Investing in the Stock Market Explained: A Guide For Beginners
Added: Mar 6, 2024
In this podcast episode, financial content creator and author Brian Feroldi discusses the psychology of investing and shares his personal journey of discovering and learning about investing. He emphasizes that fear and greed are the two fundamental drivers of investing behavior, and humans are naturally inclined to make poor investment decisions due to psychological biases.Key takeaways
Dollar-cost averaging into index funds is a recommended strategy for long-term investors to mitigate psychological biases and benefit from market returns.
Fear and greed are the primary drivers of investing behavior, leading to emotional decision-making and poor investment choices.
Take advantage of available employer-sponsored retirement plans such as 401K and match contributions to maximize retirement savings.
Diversify your investments globally through total world stock market indexes to reduce home country bias.
Stocks represent ownership in a corporation and their value is influenced by the company's profitability and investor psychology.
Discovery of Investing
Feroldi first discovered investing after graduating from college in 2004. Despite studying business in school, he was financially illiterate when it came to personal finance and investing. His interest in investing was sparked by reading the book "Rich Dad Poor Dad" by Robert Kiyosaki, which introduced him to the concepts of wealth creation and investing. He initially dabbled in real estate investing but found that stock market investing aligned better with his personality and investing style.
Understanding Stocks
Feroldi explains that stocks are recordkeeping tools for determining ownership in a corporation. When individuals buy stocks, they are essentially acquiring a portion of the company's profits and assets. The value of a stock is derived from the underlying business's profitability, and as profits fluctuate, so does the stock's value. Additionally, the psychology of investors plays a significant role in stock price movements, with fear and greed influencing market behavior.
Psychology of Investing
The psychology of investing is driven by fear and greed, leading individuals to make irrational decisions based on emotions rather than logic. Investors are prone to following the crowd, mimicking others' actions, and reacting strongly to short-term market fluctuations. Feroldi highlights the importance of removing emotions from investing by adopting a disciplined approach, such as dollar-cost averaging into index funds over a long period. This strategy helps mitigate the impact of psychological biases on investment decisions.
Historical Stock Market Returns
Feroldi references historical data showing that the S&P 500, a benchmark index of the US stock market, has delivered an average annualized return of around 10%. This return is primarily driven by the appreciation of stock prices and dividends paid by companies. While market returns can fluctuate in the short term, the long-term trend of the stock market has been upward. He emphasizes the importance of holding investments for extended periods to capture the market's potential returns.
Dollar-cost Averaging
Feroldi's investing philosophy revolves around recommending dollar-cost averaging into index funds for the majority of investors. Dollar-cost averaging involves investing a fixed amount of money at regular intervals, regardless of market conditions. Index funds, which track a market index like the S&P 500, offer diversification and low fees, making them a suitable option for long-term investors. By consistently investing in index funds over time, individuals can benefit from the stock market's wealth-building potential.
Dollar cost averaging is particularly effective in the 401k setting, where investments are made automatically without the need for constant decision-making. Feroldi emphasizes the importance of consistency in investing and highlights the potential for higher future returns when investing during market downturns. He also addresses the debate around lump sum investing versus dollar cost averaging, noting that while lump sum investing may be academically correct, it can be psychologically challenging for many investors.
Dominance of the US Stock Market
Feroldi discusses the dominance of the US stock market and explains that it is the largest and most influential market globally. He acknowledges the concept of home country bias, where investors tend to prefer investing in their home market, but also highlights the benefits of diversifying globally through total world stock market indexes. While he personally focuses on the US stock market due to familiarity and data availability, he recognizes the potential for similar results by investing in a total world stock market index.
Origins of the 401K
Feroldi delves into the history of the 401K, highlighting how a benefits attorney named Ted Benna discovered a tax loophole in 1978 that allowed individuals to invest in the stock market through retirement savings plans. This discovery led to the creation of the 401K, which has since become a popular way for Americans to save for retirement. He explains that the 401K now holds trillions of dollars in assets, all stemming from this accidental discovery.
Understanding the Roth IRA
Moving on to the Roth IRA, Feroldi explains that it was created by a senator named Roth as a twist on the traditional IRA. With a Roth IRA, individuals contribute post-tax money, allowing their investments to grow tax-free. Feroldi highlights the benefits of a Roth IRA for individuals in lower tax brackets who anticipate being in higher tax brackets in the future.
Investment Strategy
When asked about investment preferences, Feroldi emphasizes the importance of setting up a solid financial foundation before diving into investing. He recommends starting with an emergency fund, paying off debt, and taking advantage of employer-sponsored retirement plans with company matches. He suggests prioritizing contributions to retirement accounts like IRAs or Roth IRAs for greater control over fees and investment choices. He also mentions the option of investing in taxable brokerage accounts for additional flexibility.
When asked about which index to invest in, Feroldi references Warren Buffett's advice to invest in the S&P 500, which is a widely recognized and diversified index. He emphasizes the simplicity and effectiveness of investing in index funds for the majority of investors, as it provides broad market exposure and long-term growth potential. While he follows a hybrid approach with a mix of index funds and individual stocks in his personal portfolio, he acknowledges that active stock picking requires a significant amount of research and dedication.
Feroldi stresses the importance of being intentional and calculated when investing, considering factors such as risk tolerance and investment timeline. He advises investors to ask themselves when they need the money back before making any investment decisions, as this can help determine the appropriate investment strategy. By understanding their financial goals and time horizon, investors can make informed decisions about where to allocate their funds.
Cost Considerations
Feroldi stresses the significance of low-cost investing, particularly when it comes to index funds. He explains that minimizing expenses, such as expense ratios, can significantly impact long-term investment returns. He recommends looking for index funds with low expense ratios, typically below 0.1%, to maximize investment growth.
Market Timing and Faith in Investing
Addressing common concerns about market timing and economic downturns, Feroldi encourages listeners to focus on long-term investing strategies. He explains that historical market trends show consistent growth over time, despite periodic crashes and recessions. He highlights the resilience of the stock market, pointing out that it has always rebounded from downturns due to factors like business innovation, government support, and the natural cycle of market corrections.
