Quick Intro for Beginners

The first thing to know about money investing is that it is much simpler to achieve than you think, as long as it is done in discipline with the right methodologies. There are a lot of people out there that make it sound like it is all a very complicated process, but don't be fooled by their language and sophisticated vocabulary, they actually describe very simple taks about financial matters in real life.

The first rule of successful investing is knowing how to measure things, mostly understanding the performance of financial assets and how they compare with each others. You only need to know simple maths (addition, multiplication, substraction, division) to understand 99% of financial calculations needed for investing money. It's a lot like buying grocery at the store and comparing prices before buying any items, and knowing how much you want to spend overall.

The second rule of successful investing is to take nothing for granted, and to learn enough about the basics of financial assets you want to buy. If you don't understand a certain type of financial assets, try to learn more about them until you fully understand their level of risks or simply don't put your money into them. It's really that simple, you will either learn something new or make a decision you can't regret.

The purpose of the coming chapters will be for you to understand the basics of most financial assets and what steps to follow to start investing money.

Next Chapter: First Steps to Investing

Tags: Saving, Investing, Definition of Investment, Financial Assets, Fixed Income, Equity, CDs

First Steps to Investing

Before we begin, we need to familiarize ourself with a few financial terms that we will need to know before investing money.

What is Investing

Investing is the act of putting your money into assets that will produce income or returns. In physical terms, buying a machine to produce goods that we can sell is investing, that is investing into real assets. Another example is buying a property that we will rent to someone, to produce a rental income. This is also investing, real estate investing, and it is the oldest and traditional way of investing money.

Step 1 put money aside, that is personal savings, that will later be a source of money for a particular project or when our regular income stops. This kind of investing is key to building our wealth, but it's not enough. The type of financial assets we can buy with our savings is also a key factor for building our wealth.

Types of Financial Assets

There are two major types of financial assets: fixed income and variable income. Fixed income assets refer to a financial asset that brings in a set amount of interest income on a regular basis, such as bonds or fixed deposits accounts (CDs). Variable income assets usually refer to equity investing, that is money put into the acquisition (ownership) of a business or a property.

Step 2 know which assets to put money into. Should we take the low risk of fixed income or the high risk of variable income ? The choice seems quite obvious at first glance but it's actually an illusion and does not take into consideration other important factors such as the strong relationship between risks and returns, a topic we will discuss in our next chapter.

Investment Banking

You probably heard that term before, but what is it really ? A bank like any other banks ? Actually it's not like any other bank. An investment bank provides a variety of services designed to assist an individual or business to increase their wealth. This is very different from traditional consumer banking, which focus only on the basic utility role of your money (deposit/withdrawal/transfer). Instead, the investment bank focuses on investment operations such as trading and asset management.

Step 3 choose which investment bank to trust for managing our money. We can buy financial products and all kind of financial instruments at asset management firms, brokers, or insurance companies. In many cases, these organizations pool the investment money they receive to make large-scale investments on our behalf, and each individual buyer/investor has a financial claim on a portion of the larger investment. Alternatively we can buy individual securities directly on a national exchange or bourse, through a broker, who will handle all market orders for us for a small commission.

Now we need to go through all those steps carefully because this is where most investing mistakes are being made, and it is the topic of our next chapter.

Next Chapter: Mistakes to avoid

Tags: Investment, Stocks, Bonds, Financial Portfolios, Mutual Funds, Retirement Funds, ETFs

Mistakes to avoid

Previously we identified the different steps to start investing, but it is not enough. If we want to invest money successfully, each step will require our full attention or else they will lead to investment mistakes, and generally that means big loss of money. We can avoid 99% of investment mistakes by identifying the right financial assets to buy and knowing how much money to put into them. Again this is a bit like going to the grocery store and knowing what to buy for a value budget.

1. How much to invest

One very important question is how much money should we allocate each month to savings ? should it be 1%, 25% or 100% of our regular income ? The answer will depend on our lifestyle and the financial needs of our future projects. Even though 100% is a bit excessive and not realistic (we need at least some money for our living expenses), a good ratio can be as little as 10% to as much as 80% of our income.

We recommend a minimum of 30% of your income if you are in your 20s, 35% to 40% in your 30s and 40s, and 20% to 25% in your 50s and 60s. Saving 0% of your personal income is not an option and would be a lifetime mistake. Likewise 90% would be excessive and could lead one to take certain investing risks that one couldn't afford.

