The first step to investing is often scary. The fear is rooted in unfamiliarity with assets, especially the diabolically risky ones. The good thing is, once an investor starts the journey, they begin to get the hang of it quickly.
Investors need at least a basic understanding of how the assets they wish to invest in works. The reason? An investor needs to get comfortable with the asset’s risk-reward ratio before putting any money into it.
There was some jargon in there, so this guide is going to help understand what first-time investors need to know, and a few tips to make the initial phase of their investment journey a pleasant experience.
Investing for the First Time? Here Are 5 Tips to Follow
Before putting the first dollar into any asset, investors should understand the two fundamental pillars on which investment decisions are based—risk and return.
How Risk Influences Investment Decisions
First-time investors should first assess the risk they can tolerate. For instance, an investor that can’t sleep at night seeing the price chart turn red should wave cryptocurrencies goodbye from afar.
In an ideal world, investors could generate double-digit returns just by investing in risk-free government securities. However, the financial world is rational, not ideal. The more risk an investor takes, the more returns they can potentially generate.
That’s how risk influences an investor’s decision. Let’s talk about rewards (or returns) now.
How Returns Influence Investment Decisions
Everybody wants a bigger bite out of the pie. The important thing is to be mindful of the risks that come along with it. Only focusing on returns is suicide.
The potential for greater returns is what draws investors, especially young ones, to equities and cryptocurrencies. It makes sense, though, given that higher returns come with greater risk.
Typically, young investors tend to have more appetite for risk than someone closer to retirement. If the capital gets wiped out, a young investor has a lot more time (and possibly very few responsibilities) to correct mistakes.
As a first-time investor, finding the sweet spot between risk and reward is where the challenge lies.
By basing decisions on the fundamental pillars of risk and reward, investors can save themselves plenty of grief.
However, there are more ways to keep an investor’s boat afloat. Because let’s face it—uncertainty is integral to finance and investors always need to stay on guard. To that point, let’s talk about five tips that will help first-time investors preserve their capital while aiming for optimum returns.
5 Tips to Follow as a First-Time Investor
There’s a lot of advice out there on how to start an investment journey. It can feel overwhelming to absorb all of the information. So, this guide will focus on five things that should top an investor’s list of best practices. Let’s dive right in.
1. Understand the asset’s fundamentals
Imagine putting money in an asset simply because a friend said so. Don’t invest money even if uncle Joe is a professional trader and recommends buying a certain stock. Invest only after understanding the asset’s fundamentals.
Now, this isn’t entirely easy for a first-time investor. The good news though is that it’s okay to know just enough.
For instance, think about cryptocurrencies. Should investors buy Dogecoin? No. Should investors buy Bitcoin? It depends. Remember, assessing the asset fundamentally is more relevant for investors. Traders should and do trade dogecoin profitably.
Why the difference between traders and investors?
Because investors are in it for the long run. Unless a person can sit in front of a price chart all day, they’ll have a tough time running a profitable trading business.
The long-term commitment warrants that an investor pays due attention to the asset’s fundamental strength. And this is precisely why Dogecoin isn’t a great investment. Dogecoin offers little tangible value and has no economic use-cases. On the contrary, several other coins offer tangible value.
For instance, stablecoins like USDT allow investors to get crypto exposure with relatively lower risk. Or think about utility tokens. Investors can buy BNB and use it to pay fees on Binance. Plus, the Binance Smart Chain is a programmable ecosystem with a range of real-world applications.
The reason an asset’s fundamentals are important is that, in the long term, they drive the asset’s value. Dogecoins will come and go, but Bitcoin and Ethereum aren’t going away anytime soon.
Study how to asset helps people and its economic utility. That should provide a fair idea of its fundamentals.
To get comfortable with understanding the fundamentals, a good starting point is to read investing articles online from a trusted website that educates investors, and watch the business channel for a few minutes every day. Doing these things won’t make a lay investor a financial wiz, but they’re good first steps.
While still getting comfy with the basics, start taking small steps.
