Advanced Money School Lesson 5: Choosing Investments

Written by: David Weliver

Hey again. Welcome back to Lesson 5 of Advanced Money School.

In Lesson 4, we began to focus on investing. We discussed the importance of an investment strategy matching your personal risk tolerance. We also discussed how asset allocation allows you to maintain your desired level of risk. We looked at traditional asset classes: stocks, bonds, and cash. Finally, we examined two often-overlooked classes: business and real estate.

In this lesson, we will cover strategies for choosing individual paper-based investments. These assets include mutual funds, stocks, treasury bonds, and real estate investment trusts.

One word of caution before we get started. You could read 1,000 books and still have much to learn about portfolio design.

Here, I offer a few important pearls of wisdom for each asset class, as well as suggestions for where to learn more.

I implore (read as strongly encourage) you to choose your investments with the utmost caution. This is especially true if you might buy individual stocks or any kind of obscure investment.

You could lose everything.

If an investment seems too good to be true; it is. Don’t be fooled and smart people get all too easily conned. And when smart people are the victims of a con, the con usually involves an investment scheme.

Later in this lesson, I touch upon target-date mutual funds and robo-advisors. If you have any hesitation about your ability to pick investments, these sections are for you.

Stocks

Stocks are an essential component of most investment strategies for good reason. When you own stock in a company, every employee in that company – from the janitor all the way up to the CEO – is working for you. As a result, stocks are the highest-performing asset class in the long run.

Between 1928 and 2013, the average annual return of stocks was 11.50%. During the same period, treasury bonds averaged a 5.21% annual return. The average annual return of stocks was almost double the return on T-bonds.

But even the average annual returns don’t tell the entire story.

Remember the power of compounding!

If you had invested $1,000 in 1928 in all stocks, you would have had $2,555,530 in 2013. If you had invested $1,000 in 1928 in all Treasury Bonds, you would have had $69,250 in 2013.

The downside to stocks is that they are more volatile. Stocks lost value in 24 of those 85 years (28%) whereas the bonds lost value in 16 of those years (19%). And when bonds did slide, the losses were less dramatic than in the stock market.

The market for stocks is especially fickle. Myriad factors influence stock prices including company results, geopolitical events, economic indicators, and the whim of speculators.

Nobody – absolutely nobody – can forecast the results.

Diversification, diversification, diversification

Diversification is the best way to capture stocks’ upside while managing short-term volatility. 

  • You want to own large and small companies from the U.S. and abroad.
  • You want to own companies that are stable and companies that are growing.
  • And you want to own companies in a variety of business sectors.

You can get this kind of diversification with thousands of different index funds. One of the most notable is the Vanguard Total Stock Market Fund – the largest mutual fund in the world. This fund gives you exposure to thousands of stocks that make up the U.S. stock market in a single trade. Within the domestic stock asset class, it provides ultimate diversification.

The opposite of such diversification is owning a single stock. Investing in a single stock amplifies your potential reward, but also your risk.

A company that comes out of nowhere to dominate its industry (e.g., Walmart or Apple) creates billionaires of its largest shareholders. A $100,000 investment in Apple at the time of its IPO in 1980 would be worth more than $50 million today, 40 years later.

But think about all the companies that don’t become Apple. An investor could also put $100,000 into the stock of a company that goes bankrupt and lose everything.

The lesson here is that stock picking is gambling. And, if you pick stocks with a significant chunk of your net worth, it’s high-stakes gambling.

Does that mean you should never, ever do it? Not necessarily.

If you’ve ever spent time researching investments you’ve undoubtedly come across websites that publish enormous volumes of news every day about every publically-traded company in the world.  In other words, you’re familiar with the multi-billion-dollar market for stock information and tips. Chances are, you’ve also been pitched “newsletters” or other paid products promising to send you winning stock picks that will make you a millionaire.

It all leads you to believe that with the right information, you can get rich picking stocks.

But ask yourself: if these experts were so good at picking stocks, why are they selling newsletters? Why aren’t they investment managers?

Yes, a small number of people outsmart Wall Street and become billionaires by picking stocks. Some, like Warren Buffett, are legends. Most of the others run hedge funds. The rest of them, I suspect, lead quiet lives of luxury. None of them care if you buy their latest stock tip for $149.95.

Do not fool yourself into believing you are one of them.

