Letter to an Emerging Dabbler - VRK100 - 28Jul2021

Letter to an Emerging Dabbler  

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Dear emerging dabbler,

Happy to note that you've taken a plunge to start your investing life and my congratulations to you!

The best way to start investing is start investing immediately!

I'm not being flippant.

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Read more: Fed Tapering is Postponed

Related post: Letter to a Dear One on What to Know Before Dabbling in Stocks

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Start your investing journey forthwith provided you've surplus money to spare. What I mean by surplus money is you've not borrowed that money. Borrowing money for investments is not investing, because borrowing is a mental burden and it adversely affects not only your personal life but also your investment returns.

The earlier you start investing your surplus money, the better. Warren Buffett started investing when he was just eleven years old. Of course, we can't and shouldn't compare ourselves with him.

First things first: Here I use the word 'you' very often. I use it in a general sense and for the sake of easy flow of writing. Please pardon me if you feel I'm giving you basic 'gyaan' here which you may be knowing already.

Financial Planning

To start with, why do you want to invest? Do you want to make some extra money from your investments? How much return do you want to make from them? How long do you want to hold  them? It's better if you can write down your goals of investing on a piece of paper or a digital medium.

It's quite likely you're having certain financial goals--like, you may want to invest for buying some things like a car or a house, or you may want to invest for your retirement, or for your children (kids cost money!) or their education, or you want to travel extensively, or you want to do some charity, or you want to spend on  improving your skills. For most people, it's a combination of these things.

Basically, we want to improve our lives. We want to live in our way, without harming our neighbours. Of course, human species are inter-dependent. We help others and take help from others also. In general, having sufficient money gives us freedom to do what we want to do with our lives. What is sufficient? It's a million-dollar question, as they say!

First, you start with your life plan, then you go on to your financial plan and then comes your investing plan.

Investments are to be part of your financial planning. Financial planning covers your investments, your loans, your life insurance, your health insurance, your credit score, your bank accounts, paper work, and others.

As you know, debt ruins peoples' lives. I'm not advising you to shun debt completely. Use it if its benefits are greater than its costs. But at certain point of our life, we should be debt-free. I can't help quoting Shakespeare here: "Neither a lender, nor a borrower."

Importance of Human Capital

What is the best investment? The best investment is investing in yourself! I'm not exaggerating. It's true. The highest reward will be from investments, like time, effort and money you spend in your life on things that are most important to you. You need to constantly improve your skills, for the world is changing too rapidly to depend on outdated competencies.

What does history tell us about people who are highly successful in money making? Some have plundered others (for example, feudal landlords, kings, kingdoms and Russian oligarchs), some have converted wonderful ideas into wonderful products and services (Bill Gates or a Dhirubhai Ambani or a Jack Ma), some have worked for companies (like Sundar Pichai), or others have excellent artistic brains (like a Picasso, a Steven Spielberg or an MF Husain).

Money making is not the ultimate goal. It's a key part of our life though. It gives us freedom and security.  

Your capital is a sum of human capital and financial capital. Your human capital is the present value of all your future earnings. In the initial stages of your career, your human capital will be high because you have a long career of 30 or 40 years, depending on the individual situation. And for many middle class guys, financial capital will be low to start with.

As you age, your financial capital increases, while human capital comes down. For example, human capital of a 30-year-old person will be much higher than a 45-year-old guy, assuming other things remain the same--simply because, the 30-year-old guy has more years of working or productive life.

As stated, financial capital moves in the opposite direction. Under normal conditions, you start saving and over the years your financial capital starts increasing provided you're investing those savings intelligently.

In the initial stages, you should focus more on increasing the potential of human capital. As your financial capital starts growing from your savings and investments, you need to get a better grip of money management. During your mid-career, it's as much important to make money as it's to preserving the money you saved and invested.

You're better off using both these capitals to your advantage. Improve your skill sets constantly. And exploit the best possible avenues to make better and optimal returns from your financial capital. In my opinion, there is no single best way to exploit these two sets of capital. As the Buddha said, you need to find you own path.