Speaking of which…
2. Start small
There are more than one reasons to start small. The most important of them all? Testing the waters.
Experience is the best teacher. Participating in the markets and investing can give investors a peek into how things work. Pouring in a truckload of money can be disastrous for someone with little experience, so starting small makes sense.
Next up, cost averaging. Investing a small amount at certain predetermined intervals helps average out the cost.
Well, markets don’t move linearly. They move in swings. First-time investors rarely have the knowledge to time the market accurately. So, investing small amounts at a predetermined interval generally helps accumulate the asset at a relatively lower price.
For instance, let’s look at Uber’s stock price over the past five years.
Say an investor invests $6,000 as a lump sum at the peak price of about $51.75. At the current price, they’re in the red by roughly $810 (or $7 per share).
Instead, had they invested $1,000 over the next 6 months, the per-share cost would have been much lower. For instance, say the average cost is lower by $3 apiece, the total loss would be $300— lower by about $510. See how investing small amounts over time can help?
This is a very straightforward example, of course, but it’s an approach that investors will thank themselves for taking a few years into their investment journey.
The final benefit of starting small is… well, to get started. Investors that have time on their side can leverage the power of compounding.
Okay, but how is that?
Most (though not all) investments earn compounding returns, i.e., the returns generated in a certain year are reinvested into the asset. Returns generated in the following year, therefore, are generated on a greater amount than the originally invested principal amount (i.e., principal + reinvested amount).
Delaying the first investment means investors lose out on the number of times that their returns will be reinvested.
For instance, say an investor invests $1,000 in an ETF that generates, on average, 7% per year. Here’s a table showing how the investment would have grown over 5, 10, and 20 years, assuming a yearly compounding frequency.
|Number of years||Investment value ($)|
As investors keep contributing to the principal value, the principal amount accumulates. Over time, the returns are generated on a consistently increasing amount—this is precisely why starting early can offer investors a major advantage.
Diversification has kept countless investors afloat when things get rough. The reason? Lack of correlation. Let’s get the lay of the land and see why diversification is so important.
Think of the old saying, “don’t put all your eggs in one basket.” If one of the baskets drops, the person won’t lose all the eggs. They still lose a few eggs though.
Diversification isn’t about avoiding losses; it’s about minimizing a portfolio’s underperformance.
So, how does diversification work? Say an investor buys stock of two great companies A and B that operate restaurant chains. Both are excellent companies with terrific fundamentals.
Over the next few years, the economy slows down. People are no longer going out for lavish dinners. The company’s revenues drop, current and expected cash flows decline, and the price at which the investor bought the stock now appears expensive causing the market price to plummet.
Tough spot, eh?
This is where diversification helps. Dividing the investment amount into multiple industries reduces the impact of the fall in company A and B’s price.
For instance, say the investor had put in $500 in companies A and B, each. Assuming the price of both companies is down 30%, the investor’s portfolio value is now lower by 30%.
However, if the investor had invested $250 in companies A and B, $250 in company C (a retail chain like Walmart, for instance), and $250 in a pharmaceutical company named D, the loss could’ve been higher.
Even if the retail and pharmaceutical stocks were trading flat, the investor’s portfolio value would’ve been down only by 15%—half the loss compared to without diversification.
|Companies||Portfolio value w/o diversification ($)||Portfolio value w/ diversification ($)|
It’s also possible that retail and pharma stocks were trading above or below the cost price, but the chances of all these industries underperforming are fairly slim.
The reason is that there’s little correlation between the three industries. Lack of correlation is fundamental to the concept of diversification. Essentially, the correlation shows the degree to which the prices of two assets move in tandem with each other.
Diversification isn’t just limited to sectors. Investors can even diversify between assets, asset classes, and risk profiles.
4. Set goals and invest with discipline
Before investing the first dollar, an investor must establish the goals they’re investing for.
Think of them as buckets. Each bucket is a different goal—replacing a car, buying a beach house, or retirement. Over time, the money in the buckets will accumulate and grow until the goal is achieved.
But how is this helpful?