The Nobel Prize-Winning Economist Paul Samuelson said:

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

This quote, perhaps, is particularly relevant for anyone who has become accustomed to instant gratification. (I’ll admit it: I’m guilty, too!) By contrast, successful investing is all about delayed gratification.

The kind of investing I advocate is like watching paint dry. If you’re looking for instant jackpots it’s plausible you’re going to get antsy.

I will say that investing in some individual stocks can be fun. It can help you learn about investing and keep you engaged with your portfolio. The key is to limit the amount of money you invest in individual stocks to a small percentage of your net worth?

How much? That’s up to you. I have about 5% of my invested assets in a hand-picked stock portfolio. I wouldn’t put any more than 5% in personally; you might decide to “play with” more or less.

Choosing individual stocks

In brief, here is my no-nonsense advice for choosing individual stocks.

1. Know the difference between growth stocks and value stocks.

Growth stocks are explosive companies with the potential to outperform the market, at least for a period of time. Value stocks are stable (often larger) companies. Value stocks trade at a stock price that analysts believe is less than what it should be. In other words, the stock represents a great “value.”

Both kinds of stocks can be good investments, but you need to know what you’re getting. Growth stocks offer higher potential rewards in the short-term, but with bigger risks. Value stocks are not risk-free, but may be safer plays. Value stocks are more likely to pay dividends, too.

Contrary to what you might think, some studies show that over 25 years, value stocks have outperformed growth stocks. That’s useful if you’re going to be choosing between a growth and a value index fund. If you’re picking individual stocks, your results will depend on your choices.

Thus, if it’s the chance of an outsize return and big payday you’re after, that’s going to be a growth stock. Want to accumulate a basket of reliable stocks for the long-run at bargain prices? Choose a value strategy.

2. Say no to penny stocks

Lots of “gurus” make big bucks selling “can’t lose” investing strategies and stock tips online. The pitches range. There are $100 newsletters making at least somewhat-defendable stock recommendations. Then, there are expensive subscriptions promising to get you in on the next Apple for pennies a share.

At best, these publications are entertainment. If you want to put $500 on a stock and see if it triples in value, go ahead. At worst, however, these businesses are charging you big bucks to teach you how to gamble your savings away. Most stocks that trade under $5 per share are much riskier than others. And true penny stocks are more likely to become worthless than ever make you rich.

Hard pass.

3. “Invest in what you know” is not bad advice

Learning how to analyze the financials of a multi-billion-dollar corporation is no easy feat. And even professionals who do this every day sometimes get it wrong.

Rather than trying to beat them at their own game, consider choosing stocks using a simpler approach. Think about the companies in your life that offer products or services with which you couldn’t live without. The ones that, based on your experience, do what they do better than the rest.

Maybe, you live by the simple elegance of Apple technologies. Or, perhaps, you’re a frequent traveler and appreciate how Southwest Airlines stands out from other airlines. They have a simple business model and reliable customer service.

Or, maybe you rely upon a specialty pharmaceutical made by Pfizer to stay healthy.

These are examples, and they by no means represent any kind of value judgment on these stocks. But choosing stocks this way is as good as any other for average individual investors.

4. Stay focused on the long-run

As a reminder, I’m talking about investing in stocks for the long-run, not trading stocks for the short-term.

I will never advocate short-term stock trading. That’s my mantra for this lesson.

I’m not saying that some people haven’t been successful as day traders – some have. I contend the risks for you far outweigh the potential for success.

Want to learn more about investing in individual stocks? I recommend The Intelligent Investor by Benjamin Graham. It’s a 70-year old book that focuses on value investing. Still, it remains, in my mind, the single best book on choosing individual stocks ever written. If you need a second opinion, the CEO of the investing app Personal Capital recommended it, too, in a recent interview with MU30.

Bonds

There is so much written about individual stocks, yet very little about bonds. Bonds are so unsexy that the vast majority of investors never even reflect upon this fact.

There’s good reason for this.

Investing in individual bonds is complex. You need a firm understanding of yields, prices, duration, and other factors that influence bonds’ values.

And, even if you have that, the benefits to choosing individual bonds over a fund are small.

Here’s what you need to know.

