Baby Steps into the Investment Universe: Beginners: Part 1 of 3

Fundamentals 04-1: This is a post for those who don't know anything about investing but want to start investing.

I frequently come across questions on Quora like

  • I have $ 100, how do I start investing?
  • I want to learn to invest, but where do I start?

These are beginners learning how to invest. We sometimes forget that there is a large investment universe out there. 

  • There are different asset class eg stocks, bonds
  • There are different investing styles eg technical vs fundamental

It can be confusing for someone without any investing knowledge. 

How do you start if you want to learn to invest as a beginner?

1)  First get an overview of the various aspects of investing eg fundamental vs technical, active vs passive, etc

2)  Once you have some basic understanding, chose your path.  This will depend on your personality, the amount of time you have, your educational background, etc 

3)  Thereafter you proceed with a more in-depth study of the chosen investing path. 

This article is to help you go through steps 1 to 2. 

If you are a beginner and you go through this article, you should reach a stage where you can make an informed decision on which investing path to follow. 

You are taking baby steps into the investing universe. 


Contents

  • What is investing?
  • Why invest?
  • What to invest - The Investment Universe
  • Comparative benefits
  • How do you choose your Investment Path? 
  • How to invest as beginners
  • Why invest in equities?
  • What are the expected returns from equities?
  • What are the risks of investing in equities?
  • The mechanics of putting your money to work
  • Why value investing?
  • Pulling it all together

Baby steps into the Investment Universe : Beginners


Case Notes

A prequel. The first post in this series was published on 14 July 2020 under "Is there a way to learn (online, free) to invest (Part 1 of 2)?" as a guide for those who want to be a value investor.  

I subsequently realized that for many, the post was too advanced as they first have to get some basic knowledge about investing.  

I encountered a "Star Wars" moment. I needed a prequel.  This post thus became the first in the series after re-titling and renumbering the other posts accordingly. This is targeted at those learning to invest as beginners. 




1) What is investing?

When you look at all the definitions of investing, you realize that it is about putting your money to work. 
  • “Investing is the act of allocating resources, usually money, with the expectation of generating an income or profit.” Investopedia
  • “Investing is the process of buying assets that increase in value over time, with a goal of generating income or selling for a profit.” Forbes

You can see from the definition that 
  • It is not tied to any specific asset.  You can invest simultaneously in different assets. 
  • You can learn to invest at any age and start at any time
  • It is not about the amount of money you have. There are ways to invest if you don’t have a large amount of savings - eg through regular contribution, through mutual funds

The key point is that you have some savings or money that is set aside for investing. 


2) Why invest?

In the modern world, the purchasing power of your savings will deteriorate with time. This is the result of inflation.

To protect from this, your savings need to generate some returns that outpace inflation. Ideally, the investment goal is to increase the value so that you can grow your wealth.

The challenge then boils down to identifying the assets so that you can earn better returns than merely saving your money in the bank. 

Many people also invest in the hope that it can generate passive income.  This is in line with the idea that you let your money work for you. 


Investment universe

3) What to invest - The Investment Universe

There are 2 main ways to categorize investments
  • By asset class eg cash, stocks, bonds
  • By investing style or school eg technical vs fundamental, active vs passive

The table below lists all the various types of investment available covering the above two categories.

But you must remember that there is some overlap eg investing in commodities could be via investing in commodity futures.

For securities/equities I have provided a second level breakdown.  


No

Category

Type

 

Description

3.1

Types of investment or Asset class

 

Properties/real estate

Land and/or building

 

Commodities

Raw material or primary agricultural produce

Forex

Currency

 

Securities, equities, stocks         

Refer to 3.2

Owning a piece of a company

 

Fixed Income, Debt, Bond

Lending money to a company or govt

 

Cash, savings deposit

Money with you or kept in a safe place

 

Futures

Asset bought for delivery and payment in the future

REIT - Real Estate Investment Trust

Investors pooling to own, operate income-producing properties.

ETF - Exchange Traded Fund

A collection of securities that often tracks an underlying index.

