Wealth Building and the Power of Compounding

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Do you want to try your hand at investing? What are the best investment strategies for beginners? 

Investing is a great way to become financially stable—and even wealthy. With so many options out there, it’s overwhelming to know where to start. Luckily, we have strategies that are perfect for beginners who want to dip their toes in the investment pool.

Check out these investing strategies for beginners, recommended by expert financial advisors and investors.

1. Start With Compounding and a 401(k)

Investing is the most powerful way to grow your money because it offers a higher rate of return than even the best savings accounts. On average, the stock market’s annual net return is about 8% (after accounting for inflation). That number is an average from decades worth of data, which means that your money will earn an average of 8% per year over the long term, even if that rate fluctuates in the short term. 

According to I Will Teach You to Be Rich by Ramit Sethi, the reason why that 8% rate is so important is the power of compound interest. With compounding, the interest you earn in a given year is added to the principal (original) amount you invested; then, the following year, you earn interest on that new principal amount. 

  • For example, let’s say you invest $100 in the stock market (to make things easy, we’ll assume an exact 8% annual rate of return). That means that after one year, you’d have earned $8, for a new total of $108. In the second year, you then earn an 8% return on that new amount, so you’d earn $8.64 for a new total of $116.64. The longer you leave your money in the stock market, the more that principal grows, and the more you earn every year.

The power of compounding also means that the longer you leave your money in the market, the more it grows—which means that the earlier you start investing, the more money you’ll have by the time you retire.  

Start by Opening Your 401(k)

A 401(k) is a great investing strategy for beginners who are in it for the long-term benefits. It’s an investment account sponsored by many employers to help their employees save for retirement. When you open a 401(k) account, you authorize your employer to send a certain amount out of each paycheck into that account automatically. A 401(k) is one of the best retirement investment accounts out there for three major reasons: 

  1. The money in your 401(k) is “pretax,” which means it isn’t taxed until you withdraw it. That means your contributions will be much bigger (because they haven’t had taxes taken out of them yet), meaning your principal investment amount is higher, which can increase the compound growth of your investments by 25 to 40%. 
  2. Your employer might match your contribution. That means that every time you funnel money into your 401(k) account, your employer will “match” that contribution up to a certain percentage of your salary. In other words, this is free money
  3. You’ll invest automatically, without even knowing it. Your 401(k) contributions come out of your paycheck before you get paid, so you won’t have to worry about investing it yourself—it’s already taken care of by the time you get paid each month. 

There is one downside to a 401(k): If you withdraw your money before age 59.5, you’ll incur a 10% early withdrawal penalty in addition to paying income tax on the money. Your 401(k) is exclusively for long-term investing, so you should avoid withdrawing the money early unless you’re absolutely desperate. 

2. Split Stocks and Bonds 50-50

Benjamin Graham’s recommended investing strategy for beginners is to split investments between stocks and bonds. His book The Intelligent Investor says the default split is 50-50 between stocks and bonds. This allows you to participate in both the gains of stocks as well as the relative safety of bonds.

At times, you can shift your balance in favor of stocks or bonds. If you feel stocks are overpriced and due for a downturn, you can shift your investment to 25% in stocks and 75% in bonds. Likewise, after a steep market downturn or when stocks are cheap, you might shift to 75% in stocks and 25% in bonds. But Graham advises no more than a 75-25 imbalance.

Why not 100% into either bonds or stocks?

  • Stocks on average rise faster than inflation, whereas bonds might not, so holding stocks better protects against inflation. 
  • However, stocks don’t always outperform bonds at all times. At the time of Graham’s last revision of his book in 1973, bonds were outperforming stocks. Keeping a balance helps you weather a variety of economic conditions. 
  • Stocks fluctuate much more than bonds do, and the wild oscillations of a 100% stock portfolio will test your psychology. 

Buying Stocks

The classic mistakes in buying stocks as an investing strategy for beginners are:

  • Paying too high a price for a stock: This is especially risky in 1) strong bull markets, when the market seems like it can only rise with no possibility of a downturn, or 2) for hot stocks, where speculators drive up the price expecting the company to outperform in the long term.
  • Withdrawing from the stock market after a steep crash, when most people view stocks as too risky. At this time, stocks are especially cheap.

