Sunday, February 25, 2007

My experiences with investing

[Disclaimer: I am no financial advisor, and the opinions expressed below are mine alone. Follow them at your own risk - I am not responsible for the consequences]

I started investing a little more than one year ago. Last week, a friend asked me how the experience has been - I replied saying that its not been too bad, but there were a lot of things learnt - including stuff about myself (primarily about attitudes and tolerance to risk). Immediately came the next question: why don't you write a blog post about it? I figured, that wasn't such a bad idea - I'm sure there are several in a similar state to what I was a year ago, who really could use some basic pointers - especially folks with a similar background as mine (desis working in the US), who could use a primer on where to start and things to avoid (if possible)! I myself could have used one when I started last year - ofcourse there is a ton of self-help books and websites out there, but nothing helps like someone who is (or has been) in the same boat as you have ....

Personally, it does not matter to me whether someone really is benefited from what I have to say, but its just interesting to recall and write about anyway - so I will go ahead and unload my thoughts regardless.

NOTE: I consider myself as a moderate investor, not too aggressive, not a big risk taker - some might even consider me very conservative! I would consider my opinions listed below as commensurate with that position. Folks reading this may not be of the same or even similar mindset. Nothing wrong with that - to each his own!

Basic considerations before you start to invest:

1. How much do you want to invest ($)?
2. How long are you planning to invest (investment horizon)?
3. Tolerance to risk?
4. Other exposure (Roth IRA, 401k etc.)?

#1 and #2 above are very important - probably THE most important considerations of all. For an average person in the US - the answers to #1 and #2 are very generally straightforward - they would read "does/should not matter" and "till retirement" (which would generally be more than 30 years away, i.e. a very long term investment horizon). The exceptions to the latter would be a situation where there is an impending need for liquidity (e.g. downpayment on a house or a birth of a baby etc.). In that case, the situation changes - all bets are off, and you are perhaps better of either considering holding on to cash [consulting a financial consultant would be a credible option, but generally not needed or too expensive].

For desis, the situation is quite different. The following important factors come into consideration: wanting to return to India, or a even requiring to send money to India or other commitments in India, possibly even purchasing a house in the US or in India. In that case, the answer to #2 is no longer "long enough" and should be considered very seriously. A lot of financial folks will tell you that if you are investing for a horizon less than 4-5 years, then you are better off holding on to cash. The reason for this is obvious - bear markets can last 2-3 years. So if you have wretched timing, then you would need atleast 4-5 years to sort of guarentee (a bad word to use when it comes to investing, nothing is guarenteed I agree, but you get the point!) a decent return on your investment. For example, the last bear market that accompanied the recession brought about by the dotcom bust lasted about 3 years and ended in late 2002. Since then its been a strong bull run (see the chart below for the S&P 500).

So does that mean that if you are investing for a 2-3 year period, you should not invest? I don't think so - but I would not invest more than a small percentage (small is relative of course!) of available money. In such a situation, cash is king (especially in today's environment of high interest rates, where cash will get you at least 5% in a savings account like HSBC Direct). In that case, you would probably consider holding on to at least 70-80% as cash and investing the rest. Others who don't have immediate financial commitments and can stomach a bit of risk can consider investing a higher percentage of their money.

Now that you've figured out if you should consider investing - if the answer turns out to be yes, here are some of my thoughts on how to go about it. Its based on my personal experiences, and is not an authoritative user manual of any kind. And I will also tell some of the experiences that I have had:

* First and foremost, there is no substitute for doing your own due diligence, i.e. your own basic reading about the ABCs of investing - basic terms, definitions etc. Yahoo Finance is an excellent resource to learn the basics. If you think you are better off reading a book - here are two that I have read, and will certainly recommend to anyone wanting to start off. The first one is called Straight Talk on Investing by John Brenner (Chairman of the Vanguard Group), and the other one is called Charles Schwab's Guide to Financial Independence by Charles Schwab (obviously!), who pioneered the discount brokerage concept. Both these books are very well written, in simple language, easy to read and are precisely meant for those who are starting out. Both these gentleman have had enourmous experience helping people invest and back up their thoughts with appropriate data and charts. If a lot of what will follow here seems to be similar to what you will find in these books, its because it is.

* When I started investing, I was gung-ho about investing in stocks. I figured it must not be that difficult to outperform the S&P 500 index - so I dedicated a portion of my investments to a 'do it yourself' approach to investing in stocks. I knew all the statistics - about 70% of all large cap funds fail to beat their benchmark index (S&P 500), and yet I still believed I could outperform the market. In 2004 or 2005, that might have been true. But 2006 was the year of transition, there was a new Fed governor (Bernanke), and the inflation was high, the economy was slowing down, and the housing market crash was coming up, the Fed was getting more and more hawkish. Bottomline - there was volatility in the market, and lots of it!! So outperforming was not trivial!! And needless to say, I learnt it the HARD way!! Here are some of the problems:

- how to pick stocks? you think you can read newsletters, and analysis, and books and websites and figure it out? easier said than done - understanding a stock's fundamentals is nontrivial and takes up a LOT (and I mean a lot) of time.

