The Simple Economist’s Guide To Investing

Investing does not need to be complicated. In fact, after reading this post, you will have enough information to get started and invest more efficiently than almost every other casual investor. For basic investing, simple index funds will give you broad diversification and returns that will match the overall market. In addition, low fees and low turnover minimize taxes and expenses that can decrease your gains over time.

investingIn the long term, economic theory suggests individuals will not beat the market when risk is considered. This idea stems from academic research developed at Princeton and MIT and is often referred to as efficient market theory. In addition, past performance does not predict future performance. Take a look at the companies who debuted on the S&P and see how many still exist. Broad based index funds take into consideration the rise and fall of individual companies, and position themselves to mimic the entire economy as a whole.

If you really want detailed guidance you can read the single best book on investing: A Random Walk Down Wall Street by Malkiel. The book is quite old but is updated every few years. Buy an older copy because the investing principles do not change. It can be a bit tedious, especially to non-investors, but the concepts are timeless and backed by more actual academic research than any other popular investment book.

The fundamental investment principles of Simple Economist Include:

  • Invest in Low Cost Index Funds
  • Don’t Buy Single Stocks
  • Limit Buying and Selling
  • Don’t Invest On Margin
  • Invest for the Long Term (5/10+ Years)

Low Cost Index Funds
The premise of an index fund is simply a fund that buys and owns a tiny piece of hundreds, or thousands, of individual companies. Instead of trying to pick the ones that will do best, it simply picks a really large group that represents the entire market. You can actually buy funds that buy every single stock available in the US. Some companies will make lots of money and some will go out of business. But the theory of index investing is that overall, companies will grow and the winners will outnumber the losers. And because individuals are not paid big bucks to reserach and pick the best stocks, the fees are very low and cost little to own or manage.

The simplest index funds hold shares in a popular index (just a large list) of companies that sell stock. There are also index funds that buy only stocks in small companies (small-cap) or only large companies. There are also ones that buy international stocks that often grow at different rates than domestic companies. This all sounds a bit confusing but I’ll list below some of the specific ones we buy. The Vanguard company developed these types of funds and their popularity  continues to grow. Many large traditional mutual funds may charge up to 2.0% a year to pick the best stocks. An average index fund would have expenses less than 0.2%. They are low cost and, according to almost any leading academic, constantly outperform actively managed funds.

Don’t Invest on Margin
Borrowing money to invest has become extremely popular in the U.S. In fact, it was so popular in the twenties that it changed the investing habits of an entire generation of people who lived through the market instability. Investing on margin simply means borrowing money to invest. And it is gaining a resurgence. In an era where interest rates are low and investment yields are high it is easy to see why people make this decision. Even many financial gurus suggest borrowing on your cars, credit cards, rental properties, student loans, or your house to simply invest as soon as possible. In theory this may work well, but often risk is left out of the equation. When markets are going up, everyone feels good about margin. But when markets go down the risk that is inherent in the type of investing is exposed. The market will go in both directions.

When you get out of debt, you have no payments. When you have no payments, you lower the amount of risk in your life. You minimize the effect of income changes (like job loss) or periods of poor market performance. While I don’t get completely upset when people take out a reasonable mortgage, I do find that the being completely debt free provides an impressive sense of financial peace. Risk Minimization actually allows you to be more aggressive with both your investments but also your job and career aspirations. I want you to invest as early as possible. That is why I suggest crushing debt so  you can get the party started and put compound interest to work.

Invest for the Long Term
Don’t invest if you need your money soon. Save for the short term. Invest for the long term. You can still put your money into a place that will earn a little bit such as a money market account. Investment will go down. And investment will go up. And trying to figure out exactly when that will happen is a fools game. There are plenty of magazines trying to sell that information, but go to the library and look up some old copies. How good was their advice? I would be surprised if you could find anything that constantly outperformed the random walk.

Getting Started:
The first step is to simply open an investment account. The basic types of accounts are brokerage accounts and retirement accounts. We’ll start with brokerage accounts. Basically, you simply open an account and it allows you to buy different index funds. Once your account is open, you can just search for index funds or search for the exact funds (use their abbreviations (i.e. FSTMX) and transfer money into that fund. It is just like transferring money into a savings account. While this process may have been difficult, it is now just as easy as opening a bank account online. You can literally be setup in fifteen minutes. Investing can seem overwhelming due to all the different choices one has to make. But I’ll cut through the clutter and suggest some specifics that can cut through the paradox of choice.

Two Great Choices to Open an Investment Account:
Fidelity Investments
Vanguard Investments

Great Total Stock Market Index Funds:
Fidelity Total Stock Market Index Fund FSTMX
Vanguard Total Stock Market Index Fund VTSMX
To compete, almost all investment companies have started their own Index funds.
Look for expense rations under 0.20%
This is a great option if you want a simple, effective solution

Great Diversified Index Funds*:
Fidelity Small Capital Index Fund FSSPX (Vanguard VSMAX)
Fidelity Middle Capital Index Fund FSCLX (Vanguard VIMAX)
Fidelity Large Capital / S&P Fund Index Fund FUSEX (Vanguard VFIAX)
Fidelity International Index Fund FSIIX (Vanguard VEMAX)

*The diversified index funds most closely represent how we have our own money invested. This is quite similar to the Dave Ramsey style system and it has served us quite well. Our retirement accounts are run through TIAA-Cref so we have slightly different names for our funds but they are almost identical. Having different types of index funds gives us the security of investing in large and mid-sized companies with the growth potential from international markets and small companies.

“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. Seriously, costs matter.” – Warren Buffett, Chairman’s Letter 1996

I’ll leave with a little bit of Buffett. The goal of investing is to put our money to work. Start with the investing principles outlined here. Get out of debt. Stop letting compound interest work against you and make it work for you. Start. Open up an account and put a few dollars in. Getting started is the hardest part. Invest your money and then give some away when you get a lot of it.

Comments are closed.