To counter these mistakes, Graham issues some simple rules for choosing stocks:

  • Diversify, but not excessively. Graham advises holding at least 10 and at most 30 stocks.
  • Buy large, prominent companies with conservative financing. Let’s define each of the three terms:
    • Large: In 1973, Graham defined large as having at least $50 million in assets or revenue. In the modern commentary of The Intelligent Investor, finance columnist Jason Zweig suggests the bar is companies with at least $10 billion in market capitalization.
    • Prominent: The company should be a leader in its industry, and be in the top 25% by size.
    • Conservative financing: The company’s market capitalization should be no more than double its book value.
  • Buy companies with a record of continuous dividend payments. In 1973, Graham argued for companies that regularly paid dividends over the past 20 years. In recent times, companies have paid dividends much less regularly, so Zweig adjusts the time frame to the past 10 years.
  • Impose a price maximum on stocks you buy. Graham argues for a maximum per-share price of 25 times average earnings over the past 7 years, or 20 times earnings over the past 12 months. 

Notably, this rule excludes hot “growth stocks,” for good reason. Growth stocks often represent new companies that are growing rapidly but are unprofitable or have only meager earnings. Thus, their price-to-earnings ratio may be far above 20 times. Graham argues that these stocks are too risky for the defensive investor—without thorough analysis, a defensive investor is very unlikely to repeatedly pick the right stocks at the right times.

Finally, don’t buy common stock for its dividend income alone. The stock price must still be reasonable, and the company should be fundamentally sound.

Don’t “Buy What You Know”

In his commentary, Zweig cautions against the common wisdom of “buy what you know.” The premise of “buy what you know” is that, as an ordinary consumer, you know what brands and products you like, and in this sense, you might know more about the company than professional stock analysts. Thus, you should buy stocks of companies you like.

Of course, this simple-minded view violates Graham’s universal principles of considering the underlying value of the stock, and the stock price in relation to its value. If you were a disciplined investor, you would consider whether the stock was overpriced, regardless of how much you liked the company emotionally.

This applies generally to being complacent about what you’re familiar with. The more you think you know about something, the less you are to probe for real weaknesses.

Notably, this applies to people owning their own company’s stock in their retirement portfolios. Does it ever make sense to have a third of your entire stock portfolio in a single company? If not, then why would it make sense to invest it in your employer?

Adding Bonds to the Mix

Now that you know how to choose stocks carefully, it’s time to start thinking about bonds. JL Collins’ book The Simple Path to Wealth offers a simple breakdown of why bonds are an essential investing strategy for beginners.

The difference between stocks and bonds is:

  • When you buy stock, you’re buying part of a company.
  • When you buy bonds, you’re loaning money to a company or government entity.

Each bond has an interest rate and term:

  1. Interest rate: This is the rate the issuer of the bond (the borrower) has agreed to pay the buyer (the lender—you or the fund you’ve invested in).
  2. Term: This is the time period the money is loaned for. Bonds are classified as short-, medium-, or long-term. For example, U.S. Treasury bonds issued by the federal government are classified as:
  • Bills: 1-5 years 
  • Notes: 6-12 years
  • Bonds: 12+ years

For example: A $1,000 bond offering 10% interest and a 10-year term, would pay $100 a year in interest, or $1,000 over the term of the bond.

While stocks and index funds are your most effective wealth-building tool, adding bonds to the mix provides several benefits:

  • Bonds are less volatile than stocks and therefore, they smooth the ups and downs of your portfolio.
  • They provide a little income by paying you interest, which is sometimes tax-free—municipal bonds for public works projects like airports are exempt from the federal income tax and from state taxes in the state in which they were issued. Also, U.S. Treasury bonds are exempt from state and local taxes.
  • As mentioned earlier, bonds serve as a hedge against deflation. During periods of deflation or falling prices, when a bond is paid back, its purchasing power is greater than when you loaned it. The increase in value balances the losses deflation causes for stocks and other assets. In contrast, during inflationary periods when prices rise, your bonds have less value (they buy less) when paid back. But at the same time, your stocks increase in value and thus keep up with inflation.

The best way to buy bonds is to invest in a bond index fund. Buying bonds via the VBTLX, Vanguard Total Bond Index Fund, mitigates the risks of owning individual bonds because the fund holds around 8,000 bonds, and a problem with one bond won’t have much impact. All of them are high-quality bonds and their terms vary over a broad range.

