Starter’s Guide to Investing (Part 1): Why you should Invest

Starter's Guide to Investing (Part 1): Why Should You Inveset

How to Start Investing

Posted: 23 September 2021

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In an attempt to broaden The Hatch Fund’s reader base, this article serves as a short primer on how to get started with investing. It is aimed at getting people to explore and think more deeply about the topic of personal finance, saving and investing. So if investing is new to you, you have come to the right place. I will keep the information as easy to understand as possible to help you get started on your investing journey.

1. What is Investing?

Before diving deeper into why you should invest, let’s first clarify on what investing means. “Investing” is different things to different people – some view it is as a get-rich-quick scheme or a place to gamble/speculate, while others view it as a way to accelerate wealth accumulation or to beat inflation.

In its most basic form, investing is simply the act of delayed gratification – you purchase an asset in hopes of selling it for more than what you paid for. Based on this, even putting money in your bank account can be seen as a form of investing – putting money with the bank to earn an interest on your deposits.

Investing can come in many forms:

Depositing into bank account to earn interest;
Buying bonds to earn coupon (similar to interest!) (e.g. SGS / Temasek / Astrea);
Buying shares of a company from organized exchanges (g. SGX, Nasdaq, NYSE, HKEX, LSE);
Opening your own business in hopes of growing it into a big business next time;
Paying a franchise license (e.g. 7-eleven) to operate a franchise store and earn money; or
Buying a cryptocurrency in hopes of selling it higher in the future.

The list goes on. Essentially, any act involving deferring spending power in exchange for potentially greater spending power in the future, based on calculated risk assessment, is investing.

The key is investing does not just involve any random form of risk-taking, instead it is about taking calculated risk. This means that you have done your homework (due diligence) on what you are investing in and you know what you are getting yourself into.

Hence, I do not label “get-rich-quick schemes” / “gambling” as investing as, more often than not, ‘doing your homework’ does not improve your chances of winning. Hence, I will categorise these as “speculation” rather than “investing”.

2. Why should you invest?

So here’s the golden question, why should you invest?

As alluded to earlier, different people invest for different reason. Broadly speaking, people invest for two very simple, yet different, reasons: (1) to preserve their wealth, and (2) to build their wealth.

Reason 1: Invest to preserve wealth / to beat inflation

The first reason to invest is to preserve wealth. Generally, this is referred to as beating inflation.

Figure 1: Singapore Inflation Indexes

Source: MTI, Singapore

In Singapore, inflation over the past 3 years has averaged ~1-2%. This means that, on aggregate, your electricity, gas, accommodation, retail goods, food, services and transportation costs have become 1-2% more expensive each year.

With the average savings account in Singapore offering ~0.7-0.8% on deposits, every dollar sitting in your bank account is slowly losing its purchasing power due to price inflation. In other words, you can buy less with $1 today than you can 5, 10 or 20 years ago.

Figure 2: Singapore Price Inflation by Category

As seen above, various consumer food items have become increasingly pricier due to inflation over the past 20 years in Singapore. This represents an average annual inflation rate of approximately 2% p.a. A $1 bottled drink in 2000 will now cost ~$1.56 in 2020. Without investing, the same dollar you saved from 2000 can only buy 2/3 a bottle of the same drink 20 years later (in 2020).

As such, one important reason to invest is to beat inflation and preserve the purchasing power of your money. As the saying goes, inflation is the enemy of a salaried worker. The last thing you want is to have sacrificed your time in exchange for money that is slowly losing its value.

Reason 2: To grow wealth / to achieve financial goal

The second reason is that people invest to achieve their financial goals. This can range from goals such as “becoming a millionaire by 30 years old”, “achieving financial independence / early retirement” or “to build wealth more quickly”.

Being in this second camp requires us to invest in riskier assets – such as stocks or real estate– as they typically provide a much higher return that is well-above the inflation rate. The concept is that risk-taking should be appropriately rewarded by its returns. This means that investors will expect higher returns for investing in riskier assets.

To think of this simply, imagine there is a king cobra in a room of 10 people. If you offered $1 to anyone who catches the snake and removes it from the room, it is likely that no one will step up. Conversely, if you offered $1,000 instead, chances are more people will volunteer to remove this snake. This is the same risk-reward concept that is ingrained in everyone of us.

An important concept to understand is the effect of compounding interest.