Goal-based investing helps investors keep tabs on their financial goals and how long it will take to achieve them. It’s a more structured approach to investing than just randomly investing all of the money.
Think about it. Most investors typically have both short- and long-term goals.
Investments that need to be redeemed in the short term should ideally be in relatively low-risk assets like a savings account or bonds. Once a financial goal is achieved, don’t let greed get the best of you; sell the asset.
Equities (and other high-risk asset classes) are typically suitable when investors have a longer time horizon. The reason?
Well, there’s a possibility that in the short-term the asset’s price could be lower than the cost that the investor purchased it for. If the price stays in that range, and the investor needs the funds, the investor’s capital may erode.
However, equities can be a valuable asset class for long-term goals, and this is where discipline has a big role to play.
Before investing in equities, know that they’re a volatile asset class. But the probability of capital erosion reduces over time.
While the storm does last, investors need to clench their armrests and control the urge to sell. There’s light at the end of the tunnel.
Let’s take an example to see how this plays out.
Say an investor had invested $10,000 in Microsoft on January 1, 2008. Come September, Lehman Brothers leaves the financial world in a mess. Equities across the world drop, including Microsoft.
An investor who invested in Microsoft in January saw the value of the investment less than halve. Now, this is a scary position to be in, especially for someone new to investing. But putting the panic aside is mission-critical to preserve capital.
Look at the chart and see what happened to those who made it past the frightening days. During early 2010, the stock price was almost back to its pre-2008 price. Let’s zoom out a little.
By the end of 2015, the price would have more than doubled for the investor. And guess what? The price continued the upward trajectory. The price of Microsoft as of this writing is $329. That’s a return of 1,000% in less than 15 years.
5. Consider outsourcing financial expertise
The idea of making decisions about something they don’t understand is scary for some people. And that makes sense.
Fortunately, there’s an alternative. Investors have the option to outsource portfolio management or investment decision-making to experts with fancy degrees and a comprehensive track record.
Ever heard of mutual funds?
They’re essentially a way to outsource investment decisions to an expert. They pool money from investors. The pooled money is then invested in a well-diversified portfolio of assets.
Instead of shares or bonds, the investors receive ‘units’ against their investment. When the assets in the portfolio generate returns, the per-unit value appreciates, generating capital gains for investors.
The good thing is, the investor doesn’t need to actively participate in managing the portfolio. This is especially a great option for someone who has little time to assess the performance of their investments.
The fund is managed by a qualified professional, who takes the call on where to invest, how much to invest, and when to rebalance the portfolio. Of course, they don’t do it for free.
When the fund generates returns, the fund manager receives a certain percentage of those returns. Plus, the fund house also needs to cover its administrative costs. What’s left after these deductions will contribute to the increase in the mutual fund’s per-unit value.
Investors can start with as little as $50. First-time investors that want to start small and take a no-fuss approach to investment should consider mutual funds.
Mutual funds are available for investors across the risk spectrum. Some of the mutual fund categories include pure equity funds, debt funds, and thematic funds. There’s a category for almost any investment style, risk profile, and asset class. For instance, the following are some U.S. stock mutual fund categories:
Mutual funds are actively managed by a professional for a fee, but what if an investor doesn’t want to pay a fee?
Well, no fee, no advice. But ETFs and Index Funds are good alternatives for passive investors. Mutual funds are typically better for a first-time investor because ETFs and Index funds carry more risk. They don’t charge any management fees, but administrative costs are still deductible from the fund’s returns.
Start Investing ASAP
The first step is usually the toughest. Flying into unchartered territory can be intimidating. However, once the journey starts, most investors quickly begin to get comfortable.
Starting small goes a long way in maintaining an investor’s consistency. Any drop in market prices won’t have a significant impact on the investor’s wealth when they invest small amounts. It gives them a chance to view how markets behave, and won’t scare them away from investing if the market sentiment sours soon after they start.
Once they’re more confident, they can move to explore other asset classes and increase the investment amounts as well. The tips discussed in this guide will help investors put their best leg forward as they make their first investment.