It wasn’t just a catchy social public service announcement series on NBC for a couple of decades.
The more you know, the more you’ll be able to build wealth.
Just blindly following the herd, thundering or not, may cost you a lot of money.
But learning more about the market, taxes, and the nature of investments can give you confidence to either act or not act, whatever the case may be, and save you from losing an inordinate amount of money during moments of market turmoil.
This guest post is from Derek at Life and My Finances.
Many people lost their gains in the recent market downturn, and I was unlucky to be among them. In fact, I lost a significant portion of my earnings due to my lack of knowledge and experience.
Are you familiar with all those tech stocks that shot up like a rocket when everyone was suddenly working from home? My friends and I were fortunate enough to see that trend coming. We invested, made money immediately (on paper), and thought we were geniuses, but then…those stocks came crashing back toward earth, with us still in the aircraft. (And, upon selling some, we suddenly owed taxes and fees, which further decimated our “genius” status.)
But I wasn’t discouraged by that. I was determined to make money with these investments. I continued to educate myself and learn via experience because I wanted to be good at it. To clearly outline my future financial goals, I used a free investment calculator which helped me with my investment estimates. Through my journey, I learned that blindly following market hype is not a successful strategy (duh!) and that proper education and understanding are crucial for successful investing. Especially investing in this recession.
In this post, I will share actionable and insightful tips with you—some that could have helped me with the recent movement of the markets, and others that I have also learned along the way.
If I had known these tips earlier, it could have saved me a lot of money. Wanna be a good and successful investor? Hopefully, these tips and tricks will prove helpful!
The Hype is Not Worth It
IPOs can be a risky investment, as most people tend to lose money on them, and I did, too. While it may be possible to make a profit through luck or timing, it’s important to have a clear strategy for when to sell. IPOs can be a decent investment if they sell early. However, it is generally best to avoid them as they are often not worth the risk. Unfortunately, no one was there to tell me this, and I’ve made some questionable investment decisions on IPOs.
Moreover, thematic ETFs, which focus on specific themes or industries, also pose a risk for investors. Over the long term, it becomes challenging to beat passive ETFs, especially since most thematic ETFs have proven unsuccessful. Morningstar reports that over 80% of thematic funds worldwide closed their doors in the past 15 years. Unfortunately, these ETFs are often driven by hype and trends, rather than solid fundamentals. An example of this would be AI, or tech stocks, which are something I invested in as they were growing incredibly fast, and in the long run, lost a significant amount of money.
Be cautious of companies that are over-hyped. Here are some examples of companies that received a lot of attention in the past, but have since fallen out of favor. Remember, hype doesn’t always equal success, and it’s important to do your own research before investing in a company. Don’t let it cloud your judgment.
Never invest in the next big thing: pic.twitter.com/p4Rf455Wea
— Compounding Quality (@QCompounding) January 11, 2023
Understanding Fair Value
Because of my losses, I decided to focus on my fundamentals and trim my position. I really wanted to become a good and successful investor, I was not letting this go. To do so, I started with understanding fair value.
The phrase “Buy Low, Sell High” is a well-known investment strategy, but it can be difficult to put into practice. One of the most important steps in successful investing is to educate yourself on the market and the stocks or funds you are considering. This is because emotions can often drive investment decisions, leading to buying high and selling low. With proper knowledge, you will be better equipped to identify when a stock or fund is overvalued or undervalued and make more informed investment decisions. Something I didn’t quite grasp at the beginning.
In a stock chart such as the one above, the black line typically represents the stock price, while the blue line represents the company’s earnings. It’s important to note that the stock price can fluctuate based on investors’ greed and fear, while earnings tend to be more stable and are reported more frequently. This can result in the stock price deviating from the underlying value of the company.
While the stock price may not always align with the company’s earnings in the short term, over the long term, it’ll return to its mean and align with the company’s earnings. This means that when a stock is undervalued, its price will eventually catch up to its true value, and when a stock is overvalued, its price will eventually come down to align with its true value.
It’s crucial to keep an eye on the company’s earnings and understand the fundamental value of the company. This can help you identify when a stock is undervalued or overvalued and make more informed investment decisions.
The Point is You Have To Get Educated
If the value of your house drops by 20%, you wouldn’t sell it to anyone. It’s your house—you know how much it’s worth. However, people do this with stocks all the time. This is something that I learned the hard way.
When you don’t know the value of your stock, you don’t know what you own. Being aware of its fair price means that you will be less likely to panic and sell at the worst time.
Knowing not to invest in cash because cash loses value—and that when stocks drop, they will most likely go back—can save you a lot of money and emotion. This kind of knowledge will come with experience, but going through a quick guide in investing can provide a great base. I, for one, surely remember all the panic and happiness that came with investing the first time I tried. But understanding myself as well as the market at a completely different level, was the first step of my investment-redemption process.
Not Investing is Risky
Okay, we understand how to determine fair value. But what about all the different investing instruments?
In investing, you must familiarize yourself with the average returns from different instruments—be it bonds, stocks or cash. How else can you make the choice, right? Historically, instruments go up over time—but cash will always go down due to inflation. Here’s an example:
Image from Compounding Quality
This is one of the reasons why I was so determined to successfully invest. I did not want to lose my buying power. I still don’t, and you shouldn’t either.
On the other hand, bonds are reliable but won’t make you rich since they won’t go up enough in value. And stocks have compound interest but are a lot riskier.
It all comes down to what you’re looking for at a given moment.
- Are you in financial distress, and need income?
- In your 20s, and looking to start saving for retirement?
- Planning to buy a house in five years, and looking for an adequate investment?
Either way, if you are planning to build wealth, you cannot just save. You have to invest.
If you’re looking for something long-term, stocks may be your option. But if you want something you can invest in and take out within a couple of years—you may want to look at other, safer forms of investment. Find out exactly what you need—since saving up money for retirement is different from saving money for a house.
In other words—if you’re investing for the short term, it’s okay to play it safe and go for the 2-4% returns. If you’re investing for five years or more, it makes sense to go for higher-risk investments like the stock market.
Here’s a breakdown of how annualized total returns fared over various time frames, according to the data analyzed by The Measure of a Plan:
- 1-year: From -37% to 53.2%
- 5-year: From -11.7% to 28.5%
- 10-year: From -4.1% to 17.6%
- 20-year: From 0.5% to 13.2%
Although, remember that inflation will eat away at your investment returns—alongside tax and other percentages that will cost you your money.
So, what exactly is happening with inflation? Well, if inflation is at 3%, in the 20 years, you will lose 45% of your purchasing power—especially if you don’t lock in your assets properly. This means that two decades from now, your money will be worth around half of what it is today. So, if a car costs $30k today, it will most likely cost nearly $60k in the future. Remember that inflation varies, so the amount of money you lose from it will differ each year.
It is crucial to make a plan to grow money—otherwise, it’ll be worth far less in retirement.
You might think high-dividend stocks are a slam-dunk, but guess what? Even dividends get taxed.
The tax rate on qualified dividends is determined by your taxable income and filing status and can be 0%, 15%, or 20%. Nonqualified dividends are taxed at the same rate as your regular income—with those in higher tax brackets paying a higher dividend tax rate. In both cases, the tax rate on dividends is based on your overall tax bracket.
Before we get too much in the weeds here, Kiplinger assures us:
Most “normal” company stocks you’ve held for at least two months will have their dividends qualified. Many unorthodox stocks – such as REITs and MLPs – and stocks held for less than two months generally will not.
So most likely, if you own a “normal” stock, the dividends that are paid out will be qualified and will have a tax rate of 0%, 15%, or 20%, depending on your yearly income.
(Residents of more than 40 states can add state income taxes to that rate, and if you have income in the multiple six figures, you’ll also likely pay the 3.8% NIIT on those dividends.)
It’s always good to be certain, though—before you’re surprised with a 35%+ tax rate vs. the 15% you were expecting.
What’s the difference between qualified and nonqualified dividends?
Qualified dividends come with the benefit of a lower tax rate.
There are three main factors that determine whether a dividend is qualified:
- It is paid by a U.S. corporation or a foreign entity that meets certain qualifications. This criterion is often easily met by investors in stocks, mutual funds, or ETFs. More about ETF/index funds.
- It meets the Internal Revenue Service’s (IRS) definition of a dividend. Some types of payments that are not considered dividends by the IRS include rebates or premiums paid by insurance companies, annual distributions made by credit unions to their members, and “dividends” paid by cooperatives or tax-exempt organizations.
If the dividend does not meet the above requirements, it is a nonqualified dividend and will be taxed at a higher rate—based on your income that year.
Remember to also keep an eye out and monitor your earnings, even through a dividend tracker.
One last item to keep in mind. Taxes may vary depending on the country of your investment; my experience was mostly American!
Right, and What About Bonds?
I furthered my knowledge by researching bonds. Especially since they’ve proven to be an extremely risky investment after the Covid run, proving that educating yourself on every instrument before investing is an absolute must. Otherwise, you’ll end up losing cash, even on bonds.
Bonds are often described as the safest form of investment. They are typically seen to be stable, conservative, and low risk. While this is often true, it’s certainly not a guarantee.
The year 2022 has been the worst ever for bondholders. Central banks have been printing money at an unprecedented pace—which has resulted in unsustainably low-interest rates. This made bonds bubbly—and the bubble did eventually burst.
While often considered the most stable investment, bonds can quickly become risky. Interestingly, banks will try to encourage you to buy bonds—claiming the more bonds you have in your portfolio, the safer it’ll be. An 80% bond portfolio is meant to be conservative—and a 60% equity/40% bonds portfolio is described as balanced. But—ironically—if you held a lot of bonds in 2022, your portfolio would have suffered huge losses. Once again, before you invest in anything, understand what you hold. If you don’t understand your investment, chances are you will lose money. Don’t dive in head first like I did!
In the End…
Investing requires dedication and effort to truly understand the fundamentals so you can make informed decisions. Basic knowledge alone is usually not enough. One must actively seek out experience, familiarize themselves with the different instruments, have a thorough understanding of their investments and the market, and not take a passive approach. This takes time, but being prepared beforehand will both give you peace of mind and also help you avoid any curveballs thrown at you. Laziness in investing can lead to negative consequences.
In the end, it’s important to invest (so don’t delay), but once you get started, please don’t stop learning! Read, ask questions, grow—do whatever you can to continually become a better investor. Your future self will thank you!
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4 thoughts on “The More You Know”
I have to nitpick a little 😬. You and I and almost everyone we know can NOT get better at stock picking by learning more. We might get lucky, but it will just be luck. The evidence is clear. If you are trying to determine the valuation of a stock to be different than the current price, you are competing with literally thousands of people employed by Wall Street farm with green eye shades, computers way faster and larger than yours, and way more experience who are also trying to do the same thing. They are not going to leave value on the table for you to scoop up.
A dummy like me who has invested in Low fee indexed mutual funds has kicked ass for the past 33 years. Not because I “learned more” about the stock valuation. (I did learn a lot about taxes.)
In the “Fair Value” section, it says, “In a stock chart such as the one above, the black line typically represents the stock price, while the blue line represents the company’s earnings.” It would be nice if there were actually a chart …
Right you are. I have corrected the error and you should see the chart now!