2. How much in Bonds, Stocks

An equally important question is how much of certain financial assets should we buy. It's very important to understand that we will need to buy different financial assets to create a mix of investment. We call this mix an investment portfolio, and it has the purpose of creating diversification, that is creating diversity in the source of income of our financial assets. Because financial assets have different income signatures and different levels of risk, we can put them together in different fashion to achieve specific income targets for a much lower level of risk that would be possible with only one financial asset. What that means really is that mixing financial assets give us more value for our money. It's a bit like a buy-1 get-2 promotion at the grocery store, you get a better deal. This is why diversification should never be neglected and the lack of diversification is a common investing mistake for many people.

The lack of diversification for buying financial assets is a major mistake that should be avoided at all costs. Putting 100% of your money into ONLY one financial asset is ALWAYS a fatal mistake.

Let's take a look at the different income signatures of financial assets and why putting 100% of your money into only one of them is always a very bad idea.

Bonds (Fixed Income)

They are fixed-income securities, the term bond is commonly used to refer to any securities that are founded on debt. When we purchase a bond, we are lending out our money to a firm or government. The main attraction of bonds is their relative safety. Buying bonds from a stable government means that our investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little or no default risk, they only have a small potential return.

We recommend putting less than 10% of your money into bonds when you are in your 20s, between 25% and 35% when you are in your 30s and 40s, and between 50% and 70% when you are over 50s.

Because bonds can have very low returns, putting too much money into them could lead to performance failure for certain lifetime objectives like retirement. While in theory they can be risk-free, in reality they carry hidden risks that can be difficult to measure and identify.

Stocks (Equity)

When we buy stocks or shares, we become a part owner of a company. In theory, this grants us a right to vote at the shareholders meeting and allows us to receive any profits that the company allocates to its owners, usually as dividends.

While bonds provide a steady source of income, stocks have variable income. In addition, stocks have a price that will fluctuate in value on a daily basis when they are publicly listed on a national exchange or bourse. When we buy a stock, we aren't guaranteed anything and many stocks don't even pay dividends. We usually make money on stocks when their price increases in value, which might never happen after we bought them. However, stocks have relatively high return potential, with prices that can double or triple over a single year. Of course, the cost for this large return potential is the risk of losing some or all of your money.

We recommend putting about 80% of your money into stocks when you are in your 20s, between 65% and 55% when you are in your 30s and 40s, and less than 35% when you are over 50s.

Because stocks can be very volatile, putting too much money into them could lead to unrecoverable money loss. However, we still believe that they should be allocated a bigger share than bonds because they have a high diversification value when many stocks are mixed together in a portfolio or a fund. There is a such diversify of risk and return signatures in stocks, that they make the best option for the success of certain lifetime objectives such as building substantial wealth. However, we strongly recommend not putting too much money (less than 5% of your money) into a SINGLE company stock.

3. What about Mutual Funds and other collective investment schemes

A mutual fund is a collective fund that holds a diversified portfolio of stocks and/or bonds. When we buy a mutual fund or even an Exchange Traded Fund (ETF), we are pooling our money together with other buyers/investors, and have a dedicated investment professional (portfolio manager) to manage collectively our financial assets. With a mutual fund we can invest our money without the time or the experience that are often required to manage efficiently financial assets. The real advantage of Mutual Funds is that they offer true diversification for our money, as they will actually hold an investment portfolio of assets that have different levels of income and risks, which is the very definition of diversification.

Theoretically, we should get a better return by giving our money to a Mutual Fund than we would if we were to choose and manage financial assets ourselves. In reality, they can be expensive in terms of management fees, and too often offer below average performance because of this. They also can be characterized by a lot of differentiating factors which make choosing a mutual fund a somewhat difficult task since there are about 1000s of them.

Technically, we could put 100% of our money into ONE mutual fund because a mutual fund already holds a diversified portfolio of assets. However, we do not recommend putting all of your money into a SINGLE mutual fund for the previously stated reasons.

Because they are portfolios of assets, we recommend buying between 5 and 10 mutual funds with different investment mandates. The right way to select mutual funds, however, is beyond the scope of this chapter, and you should solicite the service of an investment professional for selecting them in your design of an investment portfolio.

4. What about Alternative Investments (Options, Futures, FOREX, Gold...)

While many (if not most) investments fall into two categories: stocks or bonds, alternative financial assets represent the most complicated types of securities and investing strategies.

We don't recommend investing in alternative assets if you have just learned how to invest money. These are complex assets with complex risk signatures, and they are definitely not for everyone. Their high-risk/high-reward characteristics make them much more speculative than plain old stocks and bonds. Yes, there is the opportunity for big profits, but they require some specialized knowledge that is beyond the scope of this chapter.

