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Investing 101: A Framework for Investing and How to Invest

Sept. 20, 2012
Investing
NerdWallet adheres to strict standards of editorial integrity to help you make decisions with confidence. Some of the products we feature are from partners. Here’s how we make money.
We adhere to strict standards of editorial integrity. Some of the products we feature are from our partners. Here’s how we make money.

by Susan Lyon

So you think you want to invest – or maybe you’re not sure.  This introduction will walk you through how to think about managing your money should you decide to invest.  Are you ready to try it?

 The Risk Return Tradeoff: Put Your Money Where Your Mouth Is

First and foremost, investing is all about the tradeoff between risk and reward: the more you are willing to risk, the more you could stand to gain – or lose.  The implications of this for your investment strategy are crucial to comprehend: you should never invest more money than you would be able to cope with losing.

 This graph demonstrates how an investor’s chances of high returns on their investment increases the more risk they are willing to take:

The Benefits of Diversification: Do’s and Don’ts

This is the most important investing advice we can give you.  We’re sure you’ve heard it before, we know you’ll hear it again, but here it is right now for your viewing pleasure: diversify, diversify, and diversify!

Diversification works because by spreading your money between multiple types of investments you are reducing the volatility of your overall portfolio: even if some riskier investments go south, others will do well, and over time they will balance each other out and lower your overall volatility.  It is possible to achieve the benefits of a diversified portfolio in as few as 20 holdings, or even fewer mutual funds since each fund already has diversified holdings to some extent.

Here are the takeaways:

  1. Don’t put all your eggs in one basket: don’t invest all your money in the same company.  Even if you’re it’s CEO.  Just don’t.
  2. Don’t try to time markets: Volumes of literature exist on behavioral finance and how people do when they try to predict waves of public optimism and pessimism to buy and sell accordingly: not well.  If you do decide to buy a company’s stock, plan to buy and hold for an extended period.
  3. Do follow the fundamentals: If you’re considering buying stock now, make sure you take the time to understand the company’s earnings prospects by thoroughly researching their financial statements.  In isolation this is not enough to predict future stock performance, but it can help make the decision.
  4. Do determine your goals: are you willing to risk a lot to make a lot, even if it isn’t guaranteed?  Or are you a safe better?  Most people are a mix of the two.
  5. Do sketch your ideal portfolio’s profile:  The next blog in the Investing 101 series will dive into asset allocation and how to figure out your dream portfolio.

The Importance of Fundamental Investing: Do Your Bottom Line Research Before Investing

The next step is to ask yourself: what theories of investing pan out in the long run, and why?

Successful investing depends on your ability to predict future performance given the information we have and know today.  Even though we can’t predict all events that may shape the future economy, it’s worth putting in the time and effort to do good fundamental research by looking at a company’s financial data: earnings, dividends, balance sheet, and so forth, to determine whether you think a company is a good investment.

There are two main schools of thought frame the two competing theories on how to best grow your pile of cash:

  • The Firm Foundation Theory: This theory stipulates that each stock (or other financial instrument) has an “intrinsic value” based on the company’s bottom line and growth prospects that the market fluctuates around and will eventually reach.  When stock prices fall below this value, it means investors should buy because the stock is currently undervalued; when prices rise above it they should sell.
  • The challenge?  You have to be able to quite accurately determine a company’s growth prospects, which can be hard to do.
  • The Castle-in-the-Air (Greater Fool) Theory: In this worldview, it goes that smart investors actually need to analyze what other investors are doing and then preempt them.  Buy before everyone else buys; sell before everyone else sells.  It’s behavioral finance at its best.
  • The challenge?  If mass psychology and identifying waves of optimism (which become bubbles) aren’t your strong suit, you’ll fail.  There have been a lot of bubbles throughout history, and they’ve caused a lot of harm.

 These two broad theories in turn lead us to two broad schools of investing: fundamental versus technical analysis:

  • Fundamental investing, per the firm foundation theory worldview, sees the market as more logic than psychology.  They rely heavily on growth indicators and past performance for financial decision-making.  This tends to be more Wall Street, fund manager, and security analyst style.
  • Technical investing, on the other hand, views the market as more psychology than logic.  They rely heavily on charting trends and patterns of past stock prices to try to predict and preempt future swings and bubbles.  This style of investing has been widely debunked.

So, you may be asking, what’s the “right” theory to follow?

NerdWallet thinks the evidence is clear: technical investing doesn’t work and can’t be sustained over time; Castle-in-the-Air style speculating on the next big bubble is dangerous and should be avoided.  We advocate a Firm Foundation worldview, where any smart investor should focus on the fundamentals of the companies s/he wishes to invest in.  Investor psychology can impact prices in the short term, but in the long run fundamentals always win out.

Trying to figure out a stock’s true intrinsic value sounds like a great idea, of course, but the Efficient Market Theory says it’s hard to do.  The theory says there’s no known information a member of the public or even a well-trained analyst could gain access to in order to beat the markets, since publicly available data has already been incorporated in its constantly readjusting market price.  Prices move too quickly to take advantage of.   So in theory nobody should ever be able to beat the market and we should all buy index funds and just go home.

But Warren Buffet and a few other great investors have been able to beat the market for an extended period.  Were their results just random luck?  The length of their success suggests real skill, but who really knows.   The important thing to note is that the few great investors who have been able to outperform the market for extended periods did so with long-term fundamental investing strategies, not with market timing.  Evidence shows that by trying to sell high and buy low based on limited real time information, you’ll only harm your odds of success.  Just don’t do it!

Am I Ready to Invest?

Stick to the fundamentals, get diversified, and remember that pursuing higher returns almost always increases risk of loss.  Sounds easy, right?  Wrong!  This is only the tip of the investing iceberg.  The next step is to understand asset allocation and start deciding how to invest your money.  Now you are ready to read the next in our series on how to figure out the best asset allocation.

Back to So You Think You Can Finance?

Sources:

  • For more detailed explanations of the main investment theories outlined above, see A Random Walk Down Wall Street by Burton Malkiel.
  • For more information on alternative savings instruments, visit NerdWallet’s Banking blog.
  • For more information on financial markets and analysis, visit NerdWallet’s Financial Markets blog.