  1. You can buy U.S. Treasuries directly from the government, fee-free, at TreasuryDirect.com.  Considered one of the safest investments in the world, T Bills, T Bonds, and TIPS are excellent diversification tools. They are also a suitable savings vehicle for the most risk-averse investors.
  2. Buying treasuries directly is much easier than buying other kinds of bonds. But, in my opinion, there are still limited benefits. There used to be an appreciable cost savings over mutual funds that charged 1% or more a year, but the rise of index fund ETFs that charge 1/10th that amount or less has made this less of a benefit. Yes, you can still save a bit buying your treasuries direct, but I’m not sure it’s worth the hassle.
  3. You can buy a limited number of select corporate, municipal, or foreign bonds through online brokers like Fidelity and Schwab. You’ll need specialty bond brokers for most others.

In my opinion, you’ll do fine with bond index ETFs like those from iShares (Fidelity) or Vanguard.

Which brings us to our discussion of index funds…

Index funds

If you’ve been reading MoneyUnder30 for any amount of time, you’ll know that I am a devout believer in index funds.

As I mentioned above, I do not think you can do any better trying to pick stocks and outsmart the market. In most cases, I also don’t think it’s worth paying between a half percent and a percent of your assets every year to a professional fund manager to see if they can beat the market.

Maybe they can, maybe they can’t. Either way, you’re out of that money.

Index funds do the work for you. Simply, reliably, cheaply. Investing with them is like watching paint dry. They are exactly what you want.

Many other people will stop right there and tell you that’s all you need to know about investing. Index funds.

I offer two qualifications:

  • If you don’t want to learn anything more about investing than the minimum you need, stop here. Index funds are fine. But, if you’re willing to take a more active role in your investing, index funds should only be a part of your strategy. A well-placed active fund, a basket of hand-picked stocks, and, especially, investments in non-paper assets — either a business or real estate – will serve you well.
  • I do worry that the seismic shift to index funds we’ve seen over the last 20 years may one day have consequences we can’t yet predict. One of the effects of so many people moving their money out of actively-managed funds and into passive index funds is that there is a lot less money moving around as managers make speculative trades.

What effect will this have? I don’t know. Maybe none. Maybe it will subtly volatility. Or maybe it will not-so-subtly suppress returns. Or something else entirely.

My uneasiness over this possibility isn’t enough to change my endorsement of index funds (or my own investment strategy).

But I do believe it’s something to watch.

How to choose index funds

When it comes to choosing an index fund, there are three things to pay attention to:

  1. The fund’s suitability to your investment goals.
  2. The fund’s expenses.
  3. Whether you want to hold the fund as an exchange-traded fund or a mutual fund.

1. The fund’s suitability to your investment goals.

By far the most important criterion is whether the index fund will achieve what you need it to.

This is where you must be careful.

For example, let’s say you invest in an index fund that tracks the S&P 500. If you think that this fund is suitable to give you exposure to the entire U.S. stock market, you would be mistaken. That fund only tracks one index, which contains 500 of the largest stocks in the United States. It leaves out thousands of others.

What you would want instead is something like the Vanguard Total Stock Market Fund. This fund provides exposure to as close to the entire U.S. stock market as possible.

When investing with index funds, you can keep things quite lean and simple. Still, you’ll still need to own at least a handful of different funds to get proper diversification.

This article I wrote describes three sample portfolios at popular brokerages using only a limited number of index funds.

2. Fund expenses

Index funds have two primary advantages over actively-managed funds.

  • The first advantage is the lack of a manager. On average, this tends to produce better returns for you because most managers have not proven that they can beat the market.
  • The second advantage is the lower cost, which can be significant.

According to the fund research firm Morningstar, the average expense ratio for actively-managed mutual funds was 1.45% in 2016.  This compares to 0.73% for index mutual funds and 0.23% for index exchange-traded funds (ETFs).

The largest savings come from choosing an index fund over an actively-managed fund. But you’ll want to compare the expenses even among similar index funds before you invest. It’s true that a few tenths of a percentage point isn’t a lot – not a lot at all.

But over several decades, it can still amount to tens of thousands of dollars.

3. ETFs vs mutual funds

Based on this significant cost difference, why would you choose a mutual fund over an ETF?

First, the cost difference isn’t always so dramatic when comparing individual funds. You’ll pay a slight premium for index mutual funds over equivalent ETFs, but don’t get scared away from mutual funds yet because of that stat.

ETFs trade like stocks meaning you can buy into an ETF for the cost of a single share. You can also buy and sell ETFs throughout the day on the open market. Finally, ETFs can have some tax advantages over mutual funds.