Assuming we invest $1,000 today into 2 different assets that earns a 10% p.a. interest rate – i.e. you get $100 in return each year as long as you hold onto the asset – here’s how the value of your investment will differ over the next 30 years if (1) the interest is reinvested each year v.s. (2) the interest is not reinvested each year:

If you reinvest the $100 into buying the same asset each year, at a 10% interest rate, the initial $1,000 invested will grow to become $17,449 in 30 years’ time.

Conversely, if you choose not to reinvest the $100 each year, the $1,000 invested each year will only grow to $4,000 in 30 years’ time, or about 4.4x lower than if it was reinvested.

This is the power of compounding interest.

As a result, the earlier you invest, the better it is for you because time is your friend! It gives you a longer runway for money to experience the exponential compounding effect, and you have more room for errors/mistakes when you start early.

A way to grow money with money

Furthermore, investing provides an alternative way for you to grow money using the money you have earned – Instead of earning a mediocre 0.4% interest with the bank, you could potentially earn much more by investing; Instead of just holding a stable job and collecting a paycheck, you could make your money work for you to build wealth more quickly. And this is perhaps one of the most compelling reasons for people to start investing.

When people talk about “investing”, they are most commonly referring to investing in stocks (equity). I believe that is the case because many of Wall Street’s most successful self-made billionaires have grown their wealth through the stock markets. Some high-profile examples are Warren Buffett, Charlie Munger and Ray Dalio.

Furthermore, the stock market has only gone up historically. And this is the reason why it is attracting more and more people to invest in it.

Source: Google Finance

It goes without saying that past performance does not guarantee the future. Hence, caveat emptor!

3. What should I know before I start investing?

In order to start investing, there are a few key questions you have to ask yourself:

3.1 What are your investment objectives?

Do you just want to preserve your purchasing power by beating inflation? Do you want to earn slightly more than inflation? Or do you want to become a multi-millionaire?

The first question has to do with identifying why you want to invest. As alluded to earlier, if you want to treat investing as a get-rich-quick scheme, I would highly suggest you reconsider. While it is true that there have been many millionaires made from speculative purchases of cryptocurrency and penny stocks, it is equally true that many more had lost their homes and livelihoods because of speculation.

Furthermore, you should be clear on your investment goals so that you can choose the right strategy to achieve it. If you want to grow your wealth from $10,000 to $200,000 in 5 years, putting it in a bank fixed deposit instrument simply won’t cut it. Hence, your investment strategy will be strongly guided by your goals.

The general rule of thumb is that consistently earning double-digit returns is possible, but difficult. Over the past 10 years, the S&P500 index which track the 500-largest U.S. companies only returned ~11% p.a. Thus, it is important that you use this as a benchmark. The S&P500 index can be thought of as the global barometer of how the stock markets are performing – if investors are not confident in the future company performance

3.2 How much do you intend to invest?

How much are you earning? How much do you need to set aside as emergency funds? What are your monthly expenses like? How much do have left over to invest? How much are you willing to invest?

The second step is to identify how much you can afford to invest. When you are just starting out, the key question here is “how much can you afford to lose without impacting your current lifestyle?”. As mentioned earlier, investing is a form of calculated risk taking – keyword being “risk”. This means that there is a risk that your investment may lose value too.

The best advice here is to always start small and get a sense of what is happening. No one becomes an expert overnight. Investing comes with experience too. The early stages of investing is often plagued with unexpected losses or lucky windfalls, but it is important that we start to identify the actual causes behind these price movements as we progress.

After you’ve gained some investment experience, then you can revisit your investment objectives:

If your goal is to become a millionaire by 30, investing 10% of you money simply won’t cut it unless you are earning a sizeable 6-figure annual paycheck (or if you already have quite a bit of capital). Hence, if the goal is to grow your capital rapidly, the amount of money you invest must correspondingly be much higher.
Conversely, if the goal is to just preserve wealth / beat inflation, you can opt to either invest a smaller portion of your money in riskier assets, or to invest the bulk of your money in low-risk assets (e.g. government bonds).

3.3 What is your risk appetite?

How comfortable are you with your investment losing its value? i.e. how big is your risk appetite?

Next, you need to gauge your risk appetite. “Risk appetite” refers to how much risk you are willing to take on in your investments. If you are someone who prefers a 50% chance of making a 1.2x return over a 5% chance of making a 12x return, that would mean that you are more conservative and, hence, have a lower risk appetite.

If you invest 50% of all your money with the expectation of earning a 10% return p.a., how comfortable are you if there is a 20% chance that its value falls by 5% the next day?

Everyone has a different level of risk appetite that is driven by your earning power, your personality, your experiences, your savings, your ability to control your expenses and a multitude of other factors. The important question is to understand how much risk you are willing to take to earn your expected return.

