Getting Started on Financial Independence: Investing

Part II in a series of posts on getting started on financial independence and resiliency. The initial impetus for this came from COVID Career Advice. The first post in the series focusing on making yourself resilient is Getting Started on Financial Independence: Financial Resiliency.

This post focuses on getting started growing your assets and investing once you’ve sorted your basic financial hygiene out. Please read that and go through the 80/20 exercise and assessment if you are not in a position of setting aside 10-20% of your take home for financial growth every month.

Short Term Goal

The short term goal for this post is to build on your foundation from financial resiliency and start building. Specifically, open a brokerage account and start a monthly habit of buying ETFs to start growing your money through investment.

Long Range Goal

Make you financial independent. Growing your financial base and resources to the point that income streams from your investments, assets, even businesses completely cover your expenses monthly (ideally, without ever drawing down on those assets). At that point, you do not need a job in the classical sense. You have freedom in how you choose to spend your time and what to do with it.

Think: Wealth = freedom (net worth is merely money). Lots of people have high net worth, few people are wealthy.

How do we do this? A few reality checks first if you haven’t got a solid financial foudnation yet, or haven’t read and taken what you can from the first post on financial resilience.

Reality Checks

Investing and Speculating are Different

Make sure you know the difference between investing, where you put money into the stocks of a company because you believe in it as a long term bet you are going to hold for 2-5+ years, and speculating, where you bet on the short term movement of a stock or asset.

Gamification of the stock market, crypto, and too many stories of YOLOs getting lucky on long shots has made everyone feel that you must be stupid if you put money into companies for the long term, but some people will always get lucky on lottery tickets.

A more reliable, consistent, less nerve-wracking approach is to work on investing in consistently great companies which return value over time through growth. Consider them better, longer, slower bets.

Your goal here is to reduce volatility in your returns rather than gamble on it. As anyone who bet on Dogecoin last year can probably tell you, not having 2/3 of your value evaporate in a week, investing in solid firms will help you sleep better at night.

All Investing is a tradeoff between risk and reward

Safe risks generate smaller returns. Large risks (SPACs, crypto, early stage companies etc) can generate large returns, but with the risk you can lose heavily. Generally, you see this as what is known as “volatility” - wide swings in the returns or losses over time.

Our goal is to try to maximize our returns while minimizing our risk (there is actually a mathematical way to do this known as the Efficient Frontier from Modern Portfolio Theory, but that is much more advanced concept we’ll possibly have a later post on. For right now, baby steps.).

There is a distinct difference between investing and speculating (or outright gambling). Know the difference. Investing is about growing your assets over time trusting in their underlying value. Speculating or trading is about making short term bets on the oft-random movement of stocks - which are “stochastic” (analyzable statistically in hindsight, but not future-predictable).

We’ll be focusing on an easy start to managing risk versus reward, and as you gain knowledge, build up your relationship to risk vs reward. Right now, we’re going safe to get you started.

Diversification is your friend

Diversification is spreading your money between different assets to hedge against volatility.

What does this mean? It’s the cliché of not putting all your eggs in one basket. Many baskets ensures that if anything happens to one basket, your other eggs are safe. If you have diverse asset classes and stocks, most shocks will not affect them all, meaning your returns will be steadier and more sure over time than dealing with wild swings or losses.

This also means that your returns are usually a little less than if you’d managed to get lucky and pick all the 100X growth stocks, but overall, diversification is a way to grow your portfolio steadily over time without risking losing a lot.

Diversification is your friend, and it’s such a well recognized concept in investing, that people have made it easy for you to stay diversified without a lot of thought.

Myth vs Reality Investing

Despite a trillion dollar industry and stock pickers making mad salary in the financial capitals of the world, few investment managers manage to outperform major stock indices over time - particularly the S&P (Standard and Poor’s index) or the NASDAQ 100.

30 Year S&P 500 returns

As you can see from this inflation adjusted graph of the last 30 years, despite major global recessions (the grey vertical bars), growth in the S&P500 is solid and consistent over the longer term.

Both these indices take strong stocks, and then track them as an indicator of a stock exchange’s or industry’s health. The observant noticed these indices tended to go up with not much volatility over time (cuz, diversified) so enterprising fund managers started to offer shares of the entire basket of these stocks which they then passively manage (readjust to make sure they are aligned with the basket of stocks the index represents - active management are funds where the fund managers actively pick stocks in line with the fund’s stated strategy and take a much higher fee for it than passively managed ETFs).

Passive funds are cheaper in terms of fees (in general, funds charge or should charge 0.2 or 0.3 % as a fee on this instead of 3%+ or higher for actively managed funds). You get good, very safe returns consistently without a lot of volatility, even in the best or worst of times. Of course these indices go down from time to time, but it’s generally indicative of whole world problems and you’re still insulated from the downshock due to the still performing stocks that do well during shocks (like covid)

These are generally known as ETFs (Exchange Traded Funds). The point is, they are inexpensive, performant, and even stock picking experts have trouble outperforming them over time, so they are a great way to get your feet wet investing. That’s what we’re going to do.

