Investing 101: Why? Have a Process and a Plan
Investing, to many people, is a mysterious realm, a bit like the Ocean. We wonder at the Ocean’s beauty, play in its margins, and know its vitality to the world. But we also know the Ocean to be fierce, hazardous, unfathomable below the surface. Investing has a similar allure and danger, although even more unknowable due to when we need our investments – in the future. According to all the physics I know, the future is an inherently invisible space until you get there.
I, as a financial advisor, am often asked, “But is now is a good time to be invested?” The next sentence expresses some concern about Twitter or North Korea. My response is typically the same – your concerns are valid. But, investing is a journey. If you only considered the hazards of every journey, you would never set out. A central tenet to long-term investing is to…be invested for a long time. Right now, in the midst of the longest bull stock market in US history, it seems as though every investor is making money (See note [1] for details). It’s like sailing on a calm, tranquil Ocean. Actually, it may even feel like the Ocean is tipped, and your boat is sailing downhill.
But, when the weather will eventually turn. When it happens, it can feel out of control. To navigate, you should have an investment process and a plan. Kind of like a map and compass. You should know where you are going, and know how to get there. When the sky darkens, you will be able to turn to the plan to keep on course.
Photo by John Chesbrough
This blog post is the start to a mini-blog-series about my investing process and philosophy. The full series will be as follows:
Investing 101 – Why? Have a process and a plan (this post)
Investing 102 – When? Manage your emotions through time-frame and liquidity.
Investing 201 – What If? Investment returns and risk
Investing 202 – Diversification and fees. Why do they matter? (future blog post)
Investing 301 – Create a comprehensive investing strategy. (future blog post)
Why do you need to invest?
First, let’s talk about if you should be invested. I don’t consider investments for someone until several other important financial pieces are in place: an emergency fund, low debt, or a plan to pay down high interest debt, etc. You should make sure your present-day finances are in order before embarking on a journey for the future. There are two big reasons to invest: future life will be expensive, and the stuff you will need to live in the future will be more expensive than today.
Reason #1 – future life will be expensive. Consider an example: Ava is nurse practitioner; she is 50 years old. She is married to Raj, an elementary school principal. They have two daughters – Sonia is just finishing college, while Abby will be starting university in the Fall. Ava and Raj are entering a new era, when they are thinking more about their retirement than getting their daughters into and through college. Currently, they make a combined income of $200,000 and want to continue their current lifestyle into retirement. They are wondering how much money they will need.
After considering several adjustments (like social security, Raj’s pension, a paid-off mortgage, etc.), they decide that they will need about $80,000 before taxes (in today’s dollars) per year from their investment accounts. To fund such an income stream, they will need a retirement nest egg of about $1.8 million. In order to illustrate the power of investing, I present two scenarios to amass $1.8 million nest egg over a 40-year working career: without investing and with investing.
Without investing, Ava and Raj would have needed to save about $45,000 every year for their entire working lives ($1.8 million divided by 40 years).
With investing. Had they systematically invested their savings, and earned the market’s average 10% return, they would have needed to save only about $4,100/year.
That’s right, if they did not invest their savings, they would need to save over ten times as much money per year. (See reference [2] for math details). This is one example of why Albert Einstein called compound interest the “8th wonder of the world.”
Reason #2 – future stuff you need to live will be more expensive than today. Sticking money under your mattress means that your money will lose its purchasing power over time: in 1994 when I graduated college, a cup of Starbucks coffee cost about $1.25. Today, a Starbucks cup of regular Joe will set you back nearly twice that. Money under your mattress won’t disappear, but its purchasing power will weaken over time. Another reason to invest your long-term money is that investing in businesses (i.e. the stock market) offers one of the best protections against the erosive power of inflation.
If investing is mysterious, how do you navigate it?
In life, we need things that are not easily understood – a car repair, a medical screening, a first date. It is a normal aspect of a complex human existance. Sometimes, the result of a disparity in information can lead to an unsavory outcome. This is essentially why the finance industry has a bad reputation. People need to invest their money. They don’t understand, or don’t care to understand, all the details. An unscrupulous sales person can take advantage. Unfortunately, there seem to be a LOT of unscrupulous folks in the finance industry.