Mutual funds may require larger minimum investments and are only priced once a day. Unlike an ETF, you can buy partial shares of a mutual fund. This makes it easy to set up fixed dollar amount recurring investments. Finally, mutual funds make it easy to reinvest dividends automatically.

One thing that is tipping the scales between ETFs and mutual funds is the relevance of trade commissions. When ETFs emerged in the mid-2000s, brokerages charged commissions between $7 and $15. This could make it quite expensive to make recurring investments in ETFs. For example, if you wanted to invest $200 in four ETFs every month, you might lose $60 of that $200 to fees! In no world would that make sense.

Over the last 15 years, however, trading commissions have fallen to zero. At first, most brokerages began offering a certain brand of ETFs commission-free (such as iShares ETFs trading free at Fidelity). Today, it seems that every broker has eliminated trading commissions.

This fact tips the scales in favor of ETFs for most investors.

So, the question remains: what role, if any, should actively-managed (mutual) funds still play in your investment strategy?

What about managed funds?

Active funds are not bad, per se.

It’s just that:

  1. They’re more expensive than index funds and
  2. Study after study has shown that the vast majority of actively-managed funds fail compared to best market averages.

Still, there are some times when you might find that an actively-managed mutual fund fits the bill.

Largely, these situations can be defined as times when you want a mutual fund’s manager to take the place of your own personal financial advisor.

For example, if you want to be a completely hands-off investor, you can hire a financial advisor. They can rebalance your asset allocation as you get closer to retirement. Or, you can invest in a target-date mutual fund which will do the same thing for less money.

Likewise, rather than paying an advisor to optimize your retirement income, a single mutual fund may be able to do this for you. Target-date mutual funds are comprised of a diversified mix of stocks and bonds that the fund manager believes will offer the best risk-reward combination for investors planning to retire within a particular 5-year period. Each year, as that time draws closer, the fund manager gradually adjusts the funds’ holdings to account for its investors getting closer to retirement.

Another example of when you may want to consider an actively-managed mutual fund is when you want your investments to align with your values. If you want to focus on sustainable investments, for example, or avoid socially-harmful investments, it’s hard to do this with index funds. By their very nature, index funds hold a piece of everything. Whatever your values, however, there’s probably an active mutual fund that caters to it. You just have to find it.

What about robo-advisors?

At this point, you might be wondering why I haven’t mentioned robo-advisors.

If you’re unfamiliar, robo-advisor is a term to describe companies that offer a certain kind of automated investment account. When you invest with a robo-advisors, you do not have to choose individual investments at all. Based upon your answers to a few simple questions, the robo-advisors will invest your money automatically in a diversified portfolio of index funds. The term robo-advisor comes from the fact that a computer is determining your ideal investment portfolio rather than a human financial advisor.

Without a doubt, robo-advisors are changing the investment business. Early robo-advisors, including Betterment and Wealthfront, have forced old-school brokerages to slash fees and launch robo-advisors of their own.

We’ve discussed at length the pros and cons to robo-advisors on Money Under 30. Here, I’ll keep it simple.

A robo-advisor is the simplest way to invest. You can answer a few questions, set up an auto-deposit, and you’re done. Easy and quick.

The downside is that you’re paying an additional fee – however modest – on top of the mutual fund or ETF expenses you have to pay one way or the other. Let’s say that fee is 0.25% per year, which is a fair industry estimate. That only works out to $25 per $10,000 invested. As long as you have a modest account balance, that’s not a lot of money. That fee might well be worth the simplicity the robo-advisors offers.

If you have a larger balance, however, that fee begins to add up. With a $100,000 balance you’re paying $250 a year. That’s still not too bad. But with a $500,000 balance, you’re paying $1,250 every single year that you wouldn’t pay if you invested directly in index funds.

Should you pay extra for the simplicity of a robo-advisors? Completely up to you. There’s no wrong answer as long as you fully understand the benefits (and additional costs) of a robo-advisor.

I will say that if indecision is keeping you or anybody in your life from even starting down the investment path, going with a robo-advisor is a fair starting point. Because you don’t make a pretty penny while being stuck or paralyzed but not even being able to start.

Other investment options

We’ve covered the basics of investing in stocks, bonds, both individually and in mutual funds. Now, let’s discuss some alternative paper assets that you might consider as you look to diversify your portfolio.

