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For more than a couple of centuries, the most powerful long-term wealth generator in the United States has been the U.S. stock market. Since its inception in the 1950s, the S&P 500 Index has returned an average of 10% to investors each year. Thus, the gap between what your cash earns when it is sitting in your bank account and 10% is your opportunity cost.
But not all Americans own stocks. And many of those that do only get exposure to the stock market through their workplace retirement plan such as a 401(k), 403(b), etc. In fact, according to recent reports, almost 90% of all stocks available for trading are owned by only 10% of investors.
Two of the main likely drivers of this phenomenon are fear and inexperience. It can be tough to consider abandoning the surety of cash for the unknown when there is an abundance of conflicting information and advice shared online by so-called experts. The constant stream of noise often leads some to assume the only way to start investing is to jump in and buy the hot stock that everyone already knows about. There is, however, a more strategic and thoughtful way to get started.
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Rather than buying a bunch of individual stocks right out of the gate that could move with or against you on any given day, you should first allocate 50% of your investible dollars to an index fund that captures the broader stock market and is meant to grow long term. An exchange traded fund (ETF), such as the SPY, is designed to capture the performance of the S&P 500 Index, offering investors exposure to 500 of the largest U.S. companies across various industries in a single investment.
Similarly, a mutual fund such as Vanguard Total Stock Market (VTSAX), which owns approximately 3,750 stocks, aims to mirror the performance of the entire U.S. stock market, providing investors comprehensive exposure to small, mid, and large-cap stocks.
Either of these options is a great starting point and will help you gain broad exposure before adding on more specialized investments.
This approach serves two purposes. On one hand, the exposure achieved through an index fund helps mitigate the risks associated with investing in the stock market and reduces the likelihood of investing your first dollars into a company just as it is reaching its peak. Secondly, investing through an index fund first allows you to gain some familiarity with the process and become comfortable with the volatile ways the markets tend to move on a daily basis.
Once you have allocated 50% to your index fund of choice, it makes sense to broaden your exposure by integrating individual stocks or ETFs that represent the sectors or industries where you already have some experience or expertise. This familiarity will not only allow you to get comfortable with the markets and gain a better understanding of why and when prices move the way they do, but it will also increase the likelihood that you remain informed about the various companies you own.
For example, a person who works in medical research might want to start by purchasing stock in a few health sciences companies or an ETF focused on biotech before broadening their search. Since stocks tend to move the most during the days leading up to and immediately following their quarterly earnings reports, it is beneficial to already have some acquaintance with the industry jargon that will help you to analyze technical speak and understand which information is most pertinent.
The most important rule to remember when investing is to only invest in things you truly understand. You should have an idea of what type of market conditions a particular investment will flourish under and what would make it crater. You should also have a clear understanding of whether and why that investment introduces above average risks into your portfolio.
Once you have identified and purchased your first few companies, broaden even further by following the Peter Lynch model of “investing in what you know.” That is, buying stocks in companies that reflect the things that you do, the places you go, and the things that you buy. And rather than buying stocks with the intention of catching a wave and selling them in a few days, Lynch is a champion of investing in companies that you can reasonably expect will perform well long term, despite the current market cycle.
Though it can be tempting to add companies to your shopping list indefinitely, it is a good idea to limit your initial investments to no more than 30 ticker symbols. Any more than that will be too difficult to keep track of.
As you continue to add additional money into your brokerage account, follow the pattern of adding half to your index fund, and with the remainder, buy a few more shares of your favorite stocks—preferably your best performers. This can sound counterintuitive since our natural inclination is to sell our ‘winners’ when markets are performing well and hang on to our ‘losers’ to give them time to recover.
That being said, some of the most impactful things you can do as an investor are also the most counterintuitive. Dollar-cost averaging and rebalancing are great examples of this.
It is also important to develop the criteria you will use to determine when to buy a stock and when to sell it. Having a target for exiting an investment before buying into it will help you separate your emotions from the investing process during periods of boom and bust.
Investing should not be about making big bets and following the crowd. You should instead seek to simplify your personal investment philosophy as much as possible and gain a thorough understanding of what you own and why you own it. This approach not only helps you navigate the often-complex world of investing with greater ease while blocking out all the noise, it also instills a sense of discipline in your financial decisions.
Starting with this straightforward hub-and-spoke approach can reduce the risk of significant losses at the onset and help you keep a long-term perspective. As you gain more experience and confidence, your investment strategy will evolve to include riskier asset classes, such as small cap stocks, cryptocurrencies, options, etc. But remember, the goal of investing is not to outperform the market at every turn. Instead, your focus should be to build wealth steadily over time.
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