Becoming Buffet: 10 things you need to consider as a beginner investor
Not even a year ago, I knew absolutely nothing about investing. Investing, to me, was reserved for the financial elite and required you to sit in front of your computer almost 24/7 watching and timing the markets.
Boy was I wrong!
A year later, I find myself in a position with several investments (6 to be exact), having bought shares in several locally and internationally reputable companies like Apple, Netflix, Google and Naspers.
The investing landscape has changed significantly over the years, becoming more accessible to the general masses. It’s a fallacy to think that investing is reserved for the top 1% or for those who graduated with a finance degree.
In fact, how do you think the top 1% got to where they are today? Warren Buffet bought his first share at the age of 11. Being one of the wealthiest investors of our time, don’t you think we should take (or, at least, read) a page from his book? As a side note, I can highly recommend his New York Times best-selling book: The Warren Buffett Way.
1 // What Exactly is an Investment?
A very broad definition of investing is the act of placing your hard-earned money (or capital) into an instrument (or vehicle) that you expect will make you a profit in the short-, medium- or long-term.
However, the term “investment” has garnered confusion because we’ve got into this habit of using it informally nowadays.
“I’m investing in my education by taking an online course to become certified in human resources.”
“I’m buying a new car as an investment for my new business.”
“I’m going to join my local gym as an investment in my health and fitness.”
For all intents and purposes, while some of these may certainly be profitable or beneficial, these are not the investments I’m going to be writing about.
For this post, I’m going to be focusing more on investments that you own (shares), lend (bonds) or gain short-term interest from (cash/money market accounts).
2 // What Are Your Options?
When I first started researching my options to invest, I was overwhelmed by the number and types of instruments into which I could place my money. Below, I want to break it down for you into simple terms, to help you understand the differences in the most common types of investments.
A stock in a company certifies that you literally own a portion of that company. If a company is made up of 100 stocks and you own 1, you technically own 1% of that company and you’re entitled to a portion of the company’s earnings.
The price of the stocks that you own will vary, depending on how the stock market values the company. If it is highly valued, this drives up the stock price, resulting in a profit if you decide to sell. However, the reverse is also true, if the market is sceptical, your stock would likely lose value resulting in an overall loss.
This means stocks (or equities) are often the highest risk investments an investor can make. But, even so, they tend to provide the highest returns over time.
A bond is a type of lending instrument where investors loan their hard-earned money to a company or government entity, in exchange for variable or fixed interest-bearing payments.
It’s similar to the bank loaning you money to buy a house and you end up paying it back over a 20 year period with a significant amount of interest.
Because bonds are not typically affected by price swings or general market volatility, they are considered a lower risk investment relative to stocks.
Listed property is pretty self-explanatory. Property developers or agencies can list their company on the stock exchange (local examples would include Growthpoint Properties or Redefine Properties).
By buying into listed property, your investment portfolio gains exposure to several types of property assets, including residential, industrial, office and commercial.
So how does listed property provide you a profitable return? In addition to rises in property share prices, you can also earn returns in the form of rental income distributions.
Because listed property is considered an equity investment, it’s risk profile is similar to that of company stocks and the price is affected by market fluctuations and valuations. However, it does allow you exposure to booming property markets without having to buy your own property or dealing with issues of being a landlord in the case of rental properties.
Unit trusts are probably one of the most common types of investments, particularly for new investors. Essentially, unit trust managers collect a pool of money from different investors and use the money to buy cash, bonds or shares within different companies that meets the funds objectives.
The fund is then divided into individual units, each unit containing an equal proportion of assets that make up the fund. Based on how each asset class performs, the price per unit within the fund will usually be updated at the end of each trading day.
Unit trusts help diversify your investment portfolio while also enabling new investors to get into the market without the need for a solid background in financial education.
Unit trusts can be offered in several different flavours, including passive and active discretionary investments (more on this later), tax-free savings accounts as well as funds that are compliant with local retirement annuity legislation.
