Investing Master Class

Lesson 4:

The Five Simple Rules for Investing

Investing Master Class

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Overview

We'll cover everything you need to know to be a smarter investor than the so-called experts. Follow the five simple rules outlined in this episode to lower your fees, build a smarter portfolio, and get time on your side. If you only watch one lesson in this series, make this the one!

Full transcript

Money. What is it? Where is it? How is it? Why is it? Gimme some.

This might be the most important episode in the course. You don't have to read a bunch of books to become a smart investor. But you do have to understand a few basic principles. Okay here we go, the five simple rules.

Rule 1: Start early

Start investing early, today, right now, even if its just $1. There will never be a better time. Here's why: compound interest. There's an urban legend that Einstein once called it the most powerful force in the universe, the eighth wonder in the world, mankind's greatest discovery. Did he really say that, who knows? Let me explain why compound interest is the single most important concept you'll ever learn.

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Remember those little snowballs you used to make as a kid or maybe you grew up in Hawaii and never saw snow until you were 47, so maybe it's like little balls of volcanic ash? But stick with me here. Imagine you start with a small snowball or ash ball and then roll it downhill. Inch by inch that small ball of snow would pick up more and more and more snow growing until it becomes a huge snowball. That's exactly how compound interest works, it builds on itself.

Or another way of saying it is that you get interest on the interest you get paid. Then you get paid some more interest on that interest, and pretty soon the interest you've earned is way bigger than the money you put in there in the first place. Just like your giant snow ash boulder, is way bigger than the little snowball you started out with.

This is a really important concept, so let's leave the snow behind and look at it another way. Imagine we have two brothers, one's 30 and one's 40 years old. They each start putting away $5,000 a year until the time they retire at 65. So at retirement age the 30 year old has invested $175,000 and the 40 year old $125,000, so $50,000 difference, it's a good amount, but it's nothing crazy. Now how much does that 50K difference turn into over time due to compound interest? Close to a half million dollars.

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That's a life changing amount of wealth to lose out on for only missing 10 years of investing, think about it. That's the kind of money you'd leave on the table if you don't start investing early. But if you're like the older brother who didn't start investing early don't panic, remember to just control what you can and start today.

Rule 2: Don't pick stocks

You remember that story we told you about the monkey who outperformed all those professional stock pickers? Well if you're wondering if anything's changed since 15 minutes or 46 years ago, it hasn't. Recently the same experiment was run, only this time they swapped out the monkey for a lovable cat named Orlando, and the newspaper was The Guardian. We had to throw in a cat thing here, this is the internet after all.

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So again, an animal, not a human being, randomly picking stocks, and over the course of a year, Orlando's stocks had a better return than ones picked by top stock pickers at top investment firms. The moral is, don't bet your retirement on picking stocks. Don't pay an expert to pick stocks for you, instead invest across the stock market as a whole.

So how do you invest in the entire stock market? Buy one of every single stock? Luckily there's a much easier, cheaper, and more effective way. Index funds — also knows as ETFs. And these are exchange traded funds that track the entire stock market for you at extremely low prices, which brings us to our next rule.

Rule 3: Keep costs low

Wake up! Usually in life, the more you pay for something, your house, your car, your clothes, your vacation, the better it is. The opposite is true when it comes to investing. Paying a financial advisor 2% a year in fees may not seem like much now, but over the course of a lifetime it could add up to hundreds of thousands of dollars. It's kind of like the compound interest we talked about before, but here it works against you. Meaning all those fees can really snowball out of control.

Let's look at two people who invest $1,000 a month for 30 years. The first pays 1.5% in fees, the next pays just 0.5%. A 1% difference might not sound like a lot, but it could translate to costing you around $300,000.

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Rule 4: Diversify

Investing in stocks and bonds comes with risk, which is partly why it can be really lucrative. You probably heard that it's good to have a diversified portfolio. It's really just another way of saying don't put all your eggs in one basket. What would've happened if you invested 100% of your money in Blockbuster? RIP. Smart investors find ways to manage the risk.

One important tool they use is diversification. If you spread your investments or eggs across lots of different industries, green energy, pharmaceuticals, industrial, tech, in lots of different countries, you can protect yourself against the ups and downs of any one part of your portfolio.

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Here's a good way to think of it. This chart shows six different common indexes, US stocks, emerging markets, Canadian stocks, bonds, real estate, and international stocks, and how they performed each year. Foreign stocks might not perform as well as emerging market stocks one year, or they might outperform them the next year. But when you invest in a wide range of indexes, or diversify your portfolio, you help protect yourself against the year to year rises and falls. Remember, a smart investor focuses on what they can control. Here that means to diversify and stick to their long term plan.

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Rule 5: Tune out the noise

That brings us to the final rule. Emotion is the enemy of smart investing. And when the market is up and down, it's easy to get emotional. The market is up, I made $72, the market is down, where's my damn $72? The world is ending, sell everything, hide the clam dip, why am I eating clam dip, I'm gonna get sick!

But history has shown that trying to time the market usually leads to worse returns. Don't listen to the entertainers on CNBC who yell "buy" or "sell"! Have the conviction to stick to your plan in both the best and worst of times. Investors who chase performance or run away from losses are doomed. The thing that differentiates good investors from bad investors is simply the discipline to drown out the noise and stick it out for the long run.

Now you might be saying the 2008 recession is hardly noise. You're right, it had a huge impact on a lot of people's life savings, and it affected the economy for years. But the people who panicked when the market hit bottom in 2008 and pulled out their retirement accounts to cut their losses missed out on the next 10 years, which has produced some of the greatest returns in the history of the stock market.

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Point is, you can never know when a recession might hit, but smart investors stick to their plans and think long term no matter what. And after learning these five simple rules that's what you are: a smart investor.