Real estate investment trusts (REITs)

A Real estate investment trust, or REIT, is an investment that owns or manages income-producing real estate.

REITs can be a great way to diversify your portfolio and generate both dividend income and capital appreciation. But you should be aware of what you’re buying.

Two things to understand are:

  1. Some REITs own property directly, while others own the mortgages for such properties. Both have unique risks.
  2. Many REITs are organized by the type of properties in which they invest. There are retail REITs, residential REITS, office REITS, etc.

When considering any REIT, look at the total returns of the investment (dividends + appreciation) – both matter. REITs are portfolios of properties just as a mutual fund is a portfolio of stocks. In both cases, the management should be a part of your decision. Look for an experienced management team with a good track record.

Finally, just as you might want to avoid buying individual stocks and bonds, consider a real estate mutual fund or ETF instead of individual REITs. Consider ETFs like Vanguard Real Estate ETF (VNQ), the Schwab US REIT ETF (SCHH), or the iShares US Real Estate ETF (IYR).

Real estate crowdsourcing

Another way to invest in real estate via paper assets is with real estate crowdfunding platforms like StreitwiseFundrise, Crowdstreet, EquityMultiple, RealtyMogul, and there are many others.

For qualified investors, these platforms allow you to “buy into” individual real estate investments with as little as $1,000 per investment.  As peer-to-peer lending companies LendingClub and Prosper allow investors to pool their money to make loans to other individuals, these companies allow investors to pool their money to finance real estate purchases and construction.

Compared to REITs, there’s the potential for higher returns if a project is successful. Of course, there’s also a lot more risk because you’re investing in a single property rather than a portfolio. Finally, there’s also the issue of liquidity. Real estate is inherently illiquid. When you make these investments, you may receive quarterly dividends, but your money will likely be tied up for years.

If you’re curious to know more, this article does a great job of fairly discussing all the pros and cons of these kinds of investments.

What about private equity or venture capital?

Before wrapping up, I want to tackle a question that inevitably comes up. How can you invest in private equity!?

As you likely know, private equity is capital that’s made available to private companies to fund growth or acquisition. Venture capital is similar, but defines money given to start-ups. These kinds of investments are high-risk, but are also capable of producing the kinds of returns that average investors only dream of.

To put it simply, these are still not investments that are very open to us average investors. Historically, you have needed to both know the right people and be able to write big checks to gain access to these kinds of investments.

Slowly but surely, however, that may be changing.

Alumni Ventures Group, for example, provides venture investment funds to accredited investors who have graduated from Ivy League and other top universities. A few funds are also open to all accredited investors. (Accredited investors are individuals with a net worth in excess of $1 million or at least $200,000 in individual annual income or $300,000 in joint income for the last 2 years).

Minimum investments are high, however…possibly as high as $50,000.

Slowly, other funds are emerging to allow individual investors access to previously out-of-reach investments like private equity.

As with real estate crowdfunding, however, these investments pool many small investments to make one large one. That’s less efficient than one large investor writing a check. That inefficiency gets passed along to the small investors as expenses that reduce your expected returns. Taken to extremes, this inefficiency may eat up the additional expected returns from this kind of investment and make it no better (or worse) than a boring old index fund.

Remember, watching the paint dry is a good thing.

Lesson 5 wrap up

Selecting the right stock and bond funds is the first step to a well-designed portfolio.

  1. Effective does not mean complicated.
  2. Effective can mean maintaining a good investment strategy with as little as one target-date fund or a few index funds.

More adventurous investors may want to venture beyond stock and bond funds. In some cases, doing so may present opportunities for outsized returns. Even if not, alternative investments not tied to the stock market can provide an extra layer of diversification.

I will caution again here by saying that effective and short term stock trading most of the time do not go hand-in-hand.

In this lesson, we discussed how to choose the most common types of paper asset investments. These included stocks, treasury bonds, mutual funds and ETFs, as well as REITs and crowdfunded real estate contracts.

Your homework is a Your Investment Style Worksheet that will identify your ideal investment strategy. You’ll discover how much you should vary your investment portfolio from a traditional mix of stocks and bonds (if at all). To complete this exercise, it may be helpful to go back and review the risk tolerance and asset allocation profile you completed in Lesson 4.

In the next two lessons, we’ll talk in more depth about investing in non-paper assets, chiefly businesses, and real estate.

See you soon!