What You Should Be Aware Of Before Investing In The Stock Market

Perhaps you're beginning to make a solid income and you want to start “investing”. But what exactly is “investing” and what's the best way to get started? A good way to start thinking about investing is to see it as committing time and/or capital to a project today in the hopes of getting an additional benefit or profit in the future. The question is: what types of investments should be made?

Invest in yourself by keeping your debt in check

Ask around and it seems like everyone has an opinion: stocks, bonds, real estate or a startup. But it may not be best to start your journey as an investor in any of these assets. Instead, to get started, you may want to invest in yourself. When you paid tuition and got a degree you were investing in yourself. With your degree in hand, and perhaps a decent a paycheck coming in, you should continue investing in yourself by keeping your debt under control. To do so, focus on your debt to income ratio (this requires your gross income which is your income before taxes and other deductions). Ideally, what you want to do is to keep your debt to income ratio around 20%-30%. For example, if you earn $4500 a month (gross) and pay $800/month in rent, $200/month for a car lease and $250/month in consumer debt, debt divided by income equals $1250/$4500 or about 27%. Your debt to income ratio is so important because the less you owe, the more money you have control over. In the example above you have control over 73% of your income which you can use to save, invest and spend.

Set aside some money for an emergency

The next step to investing in yourself is coming to terms with the modern employment reality. Lets face it, for most of us employment for life is a thing of the past as job security is rare in light of productivity and efficiency gains. What this means is that you should try and set enough money aside to cover roughly 3 months of expenses while you search for a new job.

Start saving at least 10-15% of your income

Once you have your debt under control, start trying to save at least 10-15% of your income. The earlier you start the better, as a dollar saved when you are younger is much more valuable than a dollar saved when you are older as each dollar properly invested could be worth much more in the future.

Don’t let all your savings sit in cash, put your money to work

Now that you control more of your income and you have some savings what should you do? What you shouldn’t do is let it all sit in cash. You worked too hard for that money to let it sit idly as dead money in a bank account. Instead of just working for money, you should make your money work for you. This is the fundamental crux of investing that most Canadians don’t understand as 62% of their total savings are held in cash.

By investing, you put your money to work purchasing assets that bring you passive income (income that flows in while you work away at your job or do whatever it is you love). This concept is hard for us to understand because most of us grew up being told that to get an income we needed to work hard, and put in the hours. Although there is nothing wrong with working for a paycheck, this advice completely omits the life changing benefits of buying/investing in assets which bring passive income and eventually can free us from being dependent on a wage. To get an idea of how powerful passive capital growth can be, consider this chart which shows that the value of the S&P 500 Stock Index has expanded by 5,212% (since 1980) while household incomes have only advanced 240% (since 1974).

Over the long term stocks have offered the highest average rate of return

So what assets should you be investing in? Well if your goal is to maximize potential income over the long term the historical record is unequivocal: stocks outperform the other traditional asset classes (bonds, treasury bills, gold) by a large margin.

Source: Siegal, Jeremy J. Stocks for the Long Run, 4th Edition. New York: McGraw-Hill, 2007

But what about real estate? The result is the same. If the S&P 500 Stock Index is compared to the Case Shiller home price index which is the leading measure of U.S. residential real estate prices, the stock market index outperforms by a large margin.

Furthermore, home ownership entails a whole range of costs that don’t apply to stock ownership. Think property taxes, insurance, maintenance, renovation and lack of liquidity (if you want to sell, there may not be a buyer).

Robert Shiller, one of the most famous Nobel Prize winning economists, recently went so far as to say:

“It would perhaps be smarter, if wealth accumulation is your goal, to rent and put money in the stock market, which has historically shown much higher returns than the housing market.”

The stock market isn’t as scary as you might think

These numbers are staggering and beg the question why anyone would invest in anything other than stocks? The problem is that many people don’t appreciate such facts because their understanding of the market is anchored in misinformation. The reason for this misinformation is linked to the relationship between human emotion and the stock market. Stocks are not just wildly swinging prices on a bunch of computer screens. They are interests in a business that reflect its value. When you buy a stock the price you pay reflects its value yet buy and sell decisions are typically made by humans who are naturally averse to loss and thus tend to make decisions grounded in emotion rather than reason. This is due to the fact that people tend to feel more strongly about the pain that comes with loss than the pleasure that comes with gain. Given the visibility of price in the stock market, the emotional distress caused by a sudden drop can be a daily possibility unlike the experience of being a homeowner whose price/value isn’t something you can easily verify on a daily basis.

Thus, due to the role of human emotion and the visibility of both gains and losses, the stock market is often understood as being volatile, scary and “a gamble”. This might explain why just 26 percent of Americans under the age of 30 (millennials) are now investing in the stock market, according to a recent survey by Bankrate.com. This is in stark contrast to the 58 percent of people between ages 50 and 64 who invest.

The important thing to remember is that although the stock market appears scary in the short-term, in the long term it’s a boring and predictable climb upward. In Berkshire Hathaway’s 50th annual letter to their shareholders Warren Buffett (arguably the greatest investor of all time) reminds us that:

"Stock prices will always be far more volatile than cash equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray."

For some perspective, consider this current snapshot of the S&P 500 Stock Index. What you will see are some hiccups but the trend is a steady line upwards indicating that if you simply followed the index since its inception in 1970 until present (45 years) you would have increased your wealth by nearly 8800%. That means that if you invested $10 000 in the Index and forgot about it you would have $1,209,950 today!

Grow your income and thus your wealth by investing in stocks

As the graph above shows, time can convert certain asset classes from the least attractive to the most attractive and vice versa. Thus, if you can think long term and realize that your investing horizon is far longer than you think you can use the stock market to grow your income and thus wealth by epic proportions. Wise investing takes discipline, effort and time but the long-term rewards of financial freedom or retirement comfort can be well worth the effort.