Other Derivatives

Options, swaps

 

Cryptocurrency

 

Bitcoin

Others - fine arts or antiques

Specific collectibles

3.2

Securities, Equities, Stocks

By sector/industry

Services, manufacturing, financial, etc

 

By Geography

Domestic, international

 

By size/market cap

Large, small, mid

 

By valuation type

Value or growth

 

By type of shares

Ordinary, preferred

 

By liquidity

Liquid, Illiquid

 

By risk-return profile

Blue chips, micro-caps

 

By how you benefit

Dividend vs price appreciation

 

3.3

Investor behaviour

 

Trading vs Investing

 

Short term eg day trading, influenced by price movements

vs

Long term view, influenced by fundamentals

 

Active vs Passive

Hands-on approach, more transactions. Direct stock picking

vs

Buy and hold, tracking some benchmark, mutual fund investing

 

High-Risk appetite vs

Low-risk appetite

How much loss is tolerable, degree of the variability that is acceptable

 

 

Regular periodic vs

Lump-sum

 

Contribute regularly, dollar averaging

vs

Irregular lump sum

 

3.4

Investing style

 

 

Fundamental vs Technical

 

Looking at economic and financial factors

vs

Looking at price trends and patterns

 

Quant vs Discretionary

 

Based more on complex mathematical models

vs

Based more on human judgments

 

 


4) Comparative Benefits

How do you choose which asset class to invest in?

One way is to compare the benefits of the various investments as shown in the table. 

Note that I have compared the investments from the perspective of a long-term investor rather than a trader. 

As such trading parameters like long market hours, ability to go long or short, etc are not relevant to this comparative analysis.


Comparative Benefits of different Assets
Table 4a
Notes
a) Easy to diversity - The ability to diversify depends on both the availability of various types of assets as well the ability to invest in small amount.

b) Good liquidity - Can buy and sell easily and within a short time eg stocks







Another factor that you may consider when choosing the assets is the market size.
  • Forex is the largest and cryptocurrency is the smallest
  • Global real estate value is far larger than the global equities market capitalization
Relative size of assets
Chart 4a: Relative market size of Asset
 
Note: There is no info for cash, futures, and collectibles (Refer to Notes 1)



Behaviour and style


Behaviour and style

Once you have identified the asset class to focus, you then have to decide on the investing style or school

The tables below summarize the Pros and Cons of each of them.  

Note that to avoid duplication I have assumed that the Pros and Cons of one choice are opposite to those for the alternative choice.  While not 100% accurate, for the purpose of guiding you, I think it would suffice. 


4.13 Pros and Cons of Trading

The main difference between trading and investing appears to be the duration in which the investments are held.

Pros of Trading

 

Cons of Trading

Quick results

High risk

Don’t require knowledge of the assets

Time intensive

Smaller capital required

Gains are taxable as income

 

For assets with high liquidity

 

Higher commission due to the frequency



4.14 Pros and Cons of Active Investing

Active vs passive refers to the investment activity.  It applies to individuals as well as to fund managers. 

Pros of Active investing

 

Cons of Active investing

Can tailor a portfolio to meet market condition

More commissions due to the frequency

Flexibility in choosing investments

More risk since trying to beat the market

Can take the opportunity of short-term trends

Research and time-intensive

Can outperform the market

Less diversified than passive investing

 

More prone to human errors



4.15 Pros and Cons of High-risk Investments

Generally, high-risk investments cover those asset classes where you can earn high returns due to leverage. 

Pros of High-risk Investments

 

Cons of High-risk Investments

Can use leverage

More risk

Hugh gains

Less control

Have limited liability

Maybe last to be paid in case of equity



4.16 Pros and Cons of Regular investments

Dollar-cost averaging is one form of investing regularly. 

Pros of Regular Investments

 

Cons of Regular Investments

Smooth out market irregularities

May not be enough to meet retirement goal

Investing discipline

Limited diversification

Make investing more accessible

Research shows lump sum does better

An easy intro to investing

 

Reduce emotional component

 



4.17 Pros and Cons of Technical Analysis

Technical analysis is often considered as the opposite of fundamental analysis. 

Pros of Technical Analysis

 

Cons of Technical Analysis

The chart provides a clear picture of price action

Too many indicators

Use objective data, mathematical precision

Does not take into account fundamentals

Reflects market sentiments

Ambiguity

Patterns easily identifiable

Short term view

Inexpensive

No indication of the true worth of asset

Can be quickly analyzed

Harder to construct a portfolio




4.18 Pros and Cons of a Quant

A quant is one who relies only on quantitative analysis.  On the other hand, the opposite of a quant employs both qualitative and quantitative techniques to invest. 

