If you’re curious about investing, but don’t know where to start—stocks, bonds, bitcoin, gold?—it can be easy to get caught up in what’s hot right now. Making money looks easy when you hear about people like Eddy Zillan, an Ohio teenager who turned $12,000 into more than a million dollars in cryptocurrency. But as Warren Buffett, the fourth-richest person in the world, famously said, “Investing is simple but not easy.” And plenty of people have been burned by jumping on the bitcoin bandwagon.
So instead of investing first and trying to figure out what you’re doing later, it’s smart to come up with a plan, just like you would for anything else, whether it’s a new exercise program or a big vacation. The simplest explanation I’ve seen for how to go about this comes from Meb Faber, CEO of Cambria Investments and host of his own investing podcast, who has devised what he calls the Investment Pyramid. It looks like an old-school food pyramid, but instead of telling you how much fruit and vegetables to eat each day, it lays out the basics of how to be a smart investor.
Here’s how it looks:
With the stock market going strong since 2009, “there’s a whole generation of investors who have never experienced the physical pain of losing 20 or 50 percent of your portfolio,” Faber told me. As one of the people who lost lots of money in the last recession, I can say firsthand that it's not a good feeling.
“Having the understanding that things can and do go down” is essential to being a smart investor, he added. That means shoring up your personal finances first. Start with an emergency fund—preferably three to six months living expenses, but even $1000 is a good start—to cover any unfortunate financial surprises. Next, pay off any high-interest credit card debt with an annual interest rate of more than eight percent.
Faber's personal finance pyramid lays out everything you'll want to take care of before you invest:
"Only once you get your house in order do your investments come into play," he writes, adding, "I am of the opinion that the vast majority of people should spend near zero time on their investments."
But you probably wouldn't be reading this article if you weren't interested in dipping your toes in the investment waters. So let's break down each step in Faber's investment pyramid up top.
Don’t do dumb things
"The foundation of a long-term, healthy portfolio is, in many ways, simply avoiding a self-inflicted explosion,” Faber writes in his paper. “Whether it’s chasing the latest hot stock, doubling down on a train wreck investment because it just has to bounce soon, or getting swept up in a herd-mentality-buying-frenzy when fundamentals are screaming the opposite, we still find ways to hurt ourselves.”
Jumping on the crypto craze is the most obvious thing that can do serious damage to your net worth. While the price of bitcoin has gone from less than $1,000 in early 2017 to around $6,000 today, if you bought any time since late November 2017, you’ve lost money—as much as 70 percent if you got in when the price was $20,000.
It’s not enough just to invest in a mix of stocks and bonds. One of the biggest mistakes investors make is what Faber calls the “home country bias." You may think America is the greatest country in the world, but that doesn’t mean you should put all your money in it. Investing in American companies “gives you a false sense of security,” he told me. “The US outperforms the rest of the world about half the time.”
Instead, consider a 50/50 split between domestic and international assets. That’s easier than it sounds since investment firms like Vanguard offer a huge array of international mutual funds and electronically-traded funds (ETFs).
You’ll also want some real assets, which include real estate, Treasury inflation-protected securities, and commodities like gold, wheat or oil. That doesn't mean going out and buying a bar of gold or a barrel of oil. Just look for an ETF or mutual fund that invests in them. Faber recommends allocating about 10 percent of your total portfolio into these types of assets.
Follow your own rules
Just as every diet has rules—no meat, no sugar, no dairy, whatever—so too does a good financial plan. Faber recommends writing down what your goal is and how you intend to get there. That means everything from what you’ll do if one of your investments loses 40 percent of its value to how much risk you’re willing to take now and in twenty years. “Have an awareness of where you want your portfolio to take you, engineer it for that result, then establish regular diagnostics to make sure it’s accomplishing its purpose,” he writes.
Following your own rules also means rebalancing your portfolio—once a year is a good policy, but it’s up to you—to make sure your actual investments are in sync with your plan. For example, if you want to hold 70 percent of your money in stocks but haven’t rebalanced in a while, you may have closer to 80 percent due to rising stock prices, which exposes you to a bigger loss in a downturn.
Know how much the fees are
No matter what you buy, understand how much the privilege is costing you. A good rule of thumb is to pay no more than one percent for a mutual fund and half a percent for an ETF. You can actually get much lower rates—Vanguard is eliminating fees on ETFs starting in August and many index funds like the Fidelity 500 charge less than a tenth of a percent.
Not sure what the fee is for your investment? Look it up online and search on “expense ratio” or “fees” for an answer. High fees can cost you hundreds of thousands of dollars in the long term so it's important to avoid them.
Don't get burned by taxes
Never underestimate the effect of taxes on your total returns. As Vanguard notes on its site, “Of all the expenses investors pay, taxes can take the biggest bite out of total returns.” The easiest way to minimize taxes on investments is by putting as much money as possible into tax-deferred accounts like your company 401(k) or traditional IRA.
That said, there are advantages to opening a Roth IRA or 401(k), namely that the taxes you pay now on the principal could be much less than the taxes you’d have to pay on your money in 30 or 40 years when you start withdrawing from a traditional retirement account. Some people recommend a mix of Roth and regular retirement accounts to diversify your tax exposure.
Don’t pick investments based on size
If you invest in a mutual fund or ETF that mirrors the S&P 500, such as iShares Core S&P 500 ETF or the Vanguard 500, you’re using a strategy known as market capitalization weighting. A company’s market capitalization is the number of outstanding shares times the price of one share. And the S&P 500 is comprised of 500 of the biggest, publicly-traded companies headquartered in the US.
The problem with that strategy, Faber says, is that it has no ties to business fundamentals like revenue, profit, and debt. So it’s not a great measure of how likely the stock price is to go up and stay up over the long term. “A value investment approach historically has done much better,” Faber told me. Value investing involves looking for undervalued assets with a potential for growth by comparing the stock price of companies with similar fundamentals. Investopedia, Kiplinger, and Motley Fool all have lists of value funds you might want to consider.
Whatever you end up choosing, be sure to follow all the rules above by making sure the fees are low, you’re not overly invested in a single asset class, and you rebalance every so often to stay on track with your long-term plan.
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