Exchange Traded Funds (or ETFs)
ETFs are quite similar to unit trusts, but differ in three main ways: they typically track a particular index on the stock exchange, the price of shares in an ETF will fluctuate throughout the day and investing in ETFs usually comes with significantly lower costs to buy and sell.
Ever heard of the S&P 500, the FTSE/JSE Top 40 or Nasdaq? These are known as indices (or index funds) and are made up of a “basket” of shares, bonds and cash. The goal of an ETF is to mimic or track one of these index funds.
If you’d like to find out more about ETFs, read this article from Easy Equities (a local provider of equities and ETFs in South Africa).
Cash investments are typically thought of as short-term investments that provide profit through interest payouts to investors. If you think of your current savings account through your bank, this is considered a type of cash investment. Others include money market accounts (MMAs) and certificates of deposit (CDs).
Cash investments are considered low risk investments, but, as a result, provide inferior returns compared to stocks or listed property over the long-term.
A cash investment is usually made if you require capital growth (in line with inflation), but need capital security and liquidity (in other words, immediate access to the funds). This is typically a type of investment you’ll have for your emergency fund.
3 // The Magic of Compound Interest
It’s a generally accepted belief that stock prices tend to increase over time. This is known as share capital gains. In addition, companies in which you are invested can frequently pay out a portion of their profits to their shareholders in the form of dividend payments. This is basically free money!
If you were not to touch your investments and reinvest any interest or dividends earned, you get to take advantage of the 8th wonder of the world: compounding interest. I’ll use a few examples to illustrate just how powerful it is.
The Power of Compounding
If you were to start investing R1000 per month for 40 years until the age of 65, you’d have earned over R11 million by the time that you retired, assuming a 12% annual return. Of that, only R480,000 would have come out of your pocket.
If you waited 5 additional years to start investing, your investment at maturity would drop to almost half. With 5 years on top of that, it would be almost a quarter in value. This is the power of compound interest. The longer you remain invested, the greater your return.
Now, let’s say you have R100,000 to invest initially and you’d like to top it up each month with a debit order. How would this affect your return? Well, your investment payout would be R6 million higher if you initially invested a lumpsum amount and contributed R1000 per month from the age of 25. Isn’t that amazing?
But be aware…
Investments in high-return equities are never smooth sailing. Your interest return is likely never going to remain stable at 12% per year. Remember, share prices are inherently volatile over the short term. You’ll have some good years, some bad years and possibly some market crashes in between.
In fact, the year that I started to invest (2018) ended up being one of the most volatile and disappointing years in recent history for any investor. But I stuck to my guns and gritted through it, knowing that it will eventually turn around. January 2019 saw me recovering a lot of my losses. The take home is that, in the long run, when everything averages out, you’re still likely to outperform bonds and cash instruments.
The key is to remain in the market for the long-haul. Investing is not a get-rich-quick scheme. It’s planting a seed and waiting for the tree to grow. It’s letting your money do the work for you, while you wait for it to mature.
4 // Determine Your Risk Appetite and Time Horizon
Not all investments are equal. Some will earn you sub-par, but secure returns. Others will take you on a rollercoaster ride as you watch your money lose value one day and gain on another, only to lose value again the next day.
This speaks to something known as the risk-return ratio. It’s typically accepted that higher risk assets (such as equities and listed property) will be volatile over the short-term (in other words, you’ll see large fluctuations day-to-day), but will average out to earn you the greatest interest over the long-term.
On the other hand, low risk investments (such as cash) will earn you a stable, secure return in the short-term, but will likely barely break above inflation in the long-term, meaning that you could possibly lose value over time. You will also miss out on some potentially mind-blowing market returns that only equities can provide.
Before you begin investing, you need to decide on your risk appetite. If you can’t bare to watch your capital lose value from day-to-day or if you’re going to stress yourself out by looking at your investments every day, you’re likely risk-averse. If you have a strong stomach, emotions of steel and you’re able to weather the storms of volatility, you’re probably risk-seeking.