Basic investment principles

Before making investments, please check how does a financial product you're considering scores against the basic investment rules given below:

1 Safety and risks
2 Liquidity
3 Convenience or ease of access
4 Taxability
5 Long or short term
6 Return

These basic rules are important, because without them we'll be like blind people walking on a treacherous path.

Please check my tweet dated 12Feb2019:

Let me elaborate the above points briefly.

1. Safety and risks:

We should not lose money in investing. When we lose money initially, it changes our investment behaviour. The mental suffering in losing money is more than the pleasure of making money. You may have made millions of dollars from your investments, but if you lose, say, 10,000 dollars, you feel bitter about the losses, losing sight of the gains you made.

Our biggest enemy in investments is our own behaviour. We buy when everybody is buying and we tend to sell  when everybody is selling. And this investment behaviour has not changed in the last 400 years of financial markets history. 

Greed and fear dominate markets. Very few people have mastered them in financial markets. Even Newton lost money heavily in stock markets due to greed.

We human beings want to avoid losses. But that doesn't mean we stop investing for the fear of losing money. We should consider risks properly and then invest. As they say, safe is risky. 

In life, there is opportunity cost for everything. By not investing in risky investments like stocks, you make poor returns and suffer the consequences of those returns.

I'm not telling you to throw away caution and start dabbling in stocks or mutual funds or other risky investments blindly. You read about stocks, companies and markets; and you start investing slow and steady. Over a period of time, you build up your knowledge and the results will show up.

Check whether your bank checking account is federally insured. The Federal Deposit Insurance Corporation (FDIC) of the US provides a deposit insurance of USD 250,000 per depositor. (My tweet dated 25Sep2019)

Keeping money in a checking account is very safe, because it's insured up to the limits mentioned above. As they say: A ship in harbour is safe, but that is not what ships are made for. We need to channel that money in checking account properly to other accounts for better returns.

2. Liquidity:

Some investments are illiquid, like real estate, land and buildings. When you need money, you can't convert them into cash immediately. The balance in your checking or savings account is easily encashable--I mean you can withdraw it whenever you need the money. 

The money you save in your stocks or mutual funds is also liquid, but you may have to wait for three or four days to encash them.

The money in your retirement plans, like 401 (k) or Roth IRA is illiquid. You cannot withdraw the money in those accounts until retirement. But subject to certain conditions, IRS (Internal Revenue Service) allows partial withdrawals for certain emergencies. 

Even among stocks, some stocks are more liquid than others. Stocks like, Amazon, Alphabet or Reliance Industries are very liquid, because millions of shares are traded in those stocks on a daily basis.

Depending on your financial goals, you need to keep some of your money in liquid investments and the rest of it in illiquid assets. One advantage with illiquid assets is the temptation to draw money dies down. Otherwise, you tend to withdraw money if it is easily accessible and encashable. It's better to spread your assets / investments across liquid and illiquid ones.

3. Convenience and access:

Your friend is telling you the best investment opportunities are available in North Dakota. She wants you to buy real estate there. But is it convenient for a guy or girl in California to invest in real estate there? Can you go there frequently and monitor those investments? 

It's definitely okay for a real estate firm to invest across America, because they have people to take care of investments anywhere across the continent.

But we individuals can't afford such decisions. We want to access our investments without spending too much time on them. I've seen people buying properties wherever their career takes them. After some years, how will they manage properties located, say in Bombay, Amsterdam, New Jersey or Dubai? 

How do they collect rents, or how do they find new tenants or get repairs done? They are practical problems. In several cases, we can't even collect rents properly.

Of course, these days we've several options, especially with financial assets. Everything is available online or on a mobile app. It's more convenient with the advent of new technology. That doesn't mean you open checking accounts in ten banks or savings accounts in five banks, and have dozens of mutual funds and score of individual stocks.

The ideal thing is to have as less contact points as possible for better control of investments. It's not desirable to have dozens of logins and passwords to manage our financial investments. Of course, we should not keep everything under a single financial company or a bank.