Either, you need to learn to do things yourself, or engage with a trustworthy and ethical financial advisor. Although there are no guarantees, you can increase your odds of finding a good one by asking two questions:
- Does the advisor act as a fiduciary to his/her/their clients? If the answer is “no,” then you’d better raise your caution flags. This person is not willing to pledge to put your financial interests above their own. Huh? Isn’t that what any good professional should do for their client? I think so.
- Is the advisor fee-only? If the person says “yes,” then you know they are only paid by you, the client. If they say “no,” then you should ask them how they get paid. This isn’t a slam dunk right or wrong answer. But, you should be comfortable with the answer. If they receive commissions from the products they recommend, you should be wary. For instance, if you found out that your doctor received kickbacks from a pharmaceutical company for recommending their drug, and your doc recommended that drug for you, you’d be right to want to ask a few more questions to be sure that the prescription fit the diagnosis, and not the other way around. Same logic in finance.
For a far more humorous romp through these questions, have a look at the 20-minute piece John Oliver put together about the industry (reference [3]).
A story for flavor
Imagine that you are in a foreign country, maybe Thailand. You are hungry, and staying in small hotel with a kitchen. You decide to go to the store for some groceries, to make a meal. You have a few problems. First off, Thai grocery stores do not look like US grocery stores, they are more likely to be open-air markets, with no prices or signs. Second, the food looks different than ours. Virtually nothing is packaged – just piles of peppers and papaya, slabs of pork, and crates of coconuts ready to be ground into milk. How would you shop? What would you buy? If you didn’t know how to cook Thai food, what are the chances you’d end up with something good? You would have an imbalance of information problem.
The obvious solution, and what you’d normally do in Thailand, is to go to a steaming food cart and buy a delicious bowl of already prepared curry for about $2. But, if you wanted to actually make Thai food for yourself, you would need to learn more about the food and the cooking. I’ve been to Thailand twice, and both times I took cooking classes. The two days were some of the most enjoyable I have spent in foreign countries. Most recently, my daughter and I took a class from Yui, at “A Lot of Thai” cooking school (thanks to Jessica, owner of Ciao Thyme in Bellingham for the recommendation!). We learned to cook amazing curries, and we spent an hour trolling the local market. Yui not only knew Thai food, but she knew loads about cooking. By working with an expert, we were able to equalize the “information disparity” a bit. The picture at the left is some Khao Soi my daughter made. If you would like to read more about that day, check out the travel blog post we wrote on our blog, Cheeseburgers in Asia – A Lot of Thai cooking school.
Back in Bellingham, I am more comfortable going to the Asian markets, and my daughter and I continue to produce some amazing Thai food in our own kitchen. We partnered with an expert to learn more, and to increase our confidence of our cooking process. Hey, that sounds a bit like something else. Investing!
In the next blog post, I will explore the idea that “a little knowledge can get you into trouble.” How an investor’s behavior can derail a process.
Want to read more about building an investment plan? This post is the first in a series. To read more, you can visit:
Investing 101 – Why? Have a process and a plan (this post)
Investing 102 – When? Manage your emotions through time-frame and liquidity
Investing 201 – What If? Investment returns and risk
Investing 202 – Diversification and fees. Why do they matter? (future blog post).
Investing 301 – Create a comprehensive investing strategy. (future blog post).
[1] A bull market is a stock market that is rising. Technically, a bull market ends when the overall market undergoes a decline of 20% in value. Although US stock markets dipped in 2011, they have not undergone a 20+% decline since the 2007-09 “Great Recession” bear market.
[2] Math details about retirement costs. In order to estimate future retirement costs, I made a few assumptions:
- Retirement need. Ava and Duane currently earn $200,000, but much of their income is spent on things that will end in retirement – a mortgage, college payments, retirement savings and taxes. Plus, they will receive some income in retirement from social security and Duane’s teacher pension. I used $80,000/year as the anticipated need from their retirement account.
- Retirement nest egg. I started with $80,000/year, but inflated it (by 3%) to arrive at a future need of $124,600/year. Then, I used a 6% investment return in retirement, and assumed that they would need $124,600/year for 30 years. I assumed they would spend all of their retirement nest egg.
- Saving for retirement. For saving without investing, I simply divided $1.8 million by 40 years. For saving with investing, I used a 10% return, for 40 years of work, to arrive at a savings rate of $4,100 per year.
[3] John Oliver on the financial industry
