My first baby step into the investment universe

I frequently come across questions on Quora like:

• I have $ 100, how do I start investing?
• I want to learn to invest, but where do I start?

These are beginners learning how to invest. We sometimes forget that there is a large investment universe out there.

• There are different asset classes eg stocks, and bonds.
• There are different investing styles eg technical vs fundamental.

It can be confusing for someone without any investing knowledge. How do you start if you want to learn to invest as a beginner?

1) First get an overview of the various aspects of investing eg fundamental vs technical, active vs passive, etc.

2) Once you have some basic understanding, chose your path. This will depend on your personality, the amount of time you have, your educational background, and other demographics.

3) Thereafter you proceed with a more in-depth study of the chosen investing path.

This article is to help you go through steps 1 to 2.

If you are a beginner and you go through this article, you should reach a stage where you can make an informed decision on which investing path to follow. You are taking the first baby steps into the investing universe.

Note that there are 3 parts to this series on Medium:

• This article is the first.
• My Second Baby Step Into the Investment Universe. This covers the analytical aspects.
• My Third Baby Step Into the Investment Universe covers the risks and behavioral aspects.

What is investing?

When you look at all the definitions of investing, you realize that it is about putting your money to work.

• “Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit.” Investopedia
• “Investing is the process of buying assets that increase in value over time, with a goal of generating income or selling for a profit.” Forbes

You can see from the definition that:

• It is not tied to any specific asset. You can invest simultaneously in different assets.
• You can learn to invest at any age and start at any time.
• It is not about the amount of money you have. There are ways to invest if you don’t have a large amount of savings — eg through regular contribution, mutual funds

The key point is that you have some savings or money that is set aside for investing.

2) Why invest?

In the modern world, the purchasing power of your savings will deteriorate with time. This is the result of inflation.

To protect from this, your savings need to generate some returns that outpace inflation. Ideally, the investment goal is to increase the value so that you can grow your wealth.

The challenge then boils down to identifying the assets so that you can earn better returns than merely saving your money in the bank.

Many people also invest in the hope that it can generate passive income. This is in line with the idea that you let your money work for you.

3) What to invest — The Investment Universe

There are 2 main ways to categorize investments:

• By asset class eg cash, stocks, bonds.
• By investing style or school eg technical vs fundamental, active vs passive

Table 1 below lists all the various types of investment available covering the above two categories.

But you must remember that there is some overlap eg investing in commodities could be via investing in commodity futures. For securities/equities I have provided a second-level breakdown.

Table 1

4) Comparative Benefits

How do you choose which asset class to invest in? One way is to compare the benefits of the various investments as shown in Table 2.

Note that I have compared the investments from the perspective of a long-term investor rather than a trader. As such trading parameters like long market hours, ability to go long or short, etc. are not relevant to this comparative analysis.

Table 2

Notes to Table 2
a) Easy to diversity — The ability to diversify depends on both the availability of various types of assets as well the ability to invest in a small amount.

b) Good liquidity — Can buy and sell easily and within a short time eg stocks.

Another factor that you may consider when choosing the assets is the market size as shown in Chart 1.

• Forex is the largest and cryptocurrency is the smallest.
• Global real estate value is far larger than the global equities market capitalization.

Chart 1

5) Behaviour and style

Once you have identified the asset class to focus on, you then have to decide on the investing style or school.

The tables below summarize the Pros and Cons of each of them.

Note that to avoid duplication I have assumed that the Pros and Cons of one choice are opposite to those of the choice. While not 100 % accurate, to guide you, I think it would suffice.

5.1 Pros and Cons of Trading

The main difference between trading and investing appears to be the duration in which the investments are held.

Table 3

5.2 Pros and Cons of Active Investing

Active vs passive refers to the investment activity. It applies to individuals as well as to fund managers.

Table 4

5.3 Pros and Cons of High-risk Investments

Generally, high-risk investments cover those asset classes where you can earn high returns due to leverage.

Table 5

5.4 Pros and Cons of Regular investments

Dollar-cost averaging is one form of investing regularly.

Table 6

5.5 Pros and Cons of Technical Analysis

Technical analysis is often considered the opposite of fundamental analysis.

Table 7

5.6 Pros and Cons of a Quant

A quant relies only on quantitative analysis. On the other hand, the opposite of a quant employs both qualitative and quantitative techniques to invest.

Table 8

6) How do you choose your Investment Path?

You now have a better understanding of what investing is all about. Given the large investment universe, how do you narrow it down?

Start by considering 3 basic questions:

• What are your investment goals?
• What is your risk appetite?
• What are your traits? — there is a series of factors to be considered here from time frame to interest.

6.1 Investment goals

This is mainly about your financial objectives and it can help narrow your choices.