Getting Started

Alright, so to get started on your royal road to a robust investment portfolio, you’re going to start with a very simple system: open a brokerage account and move your 20% a month into it and purchase ETFs. Yup, it’s that simple.

That’s it (and note, there is always the chance these indices track down if they are high at the moment.). For real safety, just throw your money into your brokerage’s passively invested S&P ETF. I personally would split money equally between both the S&P500 and NASDAQ ETFs they offer (make suer they do not have fees greater than say, 0.3%) to get a little growth bump as well. YMMV depending on how conservative you wish to be.

Choosing and Opening a Brokerage Account

For your main brokerage account, I actually encourage boring. Sure, there are neo-brokerages with slick apps heavily focused on gamifying trading but they are centred on speculating, not investing. You want:

  1. A solid, dependable brokerage with good reputation and solid security
  2. Offers commission-free trades (or very low cost ones)
  3. Low cost ETFs that are passively managed, low fee, and free to trade
  4. Allows Limit Buys (more on that later)
  5. Good web and mobile user experience
  6. Fractional shares investing (nice to have, but very handy)

Brokerages actually make most of their money by loaning out the money you are not using in your account. This is enormously profitable for them. They do not even need to charge you commission on trades, it’s just something they do cause they always have. Reject this. There are excellent commission-free brokerages available almost everywhere and you should take advantage of them.

Wherever you are located, the account opening process generally means you need to be a citizen or resident of a particular country and have a bank account located there. So, the account opening process can be a pain, though in North America, many new apps make it as painless as possible. You will more than likely need to provide tax information as well since, surprise… you need to pay taxes on your gains when you sell (though, since we’re investing in ETFs you can kinda avoid paying any for quite a while depending on your tax jurisdiction.). You will need to upload some sort of government identifying information to identify yourself. This is a requirement all brokerages and financial institutions have known as KYC (“Know Your Customer”). Don’t freak out. Think of it as opening a bank account. Cause effectively you are, and they are governed by even tighter regulations.

In general, I advise against using your bank’s brokerage arm unless it is a completely separate company. Bank brokerages, much like banks, have lots of fees, generally charge for trades and are just generally sucking profit away from you with sneaky fees much the way your bank does. I also advise against companies like Robin Hood or similar places that are focused on gamification, options trading, and more speculation. It’s fine if you want to do that too, but let’s get you investing more sanely first and then decide to open an account like that for what I like to call “mad money” investments. Speculating is fine. Just don’t put all your eggs in that basket.

Another thing to watch for, especially if you are investing in US equities or funds (and you most likely will) is the exchange rate that the foreign brokerage applies against transactions. For example, my brokerage takes a clean 1.5% currency conversion fee every time I do any transaction on US equities or funds or convert them back to CAD. This is a sweet deal for them on top of whatever spot rate they are getting but I find is not too bad a “tax”. Be wary especially of bank brokerages which generally have very unfavourable exchange rates. Make sure you know what they are up front.

Don’t be afraid to spend a week-ish or two weekends researching which brokerage is best for you (google “best brokerages 2021 ” to get a shortlist). Ultimately, find one you are comfortable with and are going to feel safe growing your money with over time (though other brokerages do make it easy for you to move your money to them in most countries). Find one that can easily connect to your main bank for deposits and that you can easily withdraw money from in case of need.

Making Your First Deposit

Account opening can take anywhere from a day to a week (or longer in some locations - a friend’s account took 2 months due to the opening of a commission free brokerage in the company and another had to do a equities trading course online due to the options trade component of the brokerage due to regulations in-country.). Be patient. They need to take care of KYC requirements and in some cases make sure you can exercise a level of financial knowledge that does not expose you to risk.

At some point, your brokerage account will finally be open and yours. It will be empty. The first thing you need to do is to fund it. You need to move money over to it to trade with. Banking is still in the dark ages in this respect, but it can take a day or more to move money over to your brokerage in even countries with banking systems. Also, once you do that most brokerage’s risk management departments will place a 3-5 day hold on your money on being able to trade with it (don’t worry, they are still making money off your money even if you can’t use it. 🙂).

So, again, be patient (in fact, patience rewards investors in nearly all cases.). As a side note, for whatever reason, I find the moving of money from bank accounts to brokerage accounts always to be a pain and fraught with some amount of stress).

At some point though, your brokerage account will be opened and funded and you will be able to open the site or app and see an account

Making Your First Trade

Most brokerage accounts make it easy to buy.

There will be some interface for searching for the equity that you are interested. If you’ve never looked at this kind of stuff before, most of these identified by their stock ticker symbol which is a 2-4 letter code on the major exchange on which it’s listed (examples: AAPL for Apple, GOOG for Alphabet, AMZN for Amazon). You will get used to talking about stocks by their ticker symbols with time until you catch yourself saying things like “Yeah, I bought 50 shares of SPYG last week.” (just wait, you will).

Generally typing up NASDAQ or S&P will generally get you to a selection of ETF funds offered by different fund managers that track those indices or some segment of them (do read the information - some only track the 200 largest by market capitalization, others will track some subset so pay attention to what you may be purchasing. I suggest just going with straight up index funds, so the classic in these examples are SPY and QQQ (Nasdaq-100 largest non-financial companies) if you need safe recommendations though, as with all things, do a little research and don’t take my word for it.