Pros of Quant

 

Cons of Quant

Low cost due to automation

Needs lots of data

Unbiased, no human emotion

Not sure it will continue to work

Efficient

Prone to garbage in garbage out

 

Cannot quantify everything

 

Ignores expertise

 

A heavy commitment of time and money



How to choose your investment path


5) How do you choose your Investment Path?

You now have a better understanding of what investing is all about. Given the large investment universe, how do you narrow it down?

Start by considering 3 basic questions
  • What are your investment goals?
  • What is your risk appetite?
  • What are your personal traits? - there is a series of factors to be considered here from timeframe to interest.

5.1 Investment goals

This is mainly about your financial objectives and it can help narrow your choices

Financial objectives

Potential assets

Preserve capital

Properties and fixed income

Generate income

Fixed income, Dividend-paying stocks, REIT

Growing wealth

Properties, stocks,

Speculating

Forex, futures, commodities


Your investment goal to some extent is influenced by your risk tolerance and investment horizon. 


5.2 Risk appetite

Risk can be thought of as not achieving your investment goal.  In the worst case, you can lose all your money. 

Your risk appetite is about balancing the potential losses with the potential gain. 

The various psychological tests have been established to help assess a person’s risk appetite only prove that it is a very personal thing.

I don’t have a magic formula on how you determine your risk tolerance. It is a personal choice. 

To complicate matters, there are 2 schools of thought when it comes to investment risk
  • The academic one that correlates risk with returns.  The general view here is that higher returns require taking on high risks
  • Those who believe that you can generate high returns with lower risk. The most famous proponent of this is Warren Buffett. He believes that you can invest safety by having a large margin of safety and a host of other risk mitigation strategies.  You can even expect higher returns.

I happen to follow the “Warren Buffett risk school” but I think this concept applies mainly if you follow the value investing approach.  It does not apply to those using technical analysis or to traders.

5.3 Timeframe

You can think of an investment time frame from 3 perspectives
  • a very short- term trader
  • a short to mid-term investor
  • a long-term investor

Apart from the investing style, your investment horizon may exclude certain asset classes. For example 
  • Investing in real estate generally requires long term horizon
  • Forex trading is generally short-term trading

Furthermore, your investment goals tend to be related to your risk appetite and investment horizon. 


5.4 Age

Age is an important factor when considering the amount and type of investment.
  • The younger you are, the more risks you can take as you have more time to recover from any losses.  You could be a trader as well as invest in forex, commodities or futures. 
  • The older probably have more savings and is able to invest in those assets that require larger sum eg real estate

The important thing to remember is that age should not be a barrier to learn how to invest. It is never too late to learn.

Similarly, there are many investment alternatives so that you can match the investments with your age.


5.5 Income

I would differentiate between income and net worth.  Income is a recurring stream while net worth is a measure of what you have accumulated over time.  

The amount that you can allocate from your income will depend on your expenses and other non-investment commitments. 

For example, with a smaller income, you may have to consider contributing regularly.   You may have to forgo some of the investment that requires large lump sum payments eg properties, corporate bonds


5.6 Net Worth

Your net worth represents your accumulated wealth.  To a certain extent, the question of how much of your net worth should be allocated to investments is an asset allocation problem. 
  • With a high net worth, you will have more money to put toward various assets. 
  • With a low net worth, you may be more risk-averse as any loss would have a big impact on our wealth.  So avoid exposure to futures, commodities, and forex

5.7 Financial literacy

Many of the asset classes are complex financial instruments. Investing in them is not about buying pieces of paper.  

You have to be financially literate ie understand the intricacies of the various instruments.

Certain investing styles require in-depth study to develop the necessary skills to be successful. For example, if you choose to be a stock-picking value investor you need to develop 2 skills
  • How to analyze companies
  • How to value them

To clarify, financial literacy is not about having an academic degree. 

I am not sure whether there is any correlation between any academic degree and a good financial decision.

Financial decision is influenced not only by your knowledge of the assets but also by your behaviour. Academic study is unlikely to improve your behaviour.


5.8 Time available

The amount of time you can allocate to your investments will affect your choice. 
  • An active stock-picking approach requires more time than a passive index fund approach. 
  • Trading requires more time than being a long-term investor

Furthermore, you need time to build up your investment skills. 
  • If you think you can be a successful trader in a few weeks, you are going to be disappointed.  I tried paper trading in futures for almost a year and failed to make any money
  • It took me years to develop the analytical and valuation skills required to be a value investor.  