Table 9

Your investment goal to some extent is influenced by your risk tolerance and investment horizon.

6.2 Risk appetite

Risk can be thought of as not achieving your investment goal. In the worst case, you can lose all your money.

Your risk appetite is about balancing the potential losses with the potential gain.

The various psychological tests that have been established to help assess a person’s risk appetite only prove that it is a very personal thing. I don’t have a magic formula on how you determine your risk tolerance. It is a personal choice.

To complicate matters, there are 2 schools of thought when it comes to investment risk:

• The academic one correlates risk with returns. The general view here is that higher returns require taking on high risks.
• Those who believe that you can generate high returns with lower risk. The most famous proponent of this is Warren Buffett. He believes that you can invest safely by having a large margin of safety and a host of other risk mitigation strategies. You can even expect higher returns.

I happen to follow the “Warren Buffett risk school” but I think this concept applies mainly if you follow the value investing approach. It does not apply to those using technical analysis or to traders.

6.3 Timeframe

You can think of an investment time frame from 3 perspectives:

• A very short-term trader.
• A short to the mid-term investor.
• A long-term investor

Apart from the investing style, your investment horizon may exclude certain asset classes. For example:

• Investing in real estate generally requires a long-term horizon.
• Forex trading is generally short-term trading.

Furthermore, your investment goals tend to be related to your risk appetite and investment horizon.

6.4 Age

Age is an important factor when considering the amount and type of investment.

• The younger you are, the more risks you can take as you have more time to recover from any losses. You could be a trader as well as invest in forex, commodities, or futures.
• The older probably have more savings and can invest in those assets that require larger sums eg real estate.

The important thing to remember is that age should not be a barrier to learning how to invest. It is never too late to learn.

Similarly, there are many investment alternatives so that you can match the investments with your age.

6.5 Income

I would differentiate between income and net worth. Income is a recurring stream while net worth is a measure of what you have accumulated over time.

The amount that you can allocate from your income will depend on your expenses and other non-investment commitments.

For example, with a smaller income, you may have to consider contributing regularly. You may have to forgo some of the investment that requires large lump sum payments eg properties, and corporate bonds.

6.6 Net Worth

Your net worth represents your accumulated wealth. To a certain extent, the question of how much of your net worth should be allocated to investments is an asset allocation problem.

• With a high net worth, you will have more money to put toward various assets.
• With a low net worth, you may be more risk-averse as any loss would have a big impact on our wealth. So avoid exposure to futures, commodities, and forex.

6.7 Financial literacy

Many of the asset classes are complex financial instruments. Investing in them is not about buying pieces of paper.

You have to be financially literate ie understand the intricacies of the various instruments. Certain investing styles require in-depth study to develop the necessary skills to be successful. For example, if you choose to be a stock-picking value investor you need to develop 2 skills:

• How to analyze companies.
• How to value them.

To clarify, financial literacy is not about having an academic degree. I am not sure whether there is any correlation between any academic degree and a good financial decision.

Financial decision is influenced not only by your knowledge of the assets but also by your behaviour. Academic study is unlikely to improve your behaviour.

6.8 Time available

The amount of time you can allocate to your investments will affect your choice.

• An active stock-picking approach requires more time than a passive index fund approach.
• Trading requires more time than being a long-term investor

Furthermore, you need time to build up your investment skills.

If you think you can be a successful trader in a few weeks, you are going to be disappointed. I tried paper trading in futures for almost a year and failed to make any money. It took me years to develop the analytical and valuation skills required to be a value investor.

6.9 Interests

People’s investments may be influenced more by interests and passion rather than returns. Passion may be more important should you choose a trading path as you will need the mindset to overcome setbacks.

Trading, stock-picking, technical, or even fundamental analysis all require time and effort to learn. Correspondingly, if you have low interest, it may be better to invest in index-type instruments and work with a financial adviser.

7) How to invest as beginners

What you invest in and/or your investing path are determined by two major factors:

• What is available in the investment universe — the comparative benefits and/or the pros and cons of each.
• Your profile — your goals, risk appetite, background, interests, and other demographics.

These two factors are not independent. For example, if you are very risk-averse, it is possible that picking individual equities may not be right for you. A better choice may be to invest through an equity index fund.

Your choice lies in the intersection of these 2 factors as illustrated by the table below.

Table 10

As an example, you may decide to focus on domestic equities and be an active stock picker with a long-term horizon using a fundamental approach.

In practice, the choices are not necessarily compartmentalized.

In theory that are more than 200 combinations of asset types and personal traits. As someone learning how to invest as a beginner you may be overwhelmed.

I recommend the following approach.

Step 1: Refer to Chart 1, sections 6.1, and 6.2. Based on your investment objectives and risk tolerance, narrow down the asset types to 3 to 5 choices.

