In 1950, one-dollar could buy you 3 pounds of coffee. In 2019, one-dollar can’t buy you a single cup. The value of our money decreases over time as goods and services become more expensive. This is called economic inflation.
So saving and stockpiling money is not enough. If this money does not grow somehow, then inflation will slowly eat away at its value. Investing gives us the ability to keep pace, and possibly even exceed the inflation rate. So what does that mean in plain English? More money and purchasing power in your bank account.
The stock market provides one of the easiest ways to invest your money. But the stock market is a wild and unpredictable beast. Understanding why stock prices move up or down is a science in itself. So for a complete amateur, this beast can be downright terrifying. One day your $100 investment is worth $150, and the next day it is worth $50. With limited knowledge, it seems foolish to subject your money to such uncertainty.
However, there are many ways to play this game. It’s all about balancing risk and return. Investing in the stock market can be less risky and easier than you think.
This post is geared towards the noobies and will be long. Therefore, I have broken it into 3 easily digestible portions:
- Part 1: What Money to Invest in the Market
- Part 2: Why Investing in the Market is Not So Scary
- Part 3: Where to Access the Market
Part 1: What Money to Invest in the Market
First things first, the stock market is not a “Get Rich Quick” scheme. Building real wealth takes time. If you are after quick investment returns so you can run up a bigger bar tab or buy some new clothes, then this is NOT the place for you.
I’ll say it again: Building real wealth takes time.
Therefore, when investing in the market, you should only use your playground money and invest for the long run (more on these points later). Subjecting your rent money or car payment to the daily fluctuations of the market is something I would strongly discourage. In other words, the money you use for daily life expenses is off the table here.
So how do I determine if I have any investable money?
Step 1 – Essential Living Expenses
First you need to understand how much it costs to live your life. I’m talking about rent/mortgage, food, bills, commuting and all those expenses that you have no choice but to pay. Let’s call these your essential living expenses. The easiest way to determine your essential living expenses is by tracking your spending. Follow this how-to-guide and track/categorize your spending for the past 3 months. This will give you a good understanding of how much it costs just to keep a roof over your head and food in your belly.
Essential Living Expenses:
- Mobile phone
- Commuting expense (includes monthly car payment)
- Monthly Student Loan Payment
- Essential Personal Care (Include: soap, shampoo/conditioner, deodorant, toothpaste, etc. Exclude: your $150 forehead moisturizing serum)
Step 2 – Calculate Monthly Cash Flow
Take your after-tax monthly income and subtract off your essential living expenses. This will give you monthly cash flow. Now hopefully this number will be positive. If it is not, then you need to change your lifestyle ASAP.
Step 3 – Set Up Your Emergency Fund
Emergency Fund = Essential Living Expenses * 3
Most experts recommend having 3-6 months of essential living expenses set aside in case of unexpected medical expenses, being laid off your job, etc. However, this is a personal decision and the comfortable cushion will vary from person to person. Regardless of your risk tolerance, it is very important to have some money set aside for the unexpected things life throws at us. Use your monthly cash flow to establish your emergency fund. If you already have an emergency fund, then you can skip to step 4.
Step 4 – Pay Off All Bad Debts
If you have bad debt, then your number one focus should be paying off this debt. Bad debt is essentially any debt with a high interest rate. For example, credit card debt, personal loans or payday loans. Car loans, student loans and mortgages are still debt, but typically they don’t carry ridiculously high interest rates.
To understand why investing doesn’t make sense when you have bad debt consider the following example. Imagine you have $100 of credit card debt with a 24% interest rate. You also have $25 cash which can be used to invest or pay down your debt.
- Option #1 – don’t invest and pay off your debt immediately
- Option #2 – invest, achieve an investment return of 10%, then pay down debt
- Option #3 – invest, achieve an investment return of 24%, then pay down debt
- Option #4 – invest, achieve an investment return of 30%, then pay down debt
In order to benefit from investing, you would need to achieve a return that exceeds 24%. Since exceeding a 24% is extremely difficult and practically unheard of in todays environment, you would be best served by simply paying off your debt immediately.
Step 5 – Playground Money
Once you have an emergency fund and are free of bad debt, then all of your monthly cashflow becomes playground money. This is money that you can choose to spend however you want. You can invest it, save for a down payment, buy clothes, buy drinks, buy your $150 forehead moisturizing serum and so on and so forth.