3. The Autopilot Strategy

An ideal strategy for the beginner investor who wants to take advantage of stock-market returns but isn’t interested in specifics, the autopilot strategy consists of purchasing broad index mutual funds or exchange-traded funds (ETFs) rather than individual stocks or industries.

The autopilot strategy is Burton G. Malkiel’s preferred method of investing, as described in his book A Random Walk Down Wall Street. No matter how knowledgeable or engaged the investor is, Malkiel advises building the core of a portfolio around index funds and only making active bets with excess cash.

The rationale behind the autopilot strategy is simple: Long-run returns of the S&P 500 Stock Index, which represents almost three-quarters of the value of the entire stock market, typically beat returns on portfolios designed by the most seasoned investment professionals. In short, if you were to invest in a mutual fund that holds a weighted representation of the stocks in the S&P 500, you would do better on average than trying to pick winners yourself or entrusting your money to an investment advisor.

Not only are returns better with broad market index funds, fees and expenses tend to be, too. Because index funds are passively managed—that is, they adjust their holdings more or less automatically based on market values—they tend to have extremely low expense ratios (.0005% or less for some). And because index funds only trade to rebalance their weights, they incur low trading costs as well.

While the S&P 500 index funds are generally the most popular type of index fund—and they will outperform actively managed funds on average—Malkiel actually recommends that investors choose a total market index fund over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks that, historically and on average, have outperformed larger ones. Try to find a fund indexed to the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI US Broad Market Index. 

Of course, as Modern Portfolio Theory teaches, diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: Some funds track REIT, corporate bonds, international capital, and emerging market indices.

4. Invest in Real Estate

The BRRRR process described in David M. Greene’s book Buy, Rehab, Rent, Refinance, Repeat is best for new investors who are focused on building a large portfolio of rental properties and growing wealth over time. Real estate investor Chad Carson recommends using BRRRR only to begin building your portfolio of investment properties—otherwise, if you use BRRRR indefinitely, you’ll accumulate a large number of mortgages, and that creates greater risk if the market drops. 

Carson suggests that once you’ve acquired several properties, you use the rental debt snowball strategy by funneling all of your rental income into paying off one mortgage at a time until all of your properties are paid off. By eliminating your mortgage payments, you increase your cash flow, and at that point, you can choose whether and how to continue building your portfolio. 

For beginning investors, they should focus on two elements of The BRRRR model:

  1. Buying a property as far below market value as possible and paying the full price (not just a down payment)
  2. Refinancing the property after you’ve renovated and rented it out

Together, these steps represent the biggest difference between BRRRR and the traditional approach to real estate investing: BRRRR investors finance the property at a later stage than traditional investors. 

Greene explains that the advantage of paying full price for a property and refinancing later is that the loan is based on the after-repair value (ARV), or the post-renovation appraisal. Since the renovations add value to the property, and the financing is proportionate to the home’s value, you get a bigger loan than you would if you’d financed the purchase of the property. 

The goal is to pay as little as possible for the property and rehab it to increase the value as much as possible. Ideally, through refinancing, you recover all of your investment (or sometimes more), and you use that money to buy and renovate the next property. (Greene acknowledges that recouping your entire investment is a “home run”—something to strive for, but not something to expect on every project.) By pulling your money back out of the project, you make the same dollars work for you over and over, thereby increasing the velocity of your money

For example, imagine you find a fixer-upper for $95,000 and spend an additional $25,000 on renovations, making your total initial investment $120,000. After the improvements, the home is appraised for $160,000. You refinance, and the lender grants you a loan for 75% of this ARV, or $120,000. You’ve recovered your entire investment to use for your next property, and, as long as the tenants’ rent covers your mortgage and expenses, you’ve gained a consistent source of income. Greene asserts that even if the income from each property is just a few hundred dollars a month, this model allows you to quickly build your volume of properties and multiply that cash flow.

Final Words

These strategies mark just the beginning of your journey as an investor. What’s important is to stay smart with your money and keep an eye on the market at all times. From there, you’ll be making money from your investments in no time

Are there any investing strategies for beginners we missed? Let us know in the comments below!

The 4 Easiest Investing Strategies for Beginners to Learn

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Katie Doll

Somehow, Katie was able to pull off her childhood dream of creating a career around books after graduating with a degree in English and a concentration in Creative Writing. Her preferred genre of books has changed drastically over the years, from fantasy/dystopian young-adult to moving novels and non-fiction books on the human experience. Katie especially enjoys reading and writing about all things television, good and bad.

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