4. Taxability:

Taxes kill our investment returns. As such, every investment should be considered based on tax aspects. Of course, we should not bother too much about paying taxes. We can defer taxes, we can avoid them (of course, legally), and we can use tax advantages to the optimum.

You can use a combination of 401 (k), Roth IRA and Roth 401 (k) plans for enjoying better tax benefits, without earning the wrath of IRS. Taxability is one of the key parameters, not the only factor to consider while investing.

5 Long or short-term:

While making investments, you should decide how long you wish to hold them. Are they for short- or long-term? As you know, you need to keep some money in short-term vehicles for emergency purposes. For middle classes, it is suggested six or nine months' salary is necessary as emergency fund.

In the US, people keep money in savings accounts for short term purpose, or they keep money in certificates of deposits (CDs). They also invest in other avenues, like, mutual funds, ETFs or exchange-traded funds, REITs or real estate investment trusts. Some REITs are traded on stock exchanges.

At the other end of the spectrum, you keep money in retirement plans for long term. The US citizens keep their long term money, in general, in retirement plans such as 401 (k) and Roth IRA.

6. Return:

And now comes return. I've deliberately kept this item at the bottom. Because we common people should not bother too much about return. If your investment process is right; you have allocated your money to different asset classes as per your goals, return and risk preferences; you've diversified your investments well; you're monitoring them properly at regular intervals convenient to you; you're reviewing them now and then and tweaking them; then returns will automatically come.

Novice investors unnecessarily focus excessively on returns. And as you rightly guessed, they make poor returns. Financial markets' history reveals that the best returns are achieved by people who've forgotten about their investments! I can give you plenty of examples. However, you should review your investments and monitor them at proper intervals.

Some people advocate buy-and-forget approach to investments. In practice, it doesn't work. The world is changing too fast for our minds to understand it. Disruption is everywhere. We need to be on guard.

Investment Process

Investing is a process, it's a journey. It's not a destination. You make mistakes in the process, you correct them and move on. Again, you make mistakes, you review your process and make adjustments as per the prevailing situation and you restart.

We need to treat our investments in a holistic manner, not see them as piecemeal. Based on the six basic investment rules mentioned above, you could start making investments in different asset classes. You decide your risk appetite, consider your time horizon, take care of personal circumstances and then start your investments.

The key features of an investment process are asset allocation, portfolio diversification, monitoring, rebalancing and review. You've different assets classes available to invest. At one end, you've stocks or equities, REITs and others; and at the other end you've bonds or fixed income. In addition, you've precious metals like gold and silver, other commodities, international stocks and bonds.

You need to have an ideal asset mix that is asset allocation. One year, stocks do well; the next year gold does spectacularly and the third year bonds give the best returns. Which asset class will give the best return in future nobody knows. Hence, we need a mix of asset classes in our portfolio.

Like a South or North Indian 'thaali,' you spread your investments in difference asset classes. As with food, there is no one size fits all. Depending on your personal situation and risk appetite, you can choose your own asset mix. The idea is not to speculate uselessly on which stock will become next Amazon or next Infosys; the idea is to have a balanced diet suitable to our body.

Investment asset classes are stocks; bonds; cash; commodities like gold, silver, industrial metals, agricultural commodities; REITs (real estate investment trusts); and others. But what is relevant to small individual investors that have started their investing life anew?

House or home is the most important of one's personal net worth for many people across the globe. But I think for most middle classes, buying a home right away is not the ideal thing.

You've listed stocks and unlisted stocks. Stocks are one of the riskiest investments and within stocks, unlisted stocks are riskier than listed stocks. (Listed stocks are stocks that are traded on stock exchanges, which can be bought and sold very easily. Unlisted stocks are basically investment in private companies or start-ups.) For most novice investors, listed stocks are the preferred ones, in the overall scheme of things.

What to invest in (asset class) is different from where to invest the surplus (asset location). Please check the section 'Investments in the US' given below for asset location. Assume you've decided to keep 60 percent of your surplus money in stocks. Do you want to invest the entire money in a single stock or do you want to spread the money you allocated for stocks in different stocks?

