Advice for a Beginner
Typically, when I write this column I am writing for an audience that has some investing experience. But you have to start somewhere. This week I received a query from a friend who wanted advice for someone just getting started.
I will share some of our exchange, because it is exactly the kind of advice I would give to just about anyone starting out. My friend wrote:
“Hey Robert, I’ve been helping my roommate follow your advice about investing. He doesn’t currently have a company match, so he filled out last year’s Roth IRA with Vanguard before the deadline a couple of weeks ago. He says he’s unsure exactly how to proceed (just $6k sitting in the account, not invested). I haven’t started mine yet, so I was wondering if you could point me in a good direction for newbies. Either good learning material or where to place the money he’s put into the account.”
We have all been there at one point or another. Given that only about half of all families invest in the stock market, this advice could benefit a lot of people. Below is what I told him.
Prepare for Volatility
The most important thing is to get your mindset around long-term investing. Don’t let the short-term fluctuations scare you away.
The S&P 500 is a good benchmark for the overall stock market. The index includes companies from a wide range of industries, including technology, healthcare, financials, consumer goods, and energy.
Over the past 50 years, the S&P 500 has an average annual return of 10.7%. But, there have been years where it has been down nearly 40%. That takes some mental preparation.
Consider that in the past 50 years, these were the worst annual returns in the S&P 500:
- 2008: The S&P 500 lost 37.0% during the Global Financial Crisis. The housing bubble burst and led to a credit crunch, causing many financial institutions to fail and a severe recession.
- 1974: The S&P 500 lost 26.5% during the oil crisis and a recession. High inflation, rising oil prices, and a stock market crash led to a severe economic downturn.
- 2002: The S&P 500 lost 22.1% during the dot-com bubble burst and the aftermath of the 9/11 terrorist attacks. Many technology companies failed, and the US entered into a mild recession.
- 2001: The S&P 500 lost 11.9% during the aftermath of the 9/11 terrorist attacks, which caused significant disruptions in the economy, and the dot-com bubble burst.
- 1981: The S&P 500 lost 5.8% during the early years of the Reagan administration, when the Federal Reserve raised interest rates to fight inflation.
On the other hand, the S&P 500 has also seen these returns in the past 50 years:
- 1995: The S&P 500 gained 34.1% due to a strong US economy, low inflation, and falling interest rates.
- 1975: The S&P 500 gained 31.6% following a deep recession in 1974. The US economy began to recover in 1975, thanks to a decline in oil prices and government stimulus.
- 2019: The S&P 500 gained 31.5% thanks to a strong US job market and low interest rates, which boosted consumer spending and corporate profits.
- 2013: The S&P 500 gained 29.6% due to a combination of improving economic data, low interest rates, and a strong corporate earnings season.
- 1989: The S&P 500 gained 27.3% thanks to a strong US economy and falling interest rates, which boosted consumer spending and corporate profits.
So, over the past 50 years we saw a loss as much as 37.0% and a gain as great as 34.1%. Before someone invests in the market, I want them to understand that this kind of volatility is possible. Over a shorter time period, losses (and gains) have been even greater.
But the key is the long-term. Through the ups and downs, the long-term average of the S&P 500 is 10.7%. If my friend continued to invest $6,000 a year into a tax-protected account like an IRA, at that rate of return he would have $1.25 million in 30 years. Double the savings rate and you would get there in 22 years at a 10.7% average annual return.
Dollar Cost Averaging
Because of the volatility, I recommended moving money into the market over time. If he moved his $6,000 into the market all at once — and it was just before the market dropped by a third — he would find himself down to $4,000 at the end of the year.
Therefore, I recommend that a new investor move money into the market over time by dollar cost averaging.
Dollar cost averaging is a strategy where an investor regularly invests a fixed amount of money into an asset, such as a stock or mutual fund, over a period of time, regardless of the asset’s price. This helps reduce the impact of market volatility on the overall investment.
For example, instead of investing a lump sum of money into a fund, an investor could invest $1,000 per month for a year. If the price of the asset goes up, the investor would buy fewer shares with their $1,000. If the price goes down, the investor would buy more shares with their $1,000. Over time, the average price per share would be somewhere in between the highest and lowest price points, which can potentially result in a lower overall cost per share.
I should note that this cuts both ways, though. If you dollar cost average into a rising market, then you would have been better off to invest the full sum in the beginning. But we don’t have a crystal ball. My motivation here is in getting an investor comfortable with market volatility.
I also provided some investment suggestions for my friend. I will discuss those in next week’s article.
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