This is an important distinction because it will determine what investments would suit you best and the length of time it would take to make meaningful profits.
How much time do you have to invest?
Another consideration is to determine how much risk you can afford to take for the amount of time you plan to stay invested. If you’re 60 years old and plan to retire in 5 years, it’s risky to shift all your savings into a high-risk portfolio in case the market crashes. However, if you’re 25 years old and have a 40 year investment horizon, you have the time to recover any short-term losses. And you’ll get to take advantage of compounding interest.
A typical rule of thumb is to subtract your age from 100. This will give you an indication of what percentage of your capital you should have invested in high-risk assets. For example, I’m 30 years old. This means that at least 70% of my capital should be invested in high-risk equities, while the remaining can be invested in bonds and cash.
5 // Active or Passive Investing?
The never-ending debate.
Do you hand over your money to qualified asset managers who will carefully select stocks they believe will earn you the highest return (but also might not)? Or do you prefer to simply track a collection of stocks that is listed on the stock exchange, knowing that your capital will almost always be in line with the index you’re tracking.
The first is known as active investing; the second as passive investing.
On the one hand, you have asset managers touting that they’re able to beat market returns. See this article by PSG describing the benefits of active asset management.
However, on the other hand, you have passive investors claiming that 90% of active managers are unable to beat the market and that you’re paying higher fees for a below-market return. See this article by 10X Investments that describes the advantages of passive investing.
How do you decide? This will come down to several factors: your risk appetite, whether you’re happy with simply making market returns, what you’re willing to pay in management fees and whether you trust asset managers to actually beat the market.
6 // Local or Offshore?
So, now that you know what your options are and your risk appetite, do you choose to invest locally or offshore?
Of course, this will be country-dependent and I can’t provide a blanket suggestion for what works best. But, as I point out in my next point, your best bet is to diversify your investment portfolio.
For myself, I plan to invest approximately half of my capital locally and the remaining 50% offshore. Why? In this way, if either fund were to tank, I’d have the other to buffer the fall, ensuring that not all my capital is affected. Also, it allows me to take advantage (or at least buffer) changes in the exchange rate.
It’s important to know that investing offshore doesn’t necessarily mean you need to physically move that money abroad. You can get exposure to international assets through local ETFs or unit trusts. For example, I’m invested in the Sygnia 4th Industrial Revolution fund (a local fund), which is predominantly invested in companies off the shores of South Africa.
Again, the answer to this question will be dependent on your personal situation. It’s worth it to seek the advice of a professional financial advisor to discuss your options and what makes the most sense for you.
7 // Diversity Trumps Loyalty
If you’ve ever done a little bit of research on investing, you’ll hear this often: “Diversify! Diversify! Diversify!”
What do they mean when they say this?
Well, let’s say, for example, you decide to invest all your money into Apple stocks, hoping to gain from their popularity and stake in the technology market. You love their products, you know that many other people love them too and you feel like it’s a trustworthy company to invest your hard-earned money. Surely you’d make a profit?
Bam! The company is caught in a fraudulent scandal and the stock price plummets by 80%. If you had invested all your money into Apple stocks only, you’d have lost 80% overnight. This isn’t unheard of. The most recent case for South Africans was the downfall of Steinhoff, in which several local asset managers were heavily invested. Since then, the stock price has lost almost 80%, the majority of that being lost within a period of 2 days after news broke of audit irregularities.
Put your eggs in many baskets
How do you protect yourself from this happening? You diversify your investment portfolio.
You ensure that you don’t put all your eggs in one basket (or stock). You buy into several companies so that, if one does tank overnight, most of your capital will remain protected. It’s highly unlikely that every company within your portfolio will tank overnight. Unless there is some apocalyptic event.
So, what’s the best way to diversify? Either you personally buy stocks in multiple different companies that you trust, spreading your capital between them. But the easier route is to place your money into a unit trust or ETF, where the fund automatically diversifies your portfolio based on their selected portfolio holdings.
