Tuesday, February 9, 2016

Should You Buy Stocks?

Whether a person should buy stocks or not comes up in every conversation I have with people. They either want to know what the best stock to buy is, or if I have any hot tips.  But what always makes me angry is when people tell me they don't invest because they think the stock market is like gambling and not worth the risk. It's just upsetting to know this is how a lot of people view this important part of finance.

Of course they could have gleaned this opinion from any number of sources. Be it the media, internet, friends and family, or their own observations.  Of course there is risk involved. Ask anyone who bought the top of market in 2000 or 2007. Their time in the market has probably not been as enjoyable as everyone else despite the fact they are sitting on gains today.  Yet no one should be passing up this important aspect of financial well being.

The problem lies within our own expectations. We see news clips highlighting how a trader racked up millions in dollars in a few months, or the penny stock that went up 1,000% in less than a year. Yet there is no news story explaining traders might work up to 80 stressful hours a week, and that most of them leave the profession after a few years of losing money. In the penny stock case no one ever mentions the majority of companies that became bankrupt and defunct.  Yet it's those few success stories always making headlines that suck us in. It leads us to falsely believe that this is the only way to make money in the stock market. If that were true Warren Buffet, Jack Bogle, and Benjamin Graham should all have been broke slumming on the street.

So how do we control our expectations? You have to take over your cultural and human instinct to think short term.  You must then realize that no matter what there will be ups and downs just as in your personal life.  Then remember there is a thing called the business cycle which affects all of us including your own job possibly rendering it unnecessary tomorrow. I know it sounds tough, but in the end it will be rewarding because your money can work harder than you.

You must also remember that you are investing this money so that it can pay you later. Good companies are not built over night. It's the same concept as if you went into business for yourself. You would invest money in your business hoping that 20-30 years later the business was successful enough to pay you while you sat at home and someone else ran things. Those paycheque's would be your dividend for doing nothing at all. The stock market is the exact same concept. It takes time for those dividend checks to build up through compounding.

Your next step is to commit to an approach that you feel comfortable with. If you have $10,000 saved up it might not feel like a good idea to invest it all at once. Even though on average 8 out of 10 years the market rises(some years more than others). The problem is the down years which can be sharp and nasty. Either way if the market goes up roughly 80% of the time you are most likely to miss out on gains. Don't believe it? Just check out a chart of the market from the last 100+ years.

Here is a summary of three approaches.

1. Invest the money all at once. This one is the least hassle, but generally has more downside risk. If you happen to be unfortunate enough to invest it right before a fall  don't stress!  You should quickly save up more money to buy additional shares at lower prices.  You have to think of it like you would a sale at the mall. If in January a leather coat sells for $300 and you buy it, you should really want to buy the leather coat in March when it's selling for $150. No matter what over time you'll end up with about 8% average annual returns. This strategy is sound for a long term investor(10+ year time horizon) because even if you did buy the top in 2000 and 2007 you would still be up on your investment today. Plus you would have been collecting dividends the entire time.

2. Invest the money at set intervals(aka dollar cost averaging). You would spread the $10k over 5 months for $2k/month. Although this will likely entail more commission fees you can blunt the effect of a market fall, but if the market rises understand you'll have less shares. Either way it's a good strategy if doing the all at once method makes you feel uneasy.  Its actually a method followed by most people as they make monthly contributions into investment accounts from their salary.  You should look to set aside a good portion of your monthly income automatically to retirement accounts.

3. Invest the money partially and opportunistically. I like to think of this method as modified dollar cost averaging. If you have $10k you would take $6k and invest it today. In the meantime you patiently wait for the market to fall 10% or more,  then you invest another $1k. Leaving you with $3k for additional opportunities. For example if the market falls more than 10% all the way to 20% you could take another $1k to invest at this time. After that you can build your cash position until opportunities present themselves again and repeat the process each time. This way you always have some cash available when there are bargains. The key is to only buy during market corrections. This is an approach commonly used by Warren Buffet. When the stock market sells off you will have ample cash each time to pick up additional shares at lower prices. You do however need to set some guidelines as to when you will invest this money plus some patience. This is essential since psychologically most of us are averse to buying when the market is going down(i.e on sale).

No matter which approach you use the end result should be the same. You should be sitting on a nice chunk of income producing assets providing you with passive income as the years go on.

The types of securities you should be putting your money into is a another topic to be discussed in future posts.

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