In summary

We need to avoid putting too much money into a single class of financial asset and we shouldn't put our money into complex financial instruments if we don't understand their source of returns and risks. It is basic common sense.

We recommend putting money into a mix of stock and bond funds to seek diversification and improve the average risk-adjusted return of your investments.

In our next chapter, we will discuss how to choose investment firms and professionals for managing your money, because you will need one eventually. Again, we need to be careful as this is often a source of investing mistakes and big money loss (see Madoff scandal), so we will have to review a few key factors to choose the right investment professional.

Next: Choosing your Investment Professional

Tags: Broker, Advisor, Financial Planner, Asset Allocation, Mutual Fund, Asset Management, Trading, Bourse, Exchange

Choosing your Investment Professional

One central factor to consider for choosing an investment professional is to know what type of compensation they receive: fee based or commission based. Those two types of compensation are today at the very center of a long heated debate in the financial industry regarding transparency, disclosures and professional duties. This is the debate between Fiduciary Duty and Suitability.

1. Fiduciary Duty vs Suitability

Investment professionals have different compensation schemes that dictates their professional duty and loyalty.

Suitability: Commission based compensation

Commission based professionals are compensated by a firm or a third party and will receive a commission when they make a sale, that is they will ONLY receive a commission when we buy them financial products and the selling price of their financial products will include their commissions.

Brokers-Dealers, Life Insurance agents and Independent Retirement Advisors (IRAs) are typically compensated by commissions. Their professional duty and loyalty lies entirely with their employers, not the clients buying their financial products, which brings certain ethical issues. To resolve this, commission based agents are legally bound to only offer financial products that are suitable to their clients in terms of risks, nothing else. Even if their financial products have below average performance and will not give a value advantage to their clients, they can still legally sell them as long as the underlying risks fit with their clients risk expectations.

You should know that the Suitability principle operates under a rigid self-regulated environment (FINRA).

Fiduciary Duty: Fee based compensation

Fee based professionals are compensated directly by their clients. This is a huge difference with commission based agents because their loyalty and duty is directly with their clients. Their clients interests go first, even before their own, no matter how little compensation they receive for their investment advice. Choosing the right financial assets to achieve their clients (us) objectives is their priority. What this also means is that you will need to pay a fee up-front for their investment expertise, even if you don't buy any of the financial products they would recommend. It's a lot like going to your physician for a consultation, and taking (or not taking) the medication he would prescribe. Unfortunately, most fee based investment professionals will only take clients with a lot of capital to invest (often with a minimum of $200,000), neglecting clients with only small savings (less than $50,000). Therefore small clients will often fall into the net of commission based agents with their questionable sales practice.

The Fiduciary Duty principle operates under a Federal and State regulated environment (State Regulators, SEC).

2. Broker-Dealers

By definition, broker-dealers are intermediaries that can buy and sell listed securities on your behalf. They can also be distributors of non-listed third party investment products. Broker-dealers fall under the self-regulated Suitability principle.

Broker-Dealers perform a dual role in carrying out their responsibilities. As dealers, they act on behalf of the firm, initiating transactions for their own account. As brokers, they handle transactions, buying and selling securities on behalf of their clients. In their dual roles, they perform two vital functions: they facilitate the free flow of securities on the open market, and they buy or sell securities in their own accounts to ensure there is a market in those securities for their clients. In this regard, broker-dealers are essential, and they are also well-compensated, earning a commission on either or both sides of a securities transaction.

3. Financial Advisors / Financial Planners / Registered Investment Advisors (RIAs)

These investment professionals might have overlapping roles making their label definition somewhat challenging to identify. Again the type of compensation they receive will eventually define their true role.

By definition, a financial advisor provides financial advice or guidance to clients for compensation. Financial advisors, or advisers, can provide many different services, such as investment management, income tax preparation and estate planning.

Financial advisor is often used as a generic term with no precise industry definition, and many different types of financial professionals fall into this general category: brokers, insurance agents, tax preparers, investment managers and financial planners are all members of this group. Estate planners and bankers may also fall under this umbrella.

What may pass as a financial advisor in some instances may be a product salesperson, such as a stockbroker or a life insurance agent. A true financial advisor should be a well-educated, credentialed, experienced, financial professional who works on behalf of his clients as opposed to serving the interests of a financial institution. Generally, a true financial advisor is an independent practitioner who operates in a fiduciary capacity in which his clients interests come before his own. Only Registered Investment Advisors (RIA), who are governed by the Investment Advisers Act of 1940, are held to a true fiduciary standard. There are some agents and brokers who try to practice in this capacity, but their commission-based compensation structure does not make them truly loyal to their clients.

