In this post I recommend another book from Peter Lynch and John Rothchild’s three classic primers on investing and stock-picking, “Learn to Earn” is the one best for absolute beginners. If that describes you, then get ready for some investment basics! Before start to read this post, you can read some other posts or visit our book list.
How to invest: savings accounts, collectibles, and houses
In life, you can either work for money, or make money work for you. “Money is a great friend once you send it off to work,” say Lynch and Rothchild in “Learn to earn”. “It puts extra cash in your pocket without your having to lift a finger.” So, the earlier you start investing, the better.
There are five basic ways to invest money. For starters, here are the pros and cons of the three more familiar ones:
- Savings accounts or similar. Savings accounts — as well as treasury bills, money-market funds, and certificates of deposit (CDs) — are short-term investments, and are great places to store cash until you have enough of it to invest somewhere else. Their biggest disadvantage is that they pay a low rate of interest, sometimes one that can’t even keep up with inflation. And when the inflation rate is higher than the interest rate you’re getting, then you’re investing in a lost cause.
- Collectibles. You can also invest money by buying collectibles, anything from baseball cards to Barbie dolls. While money devalues with time, objects often become more desirable as they get older and you can sell them at a higher price. However, you’ll have to take good care of them because even collectibles lose value with wear and tear, and they become worthless if lost or stolen. You’ll also have to become an expert — not only in the items you collect, but also in the market and the prices, lest you want to risk getting ripped off.
- Houses or apartments. While buying a new car is not an investment – “nothing will eat up your bankroll faster than a car will,” note Lynch and Rothchild – buying a new house is. In fact, it is the most profitable purchase you’ll ever make. For four reasons: 1) you usually buy it on borrowed money; 2) its value will increase while you live in it; 3) you won’t pay any taxes on the gains; and 4) when you do sell the house, the government will give you a tax break. An added bonus is that acquiring the discipline to pay off your mortgages will prepare you well for stock-investing.
How to invest: the pros and cons of bonds and stocks
In addition to putting your money into savings accounts or buying houses and collectibles, you can also make your money work for you by investing it into bonds and stocks, following the advice of “Learn to earn”. Let’s see what this means in actual fact.
- Bonds. A bond is “a glorified IOU,” “a record of the fact that you’ve loaned your money to somebody else.” When you purchase a bond, you’re actually not buying anything – you’re just making a loan. The bond – which shows the amount of the loan and the deadline – is a proof that the deal happened. Investing in bonds is similar to putting money in a savings account: in both cases, you earn money only from the interest. In theory, you should be able to earn more with bonds because they are long-term deals and you get paid a higher rate of interest. If you, say, buy a $10,000 ten-year bond with an interest rate of 8%, the bond issuer will pay you back $18,000 after a decade. However, taking into consideration the inflation rate over the same period and figuring in the taxes, you’ll actually earn much less than $8,000.
- Stocks. A bond is a much more protected investment than a stock. If you buy a bond from the U.S. government – via, say, the U.S. Savings Bond – you’re guaranteed to be repaid in full, no matter what. Even so, outside of a house, stocks may be the best investment you’ll ever make. “When you buy a bond, you’re only making a loan, but when you invest in a stock, you’re buying a piece of a company,” Lynch and Rothchild explain. “If the company prospers, you share in the prosperity. If it pays a dividend, you’ll receive it, and if it raises the dividend, you’ll reap the benefit.” The stock market is not as reliable as the U.S. government, but if you have time and a plan, you’ll probably earn much more from it in the long run.
Stocks are the best of all five basic types of investment. This important lesson, however, comes with an even more important caveat: stocks will earn you money only if you give them time. If you don’t, you’re forcefully turning the stock market into a casino. To get the most out of stock investing, buy stocks from respectable or promising companies using money you can afford to set aside forever. Then hold on to these stocks as long as the companies behind them have a future. After all, if you don’t sell any shares during crashes and depressions, you’ll never make a real loss; and, though they sometimes go through bad times, good companies usually come off really well in the end.
Mutual funds: their nature and history
Now that you’ve learned, thank to “Learn to earn” what to invest in — stocks — it’s time to decide whether you want to pick them on your own or let somebody else do it. Many people don’t want to bother with numbers or research, so they choose the latter. That’s what mutual funds were invented for.