Investing is for the Long-Term
If you do decide to invest your playground money, consider this money untouchable for at least 15-20 years. The stock market will fluctuate from day-to-day and year-to-year. Some years it will be up, other years it will be down. However, the market has historically always provided a positive return when evaluated over a 20-year period. In other words, if you bought the entire market and waited 20 years, then historically you would have achieved a positive investment return.
For the non-finance folk: if you plan to invest for a long period of time then you can ride the rollercoaster. This roller coaster will go up and down, however it will always finish at a higher point than it started (yes I know this defies physics, but it’s just a stupid metaphor so let it go).
Your money can be invested in the market via several different accounts including retirement accounts (401ks, IRAs, etc.), medical accounts and brokerage accounts. More on this to come in Part 3: Where to Access the Market.
Downpayment or Other Large One-Off Expense
If you plan you use your playground money within 1-5 years for a down payment on a home or a large one-off expense (ex: vacation, car purchase, etc.) then the market is not the best place for it. Instead opt for a high-yield savings account. You will get anywhere from 1-3% return on your money, which greatly exceeds the marginal interest rates that traditional savings accounts are currently offering.
Part 2: Why Investing in the Market is Not So Scary
So now that you know which money you could invest in the market, it’s time to answer the question: Why is investing in the market not so scary? The answer boils down to the simple statement below:
The market ALWAYS goes up in the long run
Let’s dive into this statement and dissect it piece by piece:
What is a Stock?
Simply put, a stock is a piece of ownership. Think of each company as a giant pizza pie. This pie can be cut into 2 halves, 4 quarters, 8 slices, 16 slices and so on. Your ownership over this pizza pie will be based on how many slices you have on your plate versus the total number of existing slices. So if you have 2 out of the 8 total slices, you own 25% of the pizza pie.
A company’s stock works in the same exact way, however instead of 8 slices, there are millions or billions. So when you buy one share of Amazon stock, you are now the proud owner of 1 of the 489 million slices of Amazon. Congrats!
What is the Market?
Okay you can stop pretending you know what I mean when I refer to “the market”. Your certain I’m not talking about your local farmers market, but your certainty stops there. So, let’s simplify things a bit. When people say “the market” they are generally referring to the stock market. The stock market is where the stock of every publicly traded company lives.
So if Joe wants to buy a piece of Amazon, he will go to the stock market and see who is selling Amazon. Conversely, if Jane currently owns a slice of Amazon but doesn’t want it anymore, she will also go to the stock market and see who wants to buy Amazon. Just to clarify, you don’t have to physically go anywhere, the stock market can be accessed online (more on that in Part 3: Where to Access the Market).
When is a Stock Considered “Up”?
A stock is considered “up” if it is worth more than you originally paid for it. So if Jane originally paid $100 for her piece of Amazon, but now Joe is willing to buy it for $120, then Amazon is “up” $20 for Jane. She can sell it to Joe or hold out and listen to other offers. If Bob comes along and offers $130, then Jane is now “up” $30. At the end of the day its just simple supply and demand. If the number of people looking to buy a given stock is greater than the number of sellers, then the price will continue to climb.
When is the Market Considered “Up”?
Okay so now you understand what a stock is and how the price of a stock can rise and fall based on supply and demand. The market is nothing more than a collection of all the individual stocks out there. So if the stock prices of individual companies are rising, then the market as a whole will be considered “up”. Conversely, if the stock prices of individual companies are falling, then the market as a whole will be considered “down”.
The S&P 500 Index tracks the individual stock prices of the 500 largest publicly traded companies. It weights all these individual stock prices together to form something called an “index”. This S&P 500 Index is widely considered the best representation of the overall US stock market. So basically, if the S&P 500 Index is up, then the stock market is up.
Think of the S&P 500 Index as a box of blueberries. Each berry represents the stock of an individual company. Some berries will be rotten, while others will be plump and juicy. If you have one or two bad berries, you would not conclude that the entire box of blueberries is bad. In fact, you would probably be quite satisfied and consider that a good box of blueberries. Conversely, if most of the berries are rotten, then you would deem that a bad box of blueberries. The point here is that you are judging the box of blueberries based on the majority and not the outcome of any single berry. The S&P 500 Index does the same, but with stocks instead of berries.
