Investing may arguably be the most popular financial planning topic. Most people roughly understand what investing is and have heard about the stock market before. If you interviewed 1,000 people closest to me (or any financial professional really), I bet the majority would say I do “something with stocks” or “something with taxes”. While they aren’t wrong, I think it’s because stocks and taxes are the two most common financial topics that impact all of us. When you begin to take investing seriously and understand what proper investment planning (or tax planning) looks like, the “something with stocks” mindset quickly goes away. I’d argue most people don’t really care about stocks or the market, they care about how it affects them. Once you understand why you are investing, and how investments impact you, then you can make better decisions about what investments to choose.
The Why.
Knowing why you are investing is critical, maybe even more important than investing itself. If your goal for investing is solely to get more money, are you no more sophisticated than a gambler? Gamblers are infamous because they are physiologically addicted to seeking more money. There is no thought towards what happens after they win or lose. Why do most lottery winners, professional athletes, and trust fund kids run out of money? Because they did not know what to do with the money once they received it.
You could argue that those examples are due to their lack of knowledge or experience with money. But I would argue that would explain most of us as well. Investing is by definition an imperfect science. You are placing money in something that you hope will return more money to you in the future. There is no guarantee that you will be right, and therefore you are taking the risk that it may not work. The critical difference between good investors and gamblers or lottery winners is the reasoning for investing, and the level of risk-taking that develops. When investors have a goal in mind and know they need money at some point in the future, they make more educated investments that increase the probability of their success.
Simon Sinek covered this concept perfectly in his book Start with Why. Businesses who know why they exist and why they invest can be much more successful than businesses who don’t. Sinek said to “find why you do what you do and everything else will fall into place.” Start with what you want in life. Do you want to buy a house in the future? Or retire? Or start a business? Focus first on why and then focus on how. If you don’t understand how to invest, that is okay. Like myself, there are countless professionals who can help educate and inform you. Start with why you want to invest, and then get help on how.
The How.
There are two main ways to make money when investing: growth and income. Take a rental home for example. You buy the home, and in the future, you want to sell it. If you sell it for more than you bought it for, that’s growth (or appreciation). On the other hand, income is all the money you receive after you buy it and before you sell it, in this case it’s the rent. If you want to calculate your return on your rental home, you would consider both the amount of income you received and the growth you made on the sale (while factoring in expenses, fees, taxes, etc.)
Each investment has varying degrees of growth and income, and investments focused on growth tend to have more risk than investments focused on income. A typical government bond for example, will pay income but will not grow at all, which is more predictable and less risky. If you buy and hold the bond until it matures, then as long as the Government is still around and able to make the payments, you can count on a check periodically while you own it, and at the end the Government will give you back the same amount that you bought it for. Alternatively, investing in a company like Amazon does not pay any income (AKA a dividend) but is solely focused on growing the company. After you buy the stock, they will not send any check to you while you own it. The goal of growth investments is to sell it for higher than you bought it, which could make your investment more volatile and less predictable.
The first step is to determine the right balance of growth and income investments for you. Balancing the amount of risk will tie in all the different factors of your financial plan, your objectives and goals, and your tolerance for risk in general. If you are buying a house in 1-2 years, it may be wise to only own income investments where you are less worried about fluctuations in the market and access to your money when you need it. If you are investing for retirement 20 years away, more growth and less income could be wise to build over the long term. You would be less worried about short term swings in price because you have years to recover and build your wealth.
The What.
Once you have determined the right amount of risk you want to take, now focus on the specific investments. This is where most people start with investing. They go straight to choosing which stocks are the best and find themselves frustrated when they are wrong. Investing in publicly traded companies is one of the best ways to generate wealth in our world today. If you’ve first started with why and how to invest, then using the stock market to build the life you want is a great resource. Whether you buy individual stocks, mutual funds or ETFs, focus some on the specifics but more on the relationship between each investment.
This is when diversification becomes important. Diversifying is the old “don’t put all your eggs in one basket” idea. If you put all your money into Amazon, and it goes out of business, then you are out of money. At the same time, perfect diversification (if even possible) by definition would always give you an exact 0% return. Diversification is about reducing risk. Find the amount of diversification that is right for you. Many business owners have significant amounts of their total wealth inside their business. It’s not so much a conversation about right and wrong as it is about your level of risk. Many owners are comfortable risking their life savings (and most likely their family’s) on one company. The goal should be enough diversification to manage your risk level while still focusing on why you are investing in the first place. A good way to frame it would be to ask, “how can I take the least amount of risk to accomplish my goal?”
There is a concept in economics that looks at the “opportunity cost” of every decision. In every single investment you make, opportunity cost is the best alternative that you did not invest in. For example, you would feel good if you invested in Amazon and made 15%. What if you found out the rest of the stock market was up 30%, how would you feel? Your good investment would not feel so good anymore. Opportunity cost in one sense is the opposite of diversification, there will almost always be a better choice out there which most likely includes more risk. It is important to balance opportunity cost and diversification, but always within the context of your overall goals. Yes, you should compare your investments to a close alternative, like stock investments to the S&P 500. We all want to make good investments, and reduce our opportunity cost as much as possible, but you are comparing your investments (finding the opportunity costs) to verify you will reach your financial goals, not to make the most amount of money.
Ask For Help.
Investment planning can be one of the hardest areas of personal finance. Don’t feel intimidated and never act. Starting with why you want to invest is the key to unlocking the investing industry. You do not need to speak the finance language to invest properly. Focus on what you want, and work with professionals who can help you reach it. Determine how much risk you should take and as well as your comfort and understanding about your investments. Only then should you focus on the specific investments. What you buy is important, that is how you generate wealth, but starting with the right mindset and methodology is key for investment planning.
TC Falkner 