In essence, a mutual fund is a professionally-managed investment scheme that brings together money from many people and invests it in many companies at once. As soon as you send money to a mutual fund, you automatically become the owner not of one, but dozens of companies the fund has already purchased. Though this may sometimes earn you less, it is also less risky than owning a single stock. With the right expert at the helm of the mutual fund, you can earn a lot of money from this type of investment in the long run. However, you will also be asked to part with some of your earnings — between 0.5% and 2% annually — to recompense the money managers for their efforts.
The earliest mutual fund was started in 1822 by King William I of the Netherlands. The first mutual fund in the United States – the New York Stock Trust – launched more than 60 years later, in 1889. Today, there are more than 6,000 mutual funds in the United States. Ever since the Investment Company Act of 1940, each of them is required to reveal the contents of its portfolio, listing everything from the biggest holdings by name and how many shares it owns in each through management and extra fees to every gain and loss during the previous years. This is all done with the objective of protecting you. Even so, it doesn’t make picking the right mutual fund any easier.
How to choose the right mutual fund
“Picking the right fund isn’t any easier than picking the right auto mechanic,” Lynch and Rothchild in “Learn to earn” state, noting that it would take them a whole book just to describe the different kinds of mutual funds in existence. Even so, they do share a few common sensical bits of advice that should help you in your quest:
- Buy funds directly from companies that manage them. You can also buy them from stockbrokers, but why go through an intermediary?
- Be wary of broker recommendations. “Whenever a broker recommends anything, always find out what’s in it for the broker.”
- Go for pure stock funds. Stocks have overperformed bonds in all but one decade of the 20th century. So, stay away from bond funds or hybrid funds and go for the pure stock funds.
- Go through the records of past performance. Past performance is no indicator of future outcomes, but it’s much better than no indicator at all. In addition to comparing the annual returns of several mutual funds, be sure to see if the manager who compiled the best record is still in charge.
- Invest in veteran funds. Financial magazines such as Barron’s and Forbes, as well as specialized companies such as Morningstar, track and rank thousands of funds for safety and performance. If you’re serious about investing in mutual funds, subscribe to these publications and follow their advice.
- Don’t switch between funds. For Lynch and Rothchild, “trying to catch the winner is a fool’s errand in which you are likely to end up with a loser. You’re better off picking a fund with an excellent long-term record and sticking with it.”
- Take the fees into account. Some funds charge an entry fee; others don’t. Also, some funds keep their expenses to a minimum (1%) and others run a bigger tab (2% or more). The bigger these fees, the more difficult for the fund to beat the market averages, because fees and expenses are subtracted from the performance.
Picking a stock: the five basic methods
For Lynch and Rothchild in “Learn to earn” — as the former has repeatedly made clear — the phrase “professional investing” is nothing short of an oxymoron. When it comes to investing, they claim, the only guy you should be listening to is you. “If you have time and the inclination,” they write, “you can embark on a thrilling lifetime adventure: picking your own stocks. This is a lot more work than investing in a mutual fund, but you can derive a great deal of satisfaction from picking your own stocks. Over time, perhaps you’ll do better than most of the funds.”
There are five basic methods people use to pick a stock:
- Darts. This is the lowest and most ridiculous form of stock-picking. Needless to say, Lady Luck won’t be on your side every time. So, better go with mutual funds if you don’t plan to put in the work and effort.
- Hot tips. Whether they come from your best friend, your teacher or from your gardener, hot tips are often based on “nothing but hot air.” At worst, they are guaranteed to lose you money; at best — when they come from a good source — they are a good place to start your investigation.
- Educated tips. Educated tips are hot tips coming from TV or internet experts. The problem with them is that — unless you follow the expert daily — you won’t know if and when they’ll change their mind. So, you might end up holding a stock long after the expert has sold it.
- The broker’s buy list. Stockbrokers are “well-trained Sherlocks” and their buy lists are based on evidence. Moreover, unlike TV experts, they will inform you if they change their mind about a certain stock. However, they cost money.
- Doing your own research. “This is the highest form of stock-picking,” write Lynch and Rothchild. “You choose the stock because you like the company, and you like the company because you’ve studied it inside and out.” With enough research, anyone can make an educated guess. Why shouldn’t that someone be you instead of a Wall Street trader?
Written for beginner investors of all ages — with Burton Malkiel’s “A Random Walk Down Wall Street” — Peter Lynch’s “Learn to Earn” is one of the best introductions to investing ever published. If you are a teenager who doesn’t know anything about stocks, this is the book for you.Leave a comment