Monday, June 30, 2008

Playbook for a First Time Investor?

Recently an old friend emailed me and asked me how she should invest her money. She's in a big hurry and wants specific funds. She doesn't have a brokerage account. She has very little understanding of capital markets or how to evaluate an investment. I wrote her this email back with a step by step plan of action (I'm not crazy about telling people what to do but felt no or less information would be more dangerous).

There are a lot of financial professionals who read this blog as well as savy personal investors. If you have responsible advise, please leave it. Especially if I forgot something important.

hi [Old Friend],

I think you should slow down and take a little time. I'm not a professional public market investor so I don't really want to be telling people what to invest in. Also, it's not my place. You have to make these choices yourself. Here's a step by step plan that will need to be adjusted for your risk tolerance and when you want the money.

Basics of Investing
  1. Be aware that 85% of all mutual funds underperform their benchmarks. that means that 85% of fund managers are not as good as putting the money in a simple index fund that mirrors the S&P 500, Dow jones, Nasdaq, etc.
  2. Be aware that actively managed funds charge you a lot of fees, around 2%. that makes it even harder to beat the averages.
  3. You want to be very well diversified. Diversification helps spread the risk over a lot of stocks and funds. If I could remember the math from business school, I could prove it to you. just trust me, you want to be diversified.
  4. Transaction costs (aka the cost of a trade are pretty low) - like $10-$30, so it's not imperative that you buy into the market all at once. this way you can put 20-40% of your money to work now and ease into the market, rather than plunging in at once.
Given these factors, here is my advice to you.
  1. Go into Schwab, tell them you want to meet with a representative.
  2. Tell them you want a very passive, low cost investing strategy that uses a lot of indexing. (this is one of the big strategies that Schwab has been built on, so they will know what you are talking about). Another FYI - Schwab is where I have my money.
  3. Tell them you want a lot of diversification, across Small Cap, Mid Cap and Large Cap, and you want Global diversification, i.e US, Europe, & Asia, (and some emerging markets).
  4. Tell them you want diversification across Stocks and Bonds (you want high quality corporate and treasury (government bonds), stay away from anything mortgage or "high yield."
  5. These are all plain vanilla ways to invest but they are very effective and it's simple so you won't be ripped off by commission looking people.
  6. A good asset allocation for you would probably be: 60% stocks, 20% bonds, 10% precious metals and 10% cash. A good US vs. International allocation would be 50% US, 35% Europe and Asia and 15% Emerging Markets.
You're young so you can take some risk, but given your understanding of this world, you don't want to take too much. If you want the money to be used in the next 1-5 years, take way less risk, go more bonds, and less stocks. More U.S. and less International.

I would print this email and go over it with the Schwab Rep.

Best of luck,