Friday, March 28, 2014

Basic Assumptions I'll Make About You in Investing

In order for the investment advice on my site to be of value, I'll make some assumptions about your attitude, personality, and basic knowledge.  No, I won't expect you to know the Black Scholes equation in your sleep, how to price Credit Default Swaps, or even where the market will go tomorrow.  Except the first one (keeping an open mind), it's alright if any of the points here don't accurately describe you and you're new to my site as long as you're flexible and willing to change.

We may not agree in our views about the markets or the economy but I'll assume we agree on some very basic things outlined below.  However, if you don't change your fundamental views and attitudes to the guidelines below, then unfortunately, there's little I can do to help you.

You must have an open mind.

This goes without saying whenever approaching someone else for advice.  You might not hear what you want to hear but you have faith that it may be of use to you.  And if you run into dangerous advice, you can always exercise your judgement and reject it.

You believe markets will go up in the long run (say a 15+ year time span.)

This is the only statement I'll urge you to accept on faith rather than economic principles or theory.  Markets have been slowly going up over time for many hundreds of years, and there's no rule that says they have to.  OK, they may reflect economic growth but then again, there's no rule that says economic growth has to continue indefinitely.

The world could radically change in less than 2 decades.  We could have nuclear war, an asteroid impact, a devastating volcanic eruption, collapse of major countries, etc. which will definitely hamper the ability to recoup your initial investment even after 15 years.  Let's assume these very low probability scenarios will never turn up - you have bigger problems to worry about if they do!

You are investing to supplement your wealth over time, not get rich quickly.

I hear of stories of people who got rich off of the markets alone but I don't personally know of anyone who accomplished that.  I suppose it happens but it's very rare and not something you can count on, even if you work very hard at this goal.  Worse, you could end up losing big by taking too much risk and/or investing in assets you know little/nothing about.

You don't believe financial markets (and Wall Street) are conspiring against the common people.

This is one of the most bizarre excuses not to invest but it's been popping up more ever since the Occupy Wall Street movement took off a few years ago.  You'd rather not improve your wealth because you perceive it'll make someone else wealthy (and you don't even have proof)?  Well, I've got news for you: most of the wealth in the stock market is from ordinary people like you and me.  Millionaires and the top 1% might own a larger share of the wealth in the stock market but that's still a minority of all the wealth.  Sure, most trades happening are between 2 institutional investors, but those institutions are managing money for ordinary people.

Even all the assets under management at a major investment bank like Goldman Sachs is just a drop in the bucket compared to the entire stock market.  It's very unlikely (and outright illegal) for them to try to manipulate the markets in their favor.

You believe markets are nearly efficient (rather than 100% efficient or rampant with inefficiencies.)

You may have heard of the Efficient Market Hypothesis.  In a nutshell, it states that you cannot use easily accessible information like past prices, financial statement data, and the news to beat the market.  Basically, if there's an obvious opportunity to make a quick buck in the markets, someone has already taken it.  From my observation, the efficient market hypothesis tends to hold up on a day to day basis, but we, as humans, are also subject to psychological biases that make it difficult to invest in our best interests 100% of the time.  For example, if you've ever owned a stock that you truly believe in but continues to lose money and you insist on holding onto it despite analysts and even your friends trying to convince you that it's a bad investment, you've been a victim of your own psychological biases.  Generally, the more volatile a market is, the more likely traders and investors will fall victim to their psychology, and this creates inefficiencies which can be exploited.  This is definitely not a subject for a beginner as I'm still on the road to figuring this out.

You will not cry if you lose a small percentage of your wealth (and give up by selling.)

AKA panic selling.  While getting out of a losing position is generally prudent given the situations, selling because you can't emotionally take the loss is a bad idea.  You aren't thinking logically and letting your emotions dictate your investment decisions!  Instead, decide how much money you're willing to lose on a trade BEFORE you enter it and get out once your threshold is reached.

You have a basic understanding of Algebra, Statistics, and Economics.

You don't need a PhD or even a college degree to be successful at investing.  Even if you never went to college, if you still have a working knowledge from your Statistics and Economics classes, you're good to go.   The more advanced concepts certainly help but they aren't necessary in the beginning.  If you need to brush up your knowledge, maybe take a look at some basic Statistics and Econ books at your local library or university.  Pay attention to the following concepts:

  • Means and Medians
  • Variance and Standard Deviations
  • Correlations
  • Economic Cycles
  • Supply and Demand

You believe successful investing doesn't have to be complicated.

I recommend a simple passive index portfolio for you to start with.  You can further customize it over time as you learn more, get help from an advisor, or undergo changes in your financial and living situation.  Making it too complicated, even with the help of a financial advisor, will likely increase the chances that something will go wrong causing you to lose money.

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