- how to pick entry points into stocks? and even worse, how to pick exit points? Understanding technical analysis is almost out of the question for me. And I cannot rely on instinct alone to guide me through this

- buy and hold is the mantra ofcourse! Warren Buffet does the same - but its easier said than done. How do you hold a stock through its decline (and precipitous decline at that) with the firm belief that it will come back up!! this is where your tolerance to risk is severely tested, and you realy understand what you are made of.

- economy of scale: with the amount of money that I was investing, stock trading was not a very bright idea. WIth the low investing amounts, you really spend a serious % of your money in trading fees. In addition, you will probably purchase your entire position in a single trade, not muc opportunity to average down.

BOTTOM LINE: If you are investing less than about $30K (even more according to some), avoid investing directly in stocks! Stick to mutual funds - more about that later.

COMMON MISTAKE: Most people have a tendency to think they are above average (I did so too ....) - but when it comes to stock investing, being average is an achievement. It will put you above the 70th percentile - so there is certainly no shame in being average! If you don't want to believe this simply because I am telling you, go ask any professional, and he will tell you exactly the same. If you ask the best professional (Schwab), he will tell you exactly the same!!

Investing in Mutual Funds

Here is how to do it:

- setup a brokerage account, stick with one of the big four (Fidelity, Vanguard, T Rowe Price, Charles Schwab). I have used Fidelity and Schwab and certainly prefer Fidelity over Schwab. Vanguard is THE place to go if you want index investing only - anything else costs money. Not a lot of money, but there is a fee (if I remember right, its $30/year, but why pay even that?) So unless you are buying only Vanguard funds, go with Fidelity and TRowe Price. I have not used TRP, but have heard some very good things about it. Their own mutual funds are good, and they also have a good selection of no-load, no transaction fee mutual funds. So does Fidelity - I like their own fund selection, and they have a very good selection apart from their own funds. Fidelity's award-winning website also won me over. Its simple, good looking and easy to use. My personal vote goes for Fidelity. Do not use Ameritrade, Scottrade or other brokers for buying mutual funds - use those for stocks alone. Trust me on this one.

- buy mutual funds. Always invest only the minimum amount to start with (~$2500 for most funds at Fidelity), and if you have more to spare, add it at regular intervals. [More about selecting funds in a separate article]

- set up automatic investing, take advantage of no-transaction-fee, and enjoy the power of dollar-cost averaging. That is one of the biggest benefits of mutual fund investing - do not lose out on it.

- how many funds? always the big question. Obviously, you want enough to be diversified, but not spread too thin. If you have 5K, I would suggest buying only 1 (2500$ + periodic incremental investing). If you have 10K, about two and so on. But no more than about 5-6 would be needed to ensure appropriate diversification across different styles (large/mid/small cap or value/growth, international and emerging market funds). The percentages obvously depend on your investing style (aggressive, or moderate or conservative etc.)

- build a core portfolio of 1 fund with atleast 40% of the holdings, and then spread the rest around. The core fund could be an S&P 500 index fund or a Russell 2000 index fund. Or it could be a balanced fund with a good blend of stocks and bonds, such as the Fidelity Balanced Fund (FBALX) or the Fidelity Puritan Fund (FPURX).

- always select funds with no load, low expenses, good fund managers, and long term track records. Do not be influenced by short-term past performance. Look for atleast a 5 year window (if not more). Look for funds that are at least within 80% of their benchmark indices (over the long term).

- be careful when you select funds - you should consdier holding at least 2 years once you buy a fund (if not more tha that)

- rebalance your portfolio once every 6-8 months.

- be disciplined, and stick with the plan, even if the markets are not doing so great, thats when the automatic investing will earn you the power of dollar cost averaging

Also see my mutual fund picks if interested.

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Additional (Feb 26, 2007)

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Watch out for capital gains and losses - till you actually sell something, they are only on paper. But mutual funds give out distributions (dividends, long term and short term capital gains) that you have to pay taxes on. So you will have tax liabilities every year even if you have not sold shares of the mutual fund. So, if you are just starting out, avoid buying fund shares at the end of a calendar year - because you may be hit with tax liabilities from distributions even though you only held shares for a short time. This is different from the system in India, where mutual funds pay taxes at source and so the shareholders don't pay tax.

* Income generating funds (in the form of dividends) are often suited for retirement accounts (such as Roth IRA or 401K), where the tax liability is absent (Roth IRA) or deferred (401K).

* Stocks give you plenty of information about companies that you see everyday - you are more informed about the world around you. You also learn a lot about companies that you never knew existed. For an information hungry guy like me, its fun! You learn so much even about common names we see every day - most commonly about stores that we see every day - JC Penney, Target, Walmart, Best Buy, etc. - to other brands like Nike, Intel, Apple and Microsoft.

* Remember - every time you sell anything - there are tax consequences - always consider tax liabilities before you sell.

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