I think the possible options available to you (as indicated by √) from a conservative approach are as per the following table.

Table 11

Step 2. Refer to section 5. Based on your financial literacy, time available, and interests, select the investing behaviour/style.

Step 3. By now, you have identified a few asset types and investment behaviour/styles. Re-look at them based on all the personal traits presented in section 6 to select one or two investment paths.

Step 4. Once you have chosen your path, the next step is to pursue a more in-depth study of the chosen path. As an example, should you choose to invest in equities and be a value investor, then subsequent steps are laid out:

• Sections 8 to 10 of this post.
• The Second and Third steps of this “Baby Step into the Investing Universe” series.

Step 5. Do not worry if you have more than one chosen path as the next step is a more in-depth study. As you gain further knowledge about the selected investment path, you can review it to see that it is the best combination of what is available.

Note:
If you follow my risk mitigation strategies, (refer to “Can you mitigate risk while making money via value investing?”) you will notice that I emphasize a 2-tiered allocation of net worth.

The first tier is based on the 3 buckets strategy. You set about 10 years of your net worth aside. This is for cash and those assets that protect the principal eg fixed income.

Indirectly, I have chosen to invest in cash and fixed income instruments even before selecting the other risky assets.

8) Why invest in equities?

The main reason why you would choose equities over other assets is that it generally delivers the best return over a long holding period.

• “…they provide the highest potential returns. And over the long term, no other type of investments tends to perform better.” Morningstar
• “.. the possibility to increase the value of the principal amount invested. This comes in the form of capital gains and dividends.” BlackRock

There are also other advantages and disadvantages as summarized in the following table.

Table 12

9) What are the expected returns from equities

The expected returns depend on your portfolio and holding period.

The table below gives you a sense of what you can expect. It is the compounded annual return if you have invested in an index portfolio for the top 10 stock exchanges in the world.

Table 13

I assumed that you hold the index portfolio for 2 comparative periods — 10 years and 20 years. You can see that even in holding some index portfolios for 20 years, there is no guarantee that you earn a positive return.

10) What are the risks of investing in equities?

There are several categories of risks when you invest in equities:

• Deterioration in the intrinsic value due to socio-economic reasons, political risks, and business risks.
• Errors in analysis — could be due to corporate governance issues.
• Behavioural — those due to your biases.
• Stock Exchange risks — trading suspension, liquidity issues, market manipulation.

Like all investments, the issue is not that there are risks. The issue is how to identify them and what you can do to mitigate them.

A more detailed list, as well as the mitigation strategies, are covered in the Third Step of this series.

11) The mechanics of putting your money to work

When it comes to putting your money to work you have the option to either do it yourself or to work with an investment adviser.

If you choose to manage on your own, you save the advisory fees. But you better learn to invest or else the results would not be better off.

On the other hand, getting an investment adviser can cut short your learning process. But you should learn how to choose the right adviser as it is not just about fees but also about expertise.

Then there is the whole host of questions about whether to use an app, which stock-broking firm to choose, etc

I would think that by the time you reach this stage, these are almost trivial questions.

12) Why value investing?

There are 3 fundamental questions when investing in equities:

• What to buy?
• How much to buy?
• When to buy or sell?

I find that the value investing school provides the best way to answer them

• You buy those companies trading at a discount to their intrinsic value.
• You put more money into those companies that you have the greatest conviction of. This could be based on the biggest margin of safety or strongest moat, etc all of which are valuing investing concepts
• You sell when the market price exceeds the intrinsic value and vice versa when you buy.

There are many investing schools, eg technical vs fundamental, active vs passive. Each of them has its success stories. Ultimately you choose a school/style that fits your personality.

13) Pulling it all together

If you don’t’ know how to drive, would you just jump into a car and start to drive anyway? If not, why would you start investing without knowing anything about it?

The first step is then to get some basic understanding of investing — what it involves, the risks, and what is available. This article provides you with a snapshot of the investment universe.

Once you know what is out there, you can then narrow down on what to invest in and/or choose your investing path. Thereafter you need to get more in-depth knowledge about the chosen investment path.

I hope that you have I have shown you a way to start. You have taken baby steps into the investment universe.

What comes next? Get more in-depth knowledge about your chosen path.

• Sections 8 to 10 have other relevant points should you choose to invest in equities.
• If you chose to be a do-it-yourself value investor, then the Second and Third Steps of this series are very relevant.

It is a journey of continuous learning.

This article was originally published on https://www.i4value.asia on 6 Sep 2020. Refer to the original article for the data sources for Chart 1 and Table 13.

Learn value investing

If you want to learn value investing, I have a book that is meant for newbies titled “Do you really want to master value investing?”

The e-book is now available from Amazon, Kobo and Google Play.

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