5.9 Interests 

People's investments may be influenced more by interests and passion rather than returns. 

Passion may be more important should you choose a trading path as you will need the mindset to overcome setbacks. 

Trading, stock-picking, technical, or even fundamental analysis all require time and effort to learn. 

Correspondingly, if you have low interest, it may be better to invest in index type instruments and work with a financial adviser.


Which investment path?


6) How to invest as beginners

What you invest in and/your investing path is determined by two major factors
  • What is available in the investment universe - the comparative benefits and/or the pros and cons of each
  • Your own profile - your goals, risk appetite, background, interests, and other demographics.
These two factors are not totally independent.  For example, if you are very risk-averse, it is possible that picking individual equities may not be right for you.  A better choice may be to invest through an equity index fund. 

Your choice lies on the intersection of these 2 factors as illustrated by the table below

What to consider in choosing your investment path
Chart 6a: What to consider when choosing your Investment Path


As an example, you may decide to focus on domestic equities, be an active stock picker with a long-term horizon using a fundamental approach. 

In practice, the choices are not necessarily compartmentalized.  

In theory that are more than 200 combinations of assets type and personal traits.  As someone learning how to invest as a beginner you may be overwhelmed. 

I recommend the following approach.

Step 1:  Refer to Table 4a, sections 5.1, and 5.2.   Based on your investment objectives and risk tolerance, narrow down the asset types to 3 to 5 choices.

I think the possible options available to you (as indicated by √) from a conservative approach are as per the following table. 

Investment choice matrix
Chart 6b. Choice matrix

Step 2. Refer to sections 4.13 to 4.18.  Based on your financial literacy, time available, and interests, select the investing behaviour/style.

Step 3.  By now, you have identified a few asset types and investment behaviour/style. Re-look at them based all the personal traits presented in section 5 to select one or two investment paths 

Step 4.  Once you have chosen your path, the next step is to pursue a more in-depth study of the chosen path.  As an example, should you choose to invest in equities and be a value investor, then subsequent steps are laid out in 
  • Sections 7 to 9 of this post
  • Part 2 and Part 3 of this “Baby Steps into the Investing Universe” series

Step 5. Do not worry if you have more than one chosen path as the next step is a more in-depth study.  As you gain further knowledge about the selected investment path, you can review to see that it is the best combination of what is available.

Note: 
If you follow my risk mitigation strategies, (refer to How to mitigate against risks when value investing) you will notice that I emphasize a 2-tiered allocation of net worth.  

The first tier is based on the 3 buckets strategy.   You set about 10 years of your net worth aside.  This is for cash and those assets that protect the principal eg fixed income.

Indirectly, I have chosen to invest in cash and fixed income instruments even before selecting the other risky assets.


7) Why invest in equities?

The main reason why you would choose equities over other assets is that it generally delivers the best return over a long holding period. 
  • “…they provide the highest potential returns. And over the long term, no other type of investments tends to perform better.” Morningstar
  • “.. the possibility to increase the value of the principal amount invested. This comes in the form of capital gains and dividends.”  BlackRock


There are also other advantages and disadvantages as summarized in the table

Pros in investing in Equities

Cons in investing in Equities

Earn high returns

The market can be volatile

Good liquidity

The market can crash and you lose a lot

Flexibility in creating a portfolio

Time and knowledge for research

An ownership stake in a company

Returns not guaranteed

Can start with little money

Returns take time

Inflation protection

 

Income from dividend

 



8) What are the expected returns from equities

The expected returns depend on your portfolio and holding period.  

The table below gives you a sense of what you can expect.  It is the compounded annual return if you have invested in an index portfolio for the top 10 stock exchanges in the world.  

I assumed that you hold the index portfolio for 2 comparative periods - 10 years and 20 years.  

You can see that even in holding some index portfolio for 20 years, there is no guarantee that you earn a positive return.