Now lets have a look at the price of the S&P 500 Index since its inception in 1957:
We can see that in certain years the price dipped (ex: post-2008 mortgage crisis). However, the overall trend of the price is undeniably upwards. The market will have its ups and downs from day-to-day, month-to-month and year-to-year, however in the long-run it will always be up.
What is the Long Run?
This is a subjective term, but for arguments sake, let’s call the long-run 20 years or more. I chose 20 years because the market has historically always provided a positive return when evaluated over a 20-year period. In other words, if you bought the entire market and waited 20 years, then historically you would have achieved a positive investment return.
Why the Market Always Goes “Up”?
The investing world generally agrees that the market will be up in the long run. However, the reason why this phenomenon occurs is quite complicated. In fact, if you ask 10 people, you will likely get 10 different answers. So rather than list out all the possible reasons and explanations, I’ll focus on the ones that I believe to be most valid and fundamentally sound.
Remember, the price of a stock is driven by supply and demand. If there are more buyers than sellers, then the price of the given stock will rise. Buyers are naturally attracted to successful companies. So to understand why the market will rise, we have to look at what will cause there to be more buyers or what will cause there to be more successful companies in the market:
- Population Growth – the world population continues to grow. More people means more potential buyers in the future and therefore higher stock prices.
- Technological Innovation – economic growth is closely linked to technology. We are producing more goods and services now than during any other point in history. A larger economy leads to more people with money to invest.
- Outpacing Inflation – the purchasing power of a single dollar decreases every year. Recall that in 1950 one-dollar could buy you 3 pounds of coffee. In 2019 one-dollar can’t even buy you a single cup. If people do not invest their money, then over time it will lose purchasing power. People who have excess money that they do not plan to spend today will need to do something to outpace inflation.
- Limited Downside, Unlimited Upside – bad companies will eventually fail and cease to exist. At most they can lose 100% of their value. Once this happens, they will no longer be traded on the stock market. However, for good companies the sky is the limit. They can double, triple or even 100x their value. What’s the net result for the market as a whole? Up! The market will constantly rid itself of bad/failing companies and replace them with new ones. Think of it this way: if there are five companies all worth $100, then the total market is worth $500. Four companies fail and their value drops to 0. But one company skyrockets and it’s value increases to $1000. The overall market is now worth $1000 and has ditched the losers.
- Capitalism –America has a capitalist economy. Companies are always looking for ways to increase earnings and profits. This fuels competition and natural selection: only the strongest companies will survive over the long-run. This results in a stronger overall market and a more attractive place for investors to put their money.
So what’s the moral of the story? If you invest in the entire market, as opposed to individual stocks, then you can take advantage of the consistent upward pressure that makes the market rise over the long term. You will not have to worry about the boom or bust nature of individual stocks as you will be capturing it all.
Part 3: Where to Access the Market
Now that you finally understand what the stock market is, it’s time to talk about how to actually access it. As mentioned in Part 2: Why Investing in the Market is Not So Scary, the stock market is not some hidden underground market that you need a special password to access. In fact, accessing the stock market is easier now than at any point in history. All you need is an internet connection and within 10 minutes you could be investing your money in the market.
There are several ways to get your money in the market. In general, you access the stock market via an intermediary. The intermediary is essentially the middle man who will execute the demands you give. So if you want to buy Amazon stock, you tell the intermediary and they will go and buy it for you.
This intermediary can take many forms, and some are better than others, especially for a noobie investor. Enter Uncle Sam and the tax code:
Playing Nice with Uncle Sam
The US Government incentivizes saving for retirement and medical expenses via special tax-advantaged accounts. The money in these accounts can usually be invested in the market and grow tax-free. Hence these accounts can act as intermediaries and allow you to invest your money in the market.
Now to receive the tax breaks you must follow certain rules. This often involves keeping your money in the retirement/medical account (and not spending it) until age 59.5. As previously discussed, when investing in the market it is best to have a long-term time horizon anyway. So if you are willing to make this long-term commitment, then you may be eligible for some preferential tax treatment.
Basically if you plan to invest in the market for the long-term, then you should first take advantage of retirement and medical accounts as they will allow you invest your money while also avoiding some taxes. Win-win!
*The following infographic includes the most common accounts that can be used as a vehicle for investing your money in the market. For more details about these accounts check out Money Accounts Cheatsheet.