Investing

Last updated April 8, 2023

This page gives an overview of things to think about before investing your money.

Why invest?

Why not just leave your money in a bank account? The short answer is: inflation. Over time, the cost of living increases, the price of things like groceries and rent increases, which means the value of each dollar is less. For example, in 2002, the price of a gallon of milk was $2.76, while in 2022, that same gallon of milk cost $4.09. As a result, $100 will buy you fewer groceries in 2022 than it would in 2002.

Because the dollar loses value over time, our savings will lose value over time too unless we find a way to help that money grow to keep up with or beat the rate of inflation.

Risk

All investments have some amount of risk. Nothing is guaranteed. Generally speaking, the safer the investment, the smaller the potential return. Conversely, the greater the potential return, the riskier the investment likely is. Investing is a balance of trying to find a rate of return that you’re satisfied with while not exposing yourself to undo risk.

A common strategy among investors is to diversify their investments so as not to put all their eggs in one basket. This is one strategy for mitigating risk. Some investments will do well, and other investments will do poorly. The gains from the investments that do well will (hopefully) offset the losses from the investments that do poorly.

Another factor to consider regarding risk is timing. Each investment will do well at certain times and poorly at others. You can limit the amount of risk you expose yourself to by keeping money that you are likely to need soon (within the next few years) in safer investment vehicles, while money you aren’t likely to need as soon can be left in riskier investments as there will be more time for them to recover before you need to cash them out.

Types of Investments

Broadly, investments may be categorized into two types: growth investments and passive income investments.

Growth investments are investments where you purchase something with the expectation that it will appreciate in value and at a later date you can sell it to someone for more money than you bought it for. Examples of growth investments include stocks, real estate, commodities like gold and silver, collectibles, or cryptocurrency.

Passive income investments are investments where you purchase something or lend your money to someone not with the expectation that it will appreciate in value, but rather that it will give you passive income as long as you hold it. Examples of passive income investments include dividend stocks, rental properties, or high-yield savings accounts.

Frequently, when people talk about investing, they are referring to investing in the stock market. However, there are many types of investments and the right ones for you depend on many factors, like your familiarity with the investment vehicle (and therefore your ability to accurately assess the risk involved) and your comfortability with the maintenance involved with the investment. Many investment vehicles require some amount of upkeep (eg. real estate: repairs, finding renters), which may be more than you want. While it’s important to be aware that other investment options exist, I still focus my investments primarily in the stock market because I’m most familiar with it and the way I invest requires very little upkeep, which suits my preferred lifestyle.

The stock market is risky. The value of stock assets can fluctuate wildly in relatively short amounts of time. However, the trend over the last hundred-plus years is that over longer periods of time, the overall value of the stock market increases and beats inflation.

This trend makes the stock market an appealing long-term investment vehicle for many.

Timing

It can be difficult to know when is the best time to put your money in. There have been several studies about the penalties and benefits about different investment strategies around trying to put money in at the best time to get the most bang for your buck, and the general consensus is: Time in the market beats timing the market. In other words, invest your money as soon as you can, rather than waiting for the perfect moment, and you’ll come out ahead.

Investment Strategies

As mentioned earlier, diversification is a key part of investing to help mitigate the risk of some investments doing poorly. However, picking, purchasing, and maintaining a catalog of diverse individual stocks would be very time consuming. Fortunately, there exist investment products that are designed to handle this problem exactly: mutual funds and index funds.

Mutual funds

Mutual funds represent a collection of multiple stocks. You invest in the mutual fund, and the mutual fund in turn invests that money into specific stocks. The fund manager does the work of deciding which stocks to invest in and when to buy or sell to respond to market conditions at the time. This means there is a financial expert making those decisions so you don’t have to. The downside comes in the maintenance fees (called expense ratio), where the fund manager/institution takes a percentage off the top. Usually, these expense ratios range from a few percent to small fractions of a percent. In general, you want the lowest possible expense ratio, so you get to keep most of the gains.

Each mutual fund typically is focused on a particular market segment. You may find mutual funds targeting specific industries, specific sized companies, or companies that adhere to certain environmental guidelines.

Index funds

Index funds, like mutual funds, represent a collection of multiple stocks. The difference is that index funds automatically track some predefined stock market index, for example the Dow Jones Industrial Average (DJIA) or the S&P 500 index, instead of being managed by a fund manager who makes those decisions. This means the expense ratio can be much lower, because they don’t need to pay a human to make decisions.

Additionally, while mutual funds may beat index funds over short periods of time when the fund manager made good bets about the direction the market was going, index funds will usually beat out mutual funds in the long run, meaning they frequently have higher return in addition to their lower expense ratio. The assertion that index funds beat out managed funds was popularized by Warren Buffet’s public bet with hedge fund managers between 2008 and 2018.

John Bogle advocates for a very simple investment strategy called the three-fund portfolio. Bogle’s advice is to invest in three funds, one representing each of domestic stocks, international stocks, and bonds. I largely follow his philosophy - because index funds that track the entire market exist, there is no need to pick and choose funds more specifically than that. My investment strategy

For this reason, I personally choose to invest almost exclusively in index funds. The main index funds I choose to invest in are: VTSAX (index on all domestic stock) and VTIAX (index on all international stock). Between these two index funds, my investment portfolio will be diversified across all stocks globally. That doesn’t mean I’m insulated from risk, though. When a recession happens, my portfolio will go down just the same. But when it recovers, my portfolio will, too.