The great military philosopher Sun Tzu advised generals to “Attack by Stratagem”. He warned, “The general, unable to control his irritation, will launch his men to the assault like swarming ants, with the result that one-third of his men are slain, while the town still remains untaken”. He goes on to identify five essentials for victory, the first and foremost, “He will win who knows when to fight and when not to fight.”
Novice investors would do well to head the warnings of Sun Tzu. For investors new to the market it is not an easy task to watch the market march to seemingly new heights on a daily basis, without feeling the urge to attack, or buy. For new investors patience is typically gained in the unpleasant lessons learned of investment losses. For some these losses are valuable insight to our own short comings as novice investors, and often as people. For others these losses may be so terrible as to drive them from the market for good.
Quite often neophyte investors rush into the market without a strategy, just as Sun Tzu warned against. They buy the book dejour on investing, devour the book,and certify themselves as ready to invest. Rubbing their palms in anticipation of riches, they jump headfirst into the market and purchase stocks, mutual funds, or exchange traded funds. I know I am probably exaggerating just a wee bit. However that strategy or lack there of is tantamount to handing money out on the street corner.
The most basic strategy that I believe all investors must understand is that of minimizing risk. A good starting point is understanding how to minimize risk among asset classes. This is where the risk pyramid is most helpful. It’s similar to the pyramid of life taught in most Psych 101 courses. Imagine a pyramid, the bottom one-third of the pyramid is where the bulk of what ever activity that is going on is shown, in the example of life it would be: from birth to say age 35, here we spend most of our time just having fun (well that’s the way it’s supposed to be); the middle one-third would be from 35-55, here arrive at that interesting stage known as mid-life and have the pleasure of facing some type of crisis; the top one-third, 55 – really old, this is where we get really, really old (thats the cynic in me, no this is where we hopefully have saved enough through investing to travel, enjoy grandchildren (read spoil), participate in hobbies or things we take pleasure in, this is where we enjoy the fruits of our labor.
I digress, the risk pyramid chronicles risk in asset types: the lowest risk in the bottom one-third, US Treasury Bills, US Treasury Bonds, CD’s, Money Market Funds; the middle one-third contains Federal Agency Bonds, Conservative Bonds, Municipal Bonds, Balanced Mutual Funds, Index Funds, and Blue Chip Stocks; the top one-third contains International Bonds, Rental Income Properties, Growth Stocks, Foreign Stocks, Collectables, Junk Bonds, and New Ventures. Investment risk increases as you go up the pyramid!
It is important that you understand the differences in the levels of risk associated with the assets in each level of the pyramid. I would encourage new investors to invest in only those investment vehicles in the bottom, and middle thirds of the pyramid, at least until they have invested on their own for a minimum of one year. With the majority, say 70% of your money being invested in the bottom one-third of the pyramid for that first year. Others will argue 50% split between the two classes of the bottom and middle thirds, and still others will say Im crazy. Actually, I would prefer 2 years of investing in these bottom two-thirds! Some people may never invest in that top one-third. That must make me a stark raving lunatic.
I know, I know, if your young shouldn’t you take some risk? Don’t “they” say, it is best to utilize risk in your investment portfolio when your young so if you experience loses you still have time and opportunity to make those losses up later. Plus, what if you didn’t utilize risk and missed out on some great opportunities that over time could have made a lot of money. See, they say, it’s risky for me not to invest in investments with a higher level of risk, I’ll lose money.
That my friends is risk, did you catch it? It’s right there in black and white just above these letters. Let me ask you, would you go out and purchase diamonds as an investment with no knowledge of their true worth? Diamonds are not cheap,and high quality diamonds are very expensive. But how does one know the difference between a really good diamond and a second rate diamond? Without the benefit of someone who is very experienced in grading diamonds, you might buy what you think is a really nice looking diamond, a big one too. So what if it costs a lot, in a few years it with be worth a lot more, won’t it? What happens if that big beautiful diamond turns out to have a flaw that you were not aware of? You get the picture. Your investment in diamonds may have actually lost you money because hey, your not a diamond expert are you?
The same can be said for investing in these assets at the top of the pyramid, and yes even those in the middle. That is why I prefer the invest and learn approach. Investing 70% of your hard earned money in those asset classes at the bottom of the pyramid for at least your first year or two in the market will allow you to build a strong base of capital. It will also give you opportunity to learn more about other assets that carry a higher level of risk. With this approach your still able to invest in equities that carry some risk, those in the middle third of the risk pyramid, and protect against losing capital based upon an incomplete understanding of those riskier asset types. You can dip your toe into the top one-third once you’ve become a seasoned investor. Remember Sun Tzu’s warning!
Two caveats, nearly all financial advisors, books on investments , and web sites related to investing and saving, recommend that you have three to six months’ living expenses in a savings account that you can easily access, as an emergency fund. Your emergency fund should be established prior to investing any other monies. Additionally, if you have a employer sponsored 401K retirement plan it is typically encouraged that at a minimum you invest the funds necessary to receive the “matching funds” from you employer. If you administer your own retirement equities or if you utilize a 401K you should never, not ever use these funds for speculative investing, such as investing in the asset classes at the top of the risk pyramid!
Finally, I would recommend new investors educate themselves regarding all classes of investment vehicles in the risk pyramid, how markets function, market psychology, and how the Federal Reserve’s management of interest rates affect markets and investors. There are several resources available to enhance your comprehension of these basic investing mechanisms. One particular resource for neophyte investors that I am impressed with is Kiplinger’s Guide to Investing Success (now in it’s sixth edition). It is written in a style that is easy to understand, it covers a wide spectrum of investing fundamentals that all investors should be aware of, it covers all classes of investments in the risk pyramid, and it evenly explains both “Growth”, and “Value” approaches to investing.
Additional resources I would recommend include: Investopedia.com, Morningstar.com (specifically for mutual funds), Benjamin Graham’s The Intelligent Investor Revised Edition (not only because it is the value investing Rosetta Stone, but for Jason Zweig’s commentary on each chapter which is specifically insightful on market psychology, ok… and yes also because it’s the Rosetta Stone of value investing), and finally Sun Tzu’s The Art of War, because investing is like going to war, planning, strategy, safety, and risk are tenants of war, and so to investing.
I leave you with this little gem from Sun Tzu’s The Art of War: “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy or yourself, you will succumb in every battle.