A Young Lawyer's Financial Guide for the Future I Part 2: Basics of Investing

Kitch's Corner: A Young Lawyer's

Financial Guide for the Future

Part 2- Basics of Investing

Welcome back to Kitch’s Corner! This is the second installment of the series where I cover the Basics of Investing. Stay tuned for the March edition, which will focus in on the various asset classes for investing and strategies for targeting each one.

Basics of Investing

It can be an overwhelming task to decide when, where, and how to invest your earnings, and unfortunately many people will delay making any decision at all. I think it’s fair to say that everyone understands why investing is important – most people, if given the choice, would like to make more money. These days, however, investing in assets is becoming much less of a choice and more of a necessity for achieving financial freedom and growing a nest egg for retirement. Currently, a significant number of attorneys in the US will not be covered by a traditional pension plan, as they have been replaced with self-managed retirement accounts. Therefore it is important to start investing for retirement as soon as possible.

While there is no “secret sauce” to successful investing, there are general rules and principles that you can learn about the financial markets, that can help demystify the world of investing. Today, we will take a look at what investing is, what it is not, and what are the important factors you should consider before you begin to invest. Next month in this column, we will also look at the various asset classes, basic portfolio analysis, and investing for retirement.

Understanding Compound Interest

The utility of making investments lies in a theory that Albert Einstein once called "the greatest mathematical discovery of all time": compound interest. Simply put, compound interest is interest that is earned on previously earned interest. For example, say that you start with an investment of $200 invested at a rate of 3% per year for two years, and each year you take out the interest. After the first year, you earn $6 and remove it, then the next year you earn $6 again for a total of $12. However, if you use the same figures but do not remove the interest, then after the second year you would earn $6.18 for a total of $12.18 – that’s the power of compound interest and it applies to every type of investment! Whether you place your money in an interest-bearing account, receive dividends from stocks, or see the value of your investments increase, the goal should be to compound your earning.

When you think about compound interest, its greatest effects are seen over time – this is why it is so critical to invest money as early as possible. Personally, I recommend that everyone have investments of some sort before entering law school, but if not then, you should start with any earnings you have from working over the summer or during the year. In a later article, I will explain why you should think about using your summer earnings to start a qualified retirement account – especially if you plan to work for a large firm.

Determining your risk Tolerance

In theory, financial markets have a risk-reward tradeoff, which means investors who take more risks expect to get higher returns, while investors who take less risks will get lower returns. This simple theory shouldn’t be construed as a predictive indicator of future returns, but it is a good starting point for beginning investors to understand the sort of investments that fit them best. Before making any investments, you should consider the factors I have outlined below, and try to determine the right amount of risk for you.

Age: This is one of the most important factors to consider when determining your appetite for risk. Young investors are usually more inclined to hold investments with higher risk, while older investors (especially those approaching retirement) tend to hold less risky assets. The theory makes sense; younger investors can handle more volatility and risk because they have more time to earn money and cover any losses they might incur, while older investors prefer to eliminate as much risk and volatility as they can. A simple way to determine your risk tolerance is to take your age and subtract it from one hundred. For example, if you are 25 years old, then your portfolio should consist of 75% stocks and 25% bonds, cash and other safer assets. While this way of determining your risk tolerance is not perfect, it is a good way to get a sense of the type of allocation that you should be making at your age.

Personality: Ultimately, no two investors are ever the same, so you should consider your personality and preferences when making investments. For instance, if you are someone that would like to invest only in ESG companies, or companies with female CEO’s, etc. then you should do your research and find those assets. The trade-off, of course, is that depending on your preferences, you may limit your investment pool – for example, only 6% of S&P 500 companies have female CEO’s. It is up to you to determine how important these factors are. Other important personal factors to consider could be: are you married? Do you have children? Do you support other family members financially? Are you a risk-taker or not? The answers to these questions will help you determine the type of assets and investing style that suits you best.

Your Goals: Before making any investment, you need to have a clear idea of your short and long-term goals. For example, if you are planning to purchase a home in the next two years, and a considerable amount of your down payment is invested in the market, then you need to determine how important that home is – because if you are invested (especially in risky assets) you might lose money. Alternatively, if you would like to purchase a home in the next fifteen years, then you may be able to handle more risk. In sum, as your goals change, your asset allocations and risk tolerance should change as well.

Investment Goals: Another important factor to consider before investing is whether you are looking for income or growth. In general, income investing means purchasing assets that pay a dividend or interest on a scheduled basis, and growth investing means purchasing assets with the intention to sell them later at a higher price (and you profit on that growth). Income investing is typically more popular amongst older investors who will need a reliable income stream in retirement, but it can be utilized by younger investors as well. When purchasing a stock that issues a dividend, be sure to purchase it before the “ex-dividend date”, or you will not be registered for the dividend distribution. Also, note that if you hold any dividend or interest-bearing assets outside of a retirement account, you will generally be taxed on the distributions at your income tax rate (unless the securities are issued by the federal or local/state government).

Investing vs. Trading

At this point, I think it is important to make a distinction between investing and trading. Although these terms are used interchangeably, it is better to think of them as distinct terms. Generally, investing focuses on the gradual accumulation of wealth by buying and holding assets that you believe have long term value. A “real” investor should always perform a thorough analysis before committing any capital to an investment – the aim is to learn as much about the business as possible.

Unlike investing, trading is more similar to gambling at a casino. The aim of a trader is to generate high returns by buying and selling assets, and that’s it. Most traders are not concerned with the actual value or financial stability of an asset. Instead, they look to changes in an asset’s price and volume to determine when to buy and sell.

Another important difference between trading and investing is the general level of risk associated with each style. Not surprisingly, traders tend to take on more risk than investors since they are not concerned with the actual value of an asset. Ultimately, a trader is trying to speculate how a stock price will move based on historical movements and data. Also, as we have seen with the recent surge in GameStop and other “meme stocks”, traders are willing to speculate on risky assets that don’t seem to have any intrinsic value – often times, these traders will take-out “margin” (borrowed money from broker-dealers) to hold larger positions on these recommended stocks. This sort of behavior can create huge swings in prices, which can lead to dazzlingly high wins and catastrophic loses.

If you would like to utilize both investing and trading strategies, I would recommend creating a category for investing and another category for trading in your monthly budget. It’s also a good idea to use different brokerage accounts for each category (make sure that you compare fees before opening an account). Personally, I like to set aside no more than 3% of my income for speculative bets, i.e. trading.

To be clear, there is no such thing as a truly risk-free investment and in some cases a careful investor might have more risk in their portfolio than any trader – remember Enron? But if you decide that you want to actively trade your money, as opposed to investing, then you need to be aware of these differences. In particular, for trading you will need to pay close attention to the tax implications of selling multiple securities that you’ve owned for less than a year, as you may be subject to short-term capital gains tax – as opposed to the more favorable long-term capital gains tax rate.

Conclusion

Whatever method you decide to employ in order to grow your money whether it be trading or investing, the key is to start early and keep up to date with business news.

Stay tuned for the next article in March, where I will give you an overview of the various asset types you can invest in and I’ll also provide some important resources that will help you be a more informed investor.