Yes, shares in these ETFs may look pricey, particularly if you’re not flush or getting started slowly or your 20% is not a phenomenal amount. This is where it may be important to have the option of fractional shares in your brokerage. Fractional shares allow you to take a percentage of ownership in a share. For example, if you only have $500 a month to invest and want to make tht consistent, and shares of ETFX are $115 USD each, fractional shares allow you to buy 4.35 shares rather than just 4 in one month. For very expensive shares when you get more sophisticated, whoppers like Amazon, Google, Berkshire hathaway or similar, fractional investment is a great way to dip your toe in expensive, but highly performant stocks. So, do make it a serious consideration when looking at the brokerage you select.

The key thing I want everyone reading these posts to get out of it’s greater financially literacy and education and a sense of their own agency in their financial future and independence.

Once you have selected your stock ticket, there will be a Buy or Trade button somewhere. If possible, set a Limit price (the max you are willing to pay for each share of stock rather than just what someone may be willing to sell it to you for in the market) as this can save you a few nickels or dimes on each share sometime. Pick your price. Pick the number of shares you want. Submit your trade, and…. wait.

With any luck, your trade will generally resolve within 15 minutes or so. Sometimes it might take longer. Sometimes with limit buy trades you may be in the situation where no one will sell to you in a rising market (say you picked a value a quarter below the market value, few people will want to sell to you unless the index is falling on that day). But assuming your trade resolved, you are now the proud owner of X shares of whatever equity you purchased in that amount. Congratulations! You just made your first stock investment. You’re now on the way to having a stock portfolio.

A word of warning: I often make this joke that the surest way to tell a stock to go down is for me to buy it. I cannot tell you the number of times that I have purchased an equity on the day to have it finish lower that night (so effectively, you may have lost a few dollars). This will happen to you. I guarantee it. Do not freak out.

In general, the daily fluctuations in stock will drive you insane if you pay too close attention to them. You need to focus on the big picture, which is that in general, given time and patience, your basket of equities will go up and generally perform as well as the market, and makes a good investment. Sure, things might go down in particularly bad years or during a recession, but over time, value increases. That is the sovereign rule of investing.

The key thing is to make sure, once you get to the point of buying indvidual stiocks, is that you are buying them for the right reasons.

Great. Sorted. Now What?

So, you’re now a stock investor. You actually have a stock portfolio. But effectively my advice here for the next little while is: wash, rinse, repeat. There’re really two ways you can go here, but the key thing is:

Consistency

Keep moving funds monthly into your investment portfolio. This has two major benefits:

  1. Dollar Cost Averaging
  2. Compounding

Dollar Cost Averaging is a pretty simply concept: consistently investing at the various price fluctuations that happen every month basically lessens volatility. Sometimes you are buying low, sometimes you are buying high, but on the whole you are evening out the volatility in the stock by buying at these times to arrive at a fair price and avoid the craziness of trying to time the market to buy when things are low before they go high (which is near impossible with 100% accuracy.).

Compounding is the magic of time. If you have something that is growing continually and those capital gains reinvest into the equity, you will see exponential growth functions over time. The math behind this is a bit complex, but the bottom line is trying to think about how long it will take your money to double each time if you just left it alone and did nothing. The is a handy “Rule of 72” that states it will take your money 72/return rate to double. So, for an 8% return, it takes 9 years for your money to double. For a 12% return, 6. For 18%, 4. You get the idea. But on top of this, you are also injecting more money in each month, which accelerates the compounding effect.

So, while it sounds boring, developing the consistent habit of moving money monthly and investing it in ETFs is not a bad strategy to go with if you don’t ever really want to think about this stuff, find it boring beyond all reason, and just want to not be losing money over the long run (which you are if you are keeping your money in the bank at 1.6% pa since inflation of 3% is chipping away at your money every year.).

The other route here is to start educating yourself more about understanding underlying company fundamentals and their stocks to try to build a literate portfolio which may outperform your ETFs. It may introduce volatility, but everyone who invests secretly wants a portfolio where they managed to get in on the ground floor of the next Apple, Amazon, Tencent, or Netflix and rides that success to their own financial independence (if not private island.). We’ll talk about the second route in a future post, and how to learn more about the fundamentals of companies and stock investment, but if you’ve made it this far and managed to actually invest some money in some ETFs, I’ve earned my writing keep for the week.

Fin

Again, the rules here are simple. Manageable, consistent, savings moved to properly vetted investments is a good road for anyone wanting to get more out of their money, and having future goals that may not include working for someone else. It’ll take some discipline and some work, but effectively, there is nothing here stopping someone, especially starting early and with compounding, to being very wealthy in 20 years' time.

Let me know what you think about the post on twitter @awws or via email hola@wakatara.com. I’d love to hear feedback about what similar or other processes or approaches may have worked for you or tweaks to the above. What have been your best finance systems to gain resiliency and stability? Even better, (reasoned) opinions on why I might be wrong and what might be even better or stronger changes that may have worked for you.