An investment advisor is defined by the Investment Advisers Act of 1940, as any person or group that makes investment recommendations or conducts securities analysis in return for a fee, whether through direct management of client assets or via written publications. An investment advisor who has sufficient assets to be registered with state securities authorities or the Securities and Exchange Commission (SEC) is known as a Registered Investment Advisor, or RIA.

RIAs have a fiduciary duty to their clients, which means they have a fundamental obligation to provide suitable investment advice and always act in their clients best interests.

A financial planner is a qualified investment professional who helps individuals and corporations meet their long-term financial objectives by analyzing their clients financial situation and setting programs to achieve their clients goals. Financial planners specialize in tax planning, asset allocation, risk management, retirement and/or estate planning. Also referred to as a Registered Financial Planner, when the financial planner is registered with the Registered Financial Planner Institute (RFPI).

All these labels above can be misleading, but what we need to remember is that the Fidiciary Duty principle should be central in our selection process, and that the only true financial advisor is a Registered Investment Advisor.

4. Asset Management Firms - AMC

An asset management company (AMC) is a company that invests its clients pooled funds into securities to match certain financial objectives or investing mandates. Asset management companies provide investors with more diversification and investing options than they would have by themselves. AMCs manage mutual funds, hedge funds and pension plans, and these companies earn income by charging service fees or commissions to their clients.

AMCs charge their clients set fees. In other cases, these companies charge a percentage of the total asset under management (AUM). Some AMCs combine flat service fees and percentage-based fees.

Typically, AMCs are considered buy-side firms. This simply refers to the fact that they help their clients invest money or buy securities. They decide what to buy based on in-house research and data analytics, but they also take public recommendations from sell-side firms (Broker-Dealers)

Next Chapter: Know Yourself

Tags: Investment Objectives, Investment Policy Statement, Risk Tolerance

Know Yourself

We are all are trying to make money, but we all come from different backgrounds and have different financial needs. Some financial assets are only suitable for certain types of individuals, defined by their lifestyle and risk personality. We really need to understand our financial limits along with our financial objectives, that will tell us where to go, and this is key for investing money successfully.

Your Financial Objectives

Most of us do not take the time to state our investment objectives before putting our money into financial assets and this is a mistake. This is the purpose of an Investment Policy Statement and we should always have one when we are about to buy financial assets.

Investment Policy Statement - IPS

This important document will articulate precisely the steps you will need to take to reach your financial objectives, that is what you expect your invested money to achieve. This document can be simple or very complex, depending on your needs and risk tolerance. Your investment professional should produce one for you before putting your money into financal assets. In that document, you will learn about your risk tolerance and the type of financial assets that are suitable for you. This process should never be neglected to be successful in investing. See below an example of the chapters found in an IPS.

1. Introduction
2. Your Investment Objectives
3. Your Time Horizon
4. Your Risk Tolerance and Performance Expectations
5. Your Asset Allocation
6. Your Advisor Duties
7. Terms of Agreement (with your signature)

Our lifestyle and the type of projects we want to finance with our invested money will determine the level of risks we can take and the financial assets we can buy in our financial portfolio.

Your Risk Personality

What defines our lifestyle ? Do we like to spend a lot of money on fast cars, and love extreme sports and the thrill of a risk ? Or do we prefer reading quietly in a sofa while enjoying the stability and safety of our home ? The main thing determining what financial assets work best for us is our capacity to take on risk.

Peter Lynch, one of the greatest portfolio manager of all time, used to say that: 'the key organ for investing is the stomach, not the brain'. In other words, we need to know how much volatility in financial assets we can stand to see.

This is not an exact science, and while some core factors determine our risk tolerance, it's important to remember that every situation is different and that a given financial asset is not the same to all people. Our Investment Policy Statement will help us identify ourselves in terms of risk tolerance and the financial assets that we can buy in full confidence.

Final Chapter: Brief Summary

Your Brief Summary

Below is a reminder of the few important items that you should always consider before buying financial assets:

  • Measure and understand the true performance of your financial assets

  • Take nothing for granted, ask if you don't understand the characteristics of certain financial assets

  • Do not put all your money into ONLY one financial asset

  • Build a portfolio to diversify your financial asset returns and reduce your overall risk

  • Learn how your advisor is getting paid (Fiduciary Duty)

  • Define your financial objectives and put them in a document (IPS)

  • There is no One-Fit-for-All financial portfolio: we all have different investment objectives and risk appetite

This concludes our quick Howto for beginners, and we invite you to learn more about investing in general by following below these valuable web resources: