As the world becomes more digitized, the demand for investments in various assets has become increasingly popular. In this article, we will discuss some tips and tricks for new investors that can be used when thinking about investing in stocks or funds.foto: Pixabay
As with all investments, investing all money into one particular stock puts a tremendous risk on the performance of that stock. Instead, a reasonable strategy is to construct a portfolio of stocks to diversify the risk. In practice, around 8-15 stocks are enough to diversify away all firm-specific risks associated with the portfolio. However, finding stocks can be hard and time-consuming, then an alternate investment that serves the purpose of diversification very well are funds. Most often, funds hold significantly more than 10 assets, implying that virtually all firm-specific risks are diversified away.
Risk is not always bad
A common conception is that risk is bad. Although investors tend to want to stay away from risk, the risk associated with stocks and funds is a requirement for higher returns; the higher the risk, the higher the potential return.
When to buy and when to sell?
Buying when the price is low and selling when the price is high is common advice for new investors. However, timing the market is often very hard and traditional empirical evidence suggests that actively trying to time the market provides little success to the investor in the long run. Instead, investing continuously over a long period of time, disregarding the notion of when the price is low or high, tends to average out the return to be stable, as well as reducing the risk over time.
Management fees for funds
When investing in funds, investors should be made aware of eventual management fees, the cost of having your assets professionally managed, associated with the fund of interest. There is huge variation across funds and their management fees; index funds that closely follow large market indices require very little management, and thus the management fees tend to be reasonably low while actively managed funds tend to have higher management fees.
Higher management fees are not always an indicator of better funds
Traditionally, higher costs are often associated with better-quality products. This is seemingly true in the funds market as well, where funds that are actively managed and have higher fees tend to have higher returns. However, when evaluating the performance of the fund, be sure to include the management fee, since the cost inevitably will affect your return. In many cases, higher management fees tend to consume the potential excess return compared to cheaper funds.
Comparing returns between different assets
When new to the market, comparing returns between stock or funds may be the first indicator of choosing which asset to buy. Of course, higher returns are preferred, but as mentioned earlier, the return is very much dependent on the risk level that you are willing to accept. Hence, comparing returns will not be sufficient when comparing different assets. Rather, we should be interested in a risk-adjusted return measurement that measures the return in relation to the associated asset risk. A common measurement for this, which is often reported on investing platforms, is the Sharpe-ratio which measures the risk-adjusted risk premium. The Sharpe-ratio tells us what our additional return will be when accepting an extra unit of risk compared to choosing an asset with no risk. The higher the Sharpe-ratio, the more profitable the asset is for its given risk level.
Historical Returns does not necessarily say anything about future returns
The historical return should not be used since it does not necessarily tell us anything about future returns. Making predictions about the market is evidently very hard, and it is more or less impossible to know for certain if a stock will go up or down. What we can do is to make statistical predictions about future returns, however, this is a fairly time-consuming and often a mathematically challenging task. By investing in funds, investors can outsource this task to professional investors, and by investing in a set of different funds you can easily obtain economies of scale with very little work required by yourself. Just beware of the management fees.
Invest for the future
Lastly, a good tip for all new investors is to try and aim for reasonable investment goals over time. In the short run, the stock markets tend to fluctuate both up and down. Investing for a relatively long time period, and continuously investing small amounts is often an easy to implement and sufficient strategy.