Putting all money in a single stock isn't advisable. Hence, you need diversification. I mean a well-diversified stock portfolio. You can start with five or ten stocks and move gradually over four or five years to 15 or 20 stocks depending on your comfort and experience.

It's better if you keep most of your equity allocation in equity mutual funds instead of picking up stocks directly on your own. Direct investing is fraught with more risks, but knowledgeable people can do direct investing provided they have sufficient money to choose the right stocks and monitor them closely without losing patience and long term orientation.

Long term orientation and patience are very important if you want to make money in financial markets. For most savvy and long term investors, the biggest returns come from waiting patiently, without losing their temperament.

Ask your friends or colleagues in your office and check whether the products or services they  are using are relevant for your financial situation. Review your investment plans every year or half-year depending on your convenience. Because you need to figure out what works for you.

In the US, there are a variety of platforms to start investing. Please check with your friends and colleagues. Or consult a registered financial advisor.

If you want to invest in stocks directly, you need to learn a few things: basic accounting principles, how to read a balance sheet, how a company is making money, how the industry is doing, what are the prospects of the country in general, do I have the right mindset to hold when all the people around me are selling stocks like crazy, can I tolerate a loss of 50 percent in a short time of say six months or a year, and others.

We've different time horizons, risk appetite, wants, aspirations, needs and emotional triggers. Getting to know about investment risks is the first step in investing. As you know, there is every chance we would lose 50 percent money in a short time of say six months or less than a year. 

We need to be prepared for such sudden and violent losses. Company managements indulge in fraud, like, they did it with Enron. Governments confiscate assets of companies, like, they did it in Venezuela. Whole industries suffer from disruption, like, wholesale retail in Amazon's hands.

As stated above, we should not be afraid of losses. What I stress is we need to be prepared mentally for all eventualities. Mistakes do happen in investing, but we need to ensure that our mistakes don't ruin us completely.

I've seen many people making excellent returns for 15 years. And suddenly in the 16th year, they blow up. I mean they blow up everything they've made in the past 15 years. To know about this, you better read some history--the Great Depression of the 1920s / 1930s and the Global Financial crisis of the 2007/2008, or even the stock market crash of 1987.

If you have patience, avoid the bad impact of greed and fear, focus on long term, hold a well-diversified portfolios across several asset classes; your chances of survival are more than 80 percent in financial markets.

Every two or three years, you can review your investment process and make necessary changes. Nothing is cast in stone. The idea is to have an investment process automated most of the time, but which can be tweaked periodically for optimal results.

You may find some of my articles useful:

Letter to a Dear One on What to Know Before Dabbling in Stocks 02Jan2010

Diversification 29Sep2013   and  Benefits of portfolio diversification 28Sep2013

Importance of Asset Allocation 28Sep2013  and  Speed Read 28Sep2013

What are Asset Classes 28Sep2013

Five Golden Rules for Investors 28Sep2013

Five Questions to Ask Before Investing 12Sep2013

A Book for Starters

I strongly suggest you read Ramit Sethi's book "I Will Teach You To Be Rich." This is a very good book for starters. Don't bother about the title of the book. The title is usually given to market the book. However, the contents of the book are good. (I've read it.) The book contains some actionable points for US-based investors.

This is the weblink for this book. Please make sure you're buying only the edition meant for US people. There is an edition for UK-based ones, which may not be suitable for US investors for obvious reasons.

Since my younger days I used to say money is like a king cobra, it's capable of poisoning human relationships. I strongly believe humans are basically good at heart and I want to die with such a noble thought. But in real life, there are sharks and cobras everywhere. If such crooks know we're strong and vigilant, they don't dare strike us. Hence, the need for constant vigilance and guard.

Financial advice is problematic, advisors have vested interests. They want to make money off your ignorance and your greed. They often charge high fees, without any value addition for the investor in most of the cases. Some financial advisors or advisory firms have platforms for investing. There are also mobile apps.

The earlier you start, the better. As suggested in Sethi's book it's better to autopilot your investments from your checking and savings accounts. Automated systems work well, even if you're lazy with your investments. Once you finished reading it, you alert me--I'll suggest other good books.

