funds, it would be prudent to take his advice.
5. Bear Markets are Great Buying Opportunities
When the stock market retreats, quite a few investors become frightened and reduce their equity holdings. Sometimes the excuse given is to hold and wait until the market rebounds before I invest additional money, it’s currently too risky, or comments along those lines. This line of thinking ensures that an investor will never buy low and sell high. Bear markets offer attractive entry points for many securities and mutual funds, but often times there is a large contingent of investors that are too timid and lack the conviction that the market will return to previous price levels. In fact, waiting until the market recovers guarantees that an investor will miss out on the price appreciation that occurs during the recovery! As a beginning investor, taking advantage of the buying opportunities a bear market offers will help you out immensely.
6. Invest Regularly
Investing a certain amount of money on a regular basis is the best thing an investor can do for his portfolio. When a person contributes a set amount of money regularly into the same investment, what occurs is called dollar cost averaging. Important to note is that not all people agree with dollar cost averaging, instead preferring to invest their money in what they deem to be the most attractive current opportunity. While there is no right answer as how to invest the funds, it is imperative to invest regularly.
Sometimes people believe there is no point to investing if they only have small amounts to invest at a time. This belief is nonsense, as many fortunes have been made by people willing to start their investment journey with a only a small amount of money. There are many different resources for beginning investors who cannot afford the high minimums that some financial firms require. Sharebuilder offers no account minimums and $4 trades. There is also another way to purchase shares for little to no cost directly from companies. Dividend Reinvestment Plans (DRIPs) allow investors to purchase shares directly from companies for little or not cost. Over time, small contributions, with the help of dividends, can add up to large account balances. For more information about whether a certain company offers a DRIP, go to their websites and search around their investor relations section. Not all companies offer these plans, but those that do usually offer investors a way to accumulate shares without incurring a lot of transaction costs.
7. Past Performance Is No Guarantee of Future Results
Many beginning investors are guilty of what is called performance chasing. When an investor picks a fund based solely on its historical performance, he is predicting that the fund will perform just as well in the future. There is a reason that when mutual funds show the historical results, the disclaimer past performance is no guarantee of future results is shown underneath it. It is very hard for mutual funds to replicate success over an extended period of time.
One reason not to partake in performance chasing is because as a fund achieves stellar results, more money flows into the fund. While this may appear meaningless, the portfolio manager will now have to find investments for a larger amount of money. This is difficult because the manager will have to find more ways to allocate capital, potentially driving up share prices in the process. Thus, it will be harder for the manager to acquire and divest shares at desired prices, which negatively affects fund performance and thus makes it more difficult to match its historical results.
8. Be Aware of Hidden Fees
The financial industry thrives on there not being a lot of transparency on fees. Actively managed mutual funds are notorious for not only having high expense ratios, but also other hidden fees and costs. Three things a beginning investor should consider before investing in a fund are:
1. Loads : There are front-end and back-end loads, also referred to as deferred sales charges on shares of certain mutual funds. These loads are in addition to the mutual fund’s annual expense ratio, and can be as high as 8.5%. Selecting a mutual fund with the maximum sales load means the investment has to increase by 8.5% just to break even!
2. 12b-1 Fees : These are fees paid by the mutual fund to cover marketing costs. When a mutual fund prints out glossy new brochures in an attempt to attract new investors, the current shareholders are usually the ones paying for it.
3. Turnover : This is a very real cost that is not published in a fund’s prospectus. The transaction costs that portfolio managers incur while buying and selling shares are paid for out of a fund’s assets. Naturally, the more turnover a mutual fund has, the more it will pay in transaction costs.
Good luck investing!
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