 

 

Stock Exchange

(e)

Index

10 years

Jan 2010 to Dec 2019

20 years

Jan 2000 to Dec 2019

% Compounded Annual return 

1

NYSE

S&P 500                        (a)

11.2

4.0

2

Nasdaq

Nasdaq Composite        (a)

14.7

3.9

3

Tokyo

TOPIX                            (b)

6.5

(0.1)

4

Shanghai (SSE)

SSE Composite             (c)

0.0

3.4

5

Hong Kong

Hang Seng Composite  (d)

1.4

1.9

6

Euronext

AEX Index                     (a)

6.1

(0.5)

7

Shenzhen

Shenzhen Composite    (e)

3.5

6.8

8

London

FTSE 100                      (a)

3.5

0.5

9

Toronto

TSX                               (a)

3.7

3.6

10

Bombay

BSE Sensex                  (a)

9.0

10.9


Refer to Notes 2 for details of the source for each of the indices


Risk in investing in equities


9) What are the risks of investing in equities?

There are several categories of risks when you invest in equities
  • Deterioration in the intrinsic value due to socio-economic reasons, political risks, and business risks
  • Errors in analysis - those could be due to corporate governance issues
  • Behavioural - those due to your biases 
  • Stock Exchange risks - trading suspension, liquidity issues, market manipulation 

Like all investments, the issue is not that there are risks.  The issue is how to identify them and what you can do to mitigate them. 

A more detailed list, as well as the mitigation strategies, are covered in Part 3 of this series.


10) The mechanics of putting your money to work

When it comes to putting your money to work you have the option to either do it yourself or to work with an investment adviser. 

If you choose to manage on your own, you save the advisory fees.  But you better learn to invest or else the results would not be better off. 

On the other hand, getting an investment adviser can cut short your learning process.  But you should learn how to choose the right adviser as it is not just about fees but also about expertise.

Then there the whole host of questions about whether to use an app, which stock-broking firm to choose, etc

I would think that by the time you reach this stage, these are almost trivial questions. 


11) Why value investing?

There are 3 fundamental questions when investing in equities:
  • What to buy
  • How much to buy
  • When to sell

I find that the value investing school provides the best way to answer them
  • You buy those companies trading at a discount to its intrinsic value.
  • You put more money into those companies that you have the greatest conviction. This could be based on the biggest margin of safety or strongest moat, etc all of which are valuing investing concepts
  • You sell when the market price exceeds the intrinsic value. 
There are many investing schools, eg technical vs fundamental, active vs passive.

Each of them has its success stories. Ultimately you choose a school/style that fits your personality


Baby steps into the Investment Universe - which path?


Pulling it all together

  • If you don’t’ know how to drive, would you just jump into a car and start to drive anyway?  If not, why would you start investing without knowing anything about it?
  • The first step is then to get some basic understanding of investing - what it involves, the risks, what is available
  • This post provides you with a snapshot of the investment universe
  • Once you know what is out there, you can then narrow down on what to invest and/or to choose your investing path.
  • Thereafter you need to get more in-depth knowledge about the chosen investment path. 

I hope that you have I have shown you a way to start. You have taken baby steps into the investment universe. 

What comes next?  Get more in-depth knowledge about your chosen path.  
  • Sections 7 to 9 have other relevant points should you chose to invest in equities.
  • If you chose to be a do-it-yourself value investor, then Part 2 and Part 3 of this series is very relevant. 
It is a journey of continuous learning. 


End of Part of 1of 3; this is a prequel

Part 2 was published on Sun 12 July 2020

Part 3 was published on Sun 26 July 2020



Notes
1) The market size was derived from various sources

Item

Remarks

Source

Properties

Value of properties in 2016 of 228 c/w stock & bond of 170 scaled to 2019 by stock & bond size

HSBC

Commodities

2019 trading value

 

Medium

Forex

6.6 X 252 : 2019 Trading vol annualized

 

Bloomberg

Securities

2019 market cap

CNBC

 

Fixed income/bond

Amount on bond - Aug 2020


ICMA

Futures

 

No Contracts traded in 2019 = 19.2 billion

No value was available

Statista

REIT

 

Value of portfolio in 2019

MSCI

ETF

Assets managed in 2018

 

Statista

Derivatives

 

Gross contract value 12 x 2 annualized

Investopedia

Cryptocurrency

 

 

Fortune



2) The sources of the indices were: 
a) Yahoo Finance
b) TradingView
c) Trading Economics
d) MacroTrends
e) Business Insider. Top stock exchange based on market cap as at Mac 2020




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Disclaimer
I am not an investment adviser, security analyst or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned in this website may not be suitable to you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.


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