You can follow a combination of active and passive investing. Active means investing directly in stocks and bonds. Passive means investing through mutual funds and exchange traded funds (ETFs).

Human behaviour

Your temperament is more important than your knowledge or skill while investing. Luck plays a key role in earning superior investment returns though we always deny the role of luck in our lives--investing or otherwise.

Long term orientation is very hard to practise in reality. Trading is not desirable, because ninety-nine percent of traders lose money. There are thousands of sophisticated traders employing terrabytes of information out there. As an individual, how do you beat those sophisticated traders? Can you spare time regularly to monitor your investments? Can you make optimal decisions under pressure?

You've some priorities in life. For most people, they are family, friends, their own job or profession or business or a secure retirement. Over our life cycle, our priorities do change depending on our personal circumstances, our career progression and / or our age.

We humans are basically social creatures. We're most influenced by what our neighbours do. We try to imitate them sometimes. Imitation, however, may not work all the time.

Investments in the US

In the US, investors start with the following investments: (I've no expertise on US scenario, this is what I've read--you better check with the US guys):

1) 401 (k) plan, where an employee's company too will contribute to the plan along with the employee's contribution, is a tax-deferred individual retirement savings account basically. (Tax-deferred means you need not pay any capital gains tax until you withdraw the amounts, most probably after retirement. Once you start withdrawing the amounts, those amounts will be taxed.) You're funding these 401 (k) plans with pre-tax dollars, meaning employees won't pay any tax on contributions made to a 401 (k) plan.

The maximum contribution, including by employer, allowed under 401 (k) plan is USD 57,000 per year for 2020 for employees under 50 years of age.

I think these 401 (k) plans offer several options--like all equity (that is stocks), or all fixed income (that is, bonds) and / or a mix of stocks and bonds. These investment options include a list of mutual funds and target-date funds. 

In general, young employees opt for all-equity option because this is retirement money and can be kept for long years based on the assumption that stocks do better than bonds over long periods. This is proven by the history of several countries across the globe.

For more on this, check US government website: irs.gov (IRA is individual retirement account.)

2) A Roth 401(k) is a company-sponsored investment savings account that is funded with post-tax money, which means that withdrawals in retirement are tax free. Not all employers offer Roth 401 (k) plans.

3) Roth IRA is a retirement savings account with tax benefits. It is not company-sponsored. You make investments on your own. The amounts you withdraw from Roth IRA are not taxable. You're typically funding this account with after-tax dollars. Compared to a traditional 401 (k) plan, Roth IRA offers more investment options, meaning it offers more flexibility.

A traditional IRA offers an immediate tax deduction for contribution, while a Roth IRA can provide tax-free income in retirement. This is the weblink. More weblinks:

401 (k)

Roth 401 (k)

Roth IRA

Roth 401 (k) versus Roth IRA

How Will US Stocks Fare in the Next Decade?

In the past ten years or so, the US stocks have given phenomenal returns. I'm not sure what the future holds for the US stocks in the next five or ten years. But one can say that the returns for the US stocks in the next decade will be less than those of the past decade.

Finally

Ultimately, investments are about alternatives. You've to decide on what asset mix works for you best. What works for me need not work for you. But the basic principles and investment processes I mentioned above work for a majority of ordinary guys like you and me.

Don't blindly follow others. We can learn from others definitely, but we need to make our own decisions and be responsible for them. Your friends, relatives and financial advisors may not keep your best interest in mind when they suggest some things to you.

Ultimately, your best money manager is you.

This is just a beginning. Keep in touch and share your thoughts. (writing this is as much fun for me as reading this may be for you).

Happy investing,

Rama Krishna V.

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References:

CNBC article dated 18Jul2020 - Why ETFs remain some of the most tax-efficient vehicles for your money

Disclosure:  I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial products discussed, if any.

Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets. He blogs at:

https://ramakrishnavadlamudi.blogspot.com/

https://www.scribd.com/vrk100

Twitter @vrk100