While traditional finance theory suggests that assets that are equally should be compensated with the same level of returns, the reality is that not all risks are built the same.

There are many ways to earn a 10% return – you can invest in the S&P500 index fund, or the bond of a company near bankruptcy, or even buy the shares of a new tech company in China. While all of those can return you a 10% return, you take on different risks when you invest in each of these.

For example, investing in a S&P500 index fund may be considered the safest option as it tracks the performance of the 500 largest US-listed companies (i.e. high-quality companies). Conversely, investing in a bond that pays 10% interest (coupon) is much riskier since the company may be on the brink of bankruptcy and paying the coupon on this bond will add financial burden to the firm. As such, there is a much higher chance for your investment to go to nothing.

Your risk appetite will dictate your portfolio allocation strategy (i.e. how you allocate your capital to different asset classes – to be covered in the next article – and which parts of the world you will invest in).

3.4 Are you willing and able to do your "homework" before investing?

How much effort are you ready to put into doing your due diligence before investing?
Do you have the time to follow the financial markets, and read up on investing, company filings (reports) and economic news?
Are you interested in learning deeply about this topic or do you want to just invest your money and forget about it?

Lastly, you need know understand how much time you can realistically cater to reading up on investing. This helps to dictate your level of involvement in managing your investment portfolio – i.e. how often you buy and sell securities.

This question helps you define your investment strategy – active investing or passive investing.

Passive investing

Passive investing involves buying investments and holding on to them for as long as possible. Instead of trying to anticipate price movements buy at the lowest points and sell at the highest points, you take a more passive approach of just buying and holding on to your investments.

If you are not too keen on reading up on the topic of investing, or if you just want to beat inflation, then you should go with something safer like an index fund or, perhaps, a robo-advisor. In other words, you should adopt a more passive form of investing – i.e. park the money and leave it to grow.

Active Investing

Active Investing, on the other hand, requires buying and selling based on market conditions in hopes of maximizing gains.

If you have the time and energy to follow the financial markets, economic news and research on companies before investing in them, then perhaps you can choose the more thrilling option of selecting your own stocks/assets and investing in them.

But why would people go the extra mile to do this?

Well, the prime reason is that they hope to “beat the market”. In other words, they want to earn a return that is well-above what you could earn if you invested in an index fund (which tracks the performance of a market, e.g. S&P500).

However, realistically, history has shown that only a very small handful of investors (including professional investors) ever really beat the market over the long term.

4. Summary

In summary, before you embark on your investing journey, you need to first know what your goals are.

After identifying your goals, you need to realistically ask yourself how much you are willing to invest / how much can you afford to lose for starters. This sets the baseline for you to get you started. You must be disciplined enough to make sure you do not put more capital at risk than intended.

We have the tendency to get greedy when the going gets good, and to get fearful when things don’t play out as expected. However, this runs counter to what the best investors typically do because you always want to buy when the market value assigned to a company is lower than its actual intrinsic value (i.e. undervalued). This is no different from when you buy a laptop – you will look around to find the cheapest store. Hence, for starters, it is important that you only put up what you can afford to lose and nothing more until you become more familiarised with investing and understand how the market swings.

Once, you gain some familiarity with investing, then you can revisit your investment goal and decide if you should inject more capital into your investment portfolio. A more aggressive investment objective will naturally require you put more capital to grow your wealth at a faster rate.

Thereafter, you have to decide which kind of investor you want to be – (1) an active one who enjoys following the markets, economic performance and various companies, or (2) a passive one who wants to park your money somewhere and watch it grow.

Over the course of your investment life, you can expect this to change. Typically, younger people will be more tolerant towards taking risks and seek higher returns. As we age, this tendency will slow transform to capital preservation as our wealth accumulates and our needs move towards catering for our family and dependents.

Regardless of which type of investor you become, the key is to stay disciplined and to keep learning as we progress. If you have not started investing, then you should start as soon as you can so that time is on your side and you can experience the fuller impact of compound interest!

Here are some useful resources to get you started:

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In part two of this mini-series, we discuss the various asset classes that you can invest in, and the characteristics of each type of asset class. This will give you a better idea of how investments are categorised and what are the key traits that make these asset classes unique.

September 23, 2021

Starter’s Guide to Investing (Part 2): What can I invest in?

This multi-part series serves to provide a quick primer on the topic of investing to kickstart your investing journey. Part 2 talks about the various asset classes you can invest in.