If you’re new to investing, I’d steer clear of buying into single companies yourself. This requires a lot of research and significant knowledge of how to value a company.
At the end of the day, diversity always trumps loyalty, no matter how much you love a specific company.
8 // Fees! Fees! Fees!
Investing doesn’t come free. You’re putting your money in the hands of asset managers who will either actively try to get you a market-beating return or those that will ensure your money tracks an index over time.
These guys also need to take a salary home at the end of the day. And the way that they do it is through charging annual fees on managing your investments on your behalf.
I won’t get into the nitty gritty about all the different fees that asset managers charge (maybe that’s for a future post). But, I will tell you that fees have a significant effect on your investment portfolio. Just as interest returns can compound over many years, so can your management fees. This erodes the potential value of your investment portfolio over time.
This is the reason that passive investing has become so popular – it’s a much cheaper alternative to active management and still provides you with returns that are in line with the market. In essence, you trade market-beating returns for lower fees.
The eroding effect of fees
This pretty great article by 10X Investments explains the effect of fees on your retirement annuity. While it can be tempting to pay higher fees for potentially eye-watering returns (the ones that active managers always boast about), you should also be aware of how often your asset management company can achieve this and whether you’re putting too much trust in them.
Again, diversity trumps loyalty, even when it comes to the company that you invest with. For full transparency, I’m invested in both active and passive funds. If, for some reason, my actively managed fund underperforms the market, I at least know that some of my cash is stashed away in a fund that will likely give me returns in line with the market. Is it starting to sink in how important diversification is?
9 // What About Taxes?
Don’t you just wish the tax man would leave you alone?
Unfortunately, you can’t escape him… even when it comes to investments. This will differ from country to country, so it’s worth it to check out your local tax laws. But there are typically two types of taxes that will be payable upon maturity of your investment.
Capital gains tax: this is a tax levied on the profit of your investment when you end up selling at its maturity. For example, if you invest a total of R500,000 and you end up making R6 million rand in capital gains, you’ll be taxed on the profit according to your local capital gains tax legislation. It works similarly for property – if you sell your house and it has appreciated in value, you end up paying tax on the profit you’ve made.
Dividends tax: Remember how I told you that companies can give a portion of their profits to shareholders in the form of dividends? Well, yeah, that tax man comes for that too. Again, the tax rates will differ depending on the country and it’s worth it to find out these details. You’ll want to make your investments as tax efficient as possible, to maximize your return upon maturity.
10 // Will I Lose Money?
Ah, the ever common clause that most asset managers tout to cover themselves: “Past performance is not an indication of future performance.”
It’s easy to get excited when you look at the fund fact sheet of an investment instrument and see that they returned 15% for the past year. Or that their average return since inception of the fund is 19% per year. I, mean, hello money!
But this is often a marketing tool.
They never tell you about the rollercoaster of a ride that you’d go through to reach that point.
The fact of the matter is… if you’re invested in high-risk equities, there will be times when you WILL lose money. Sometimes only a little. But other times it will be A LOT. And it will scare the crap out of you as you slowly watch your capital decrease from day to day.
As I mentioned, last year was a tough one for me. I saw my investment lose R10,000 over the year, which was more than 10% of its value. There were moments I felt anxious and uncertain. I was so close to withdrawing all of it and stashing it into safer instruments like cash. But I’m glad that I didn’t. In January alone, I’ve recovered R7,000 of my losses. It’s encouraged me to ignore the short-term noise and to focus on my long-term goals. I’m in it for the long-haul – come rain, hail, snow or market crashes.
If you desire to get started on making your money work for you, download the Financial Starter Pack and read the associated blog post to learn how to use it.
Dr. Kyle O'Hagan is a UCT scientist and an avid personal finance blogger. With over 20 years worth of experience in the SA schooling system, he has come to appreciate the value of a proper education and feels that personal finance is an area that is often neglected, particularly at a young age.
O'Hagan is one of Personal Finance's New Voices and his finance blog is called the Saving Scientist.