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I’m not an investing guru, but I love learning about investments and was crazy enough to take the CFA exams.
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Among my friends, several of whom don’t share my passion for finance, this makes me their go-to source for advice.
The conversation usually goes as follows:
Friend: "I want to start investing. Any stocks you recommend?"
Me: "Whoa, back up. If you’ve got the time horizon and the ability and willingness to handle the risk, I don’t recommend individual stocks for you. I recommend buying the market."
Friend: "Huh? What does that mean?"
This article answers these questions with the most basic explanation possible. Many readers with a foundational knowledge of finance may find these steps rudimentary, but the underlying concepts are complex, and I’ve hyperlinked to many of my favorite articles.
1. Invest in the market — not individual stocks.
First, let’s define "the market." My friend mistakenly believed that buying a stock meant he was now invested in "the market" — but this is incorrect. Think of investing in the market as purchasing a whole basket of stocks all mixed together.
For simplicity, "the market" usually means the S&P 500 (the 500 largest company stocks you can buy). There are other definitions, but this is the simplest. Buying "the market" means you own the whole basket of stocks, and buying this basket has given a return of 9.55% per year on average. Pretty impressive.
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2. The best way to buy 'the market' is through an ETF.
"OK" says my friend, "I’ll agree that I should buy the market. But how?" The best way is through an exchange-traded fund (ETF). An ETF is essentially a basket of stocks that you can buy just like any individual stock. Many also suggest buying index funds (which are very closely related) — but I recommend ETFs for several reasons — primarily because they are cheaper.
There are hundreds of ETFs to choose from (and you can buy ETFs for bonds, foreign stocks, and other asset classes), but some of the most recommended ETFs for US stocks are VTI, VOO, VTV, and VOE (all four are Vanguard funds).
3. Resist the urge to be an 'active' investor.
"OK. You’ve convinced me on sticking with ETFs … but there’s also this IPO coming, and I want some shares! Can’t I beat the market?" Although there may be times where buying individual stocks is wise, to "know-nothing" investors like my friends, I don’t recommend it.
Think of it this way. There are two types of investors: passive and active. Passive investors buy the market — they don’t try to beat the market. In other words, they follow steps one and two. Active investors try to beat the market. Any time you choose an individual stock or most mutual funds, you are entering the "active" arena — an arena filled with professional money managers who spend their entire day studying the stocks you are just casually buying.
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The problem with trying to beat the market is that it is a zero-sum game. Meaning, if you are going to win, someone else must lose. Another concept foreign to my friend was that every time he buys a stock he is buying it from an actual person who isn’t trying to give my friend a deal. People who sell no longer view their stock as an investment worth holding, so they choose to sell it, and lucky for them, there are many "know-nothing" investors willing to buy it. Sometimes purchasing individual stocks pays off ("but I bought the Tesla IPO and I made a killing!") — but when it does, it’s luck.
For the average "know-nothing" investor, individual stocks, especially IPOs, are a losing game. Turns out, the other "active" investors are pretty good. The worst example I’ve seen of this is a friend who was ecstatic to get Facebook IPO shares, panicked and sold the shares three weeks later when the stock dropped, and then missed the ensuing rally (which is still ongoing). When passive investors try to go active, they commonly buy high and sell low.
These steps aren’t foolproof, but they are simple and straightforward — and surprisingly enough, following these three steps actually allows the average know-nothing, passive investor to outperform the average active investor. Yes, that’s correct — if you follow these steps, you actually beat those active professional investors, on average. This is one of the great investing paradoxes.
In fact, a famous bet made between Warren Buffett and a New York hedge fund, Protégé Partners, epitomizes this point. Buffett essentially put his money on the passive investor to beat the active investor, and with four years remaining on a 10-year bet, he is in very good shape.
I’ll add that the recommendations I’ve laid out here mirror what Buffett and Charlie Munger recommend for "know-nothing" investors who ask them the same question. As Charlie says:
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"Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund." (Very similar to the ETFs I describe in No. 2).
Sounds like solid advice to me.
Tyler Hogge is an MBA student at Cornell University and a CFA charterholder as of 2014. Prior to school, Hogge was in software sales and business development with Clearwater Analytics, an enterprise software firm based in Boise, Idaho. He can be reached on Twitter @thogge or by email attylerhogge@gmail.com.
