If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To understand the basics of stocks, bonds, mutual funds and exchange traded funds.
Prerequisites: SA302: Investing Basics: Time Value of Money
Handout: Investment Vehicle Summaries
Assignment: (see end of post for homework assignment)
Anyone worth listening to in the investing world will encourage you to only invest in things that you understand. There are incredibly complex investments out there—complicated real estate deals, hedge funds, futures, limited partnerships and the list goes on (and on and on…).
Stocks and bonds are not necessarily complex investments, but many people don’t understand them and therefore are nervous to take advantage of them to grow their hard-earned wealth. This partially explains the reason that less than 50% of Americans have stock investments.
In addition to learning about basic stocks and bonds, we will also be discussing common mutual funds and exchange-traded funds (ETF’s).
By educating yourself about these investments you will feel more comfortable with investing in them. Then you will be able to take advantage of the average 7% long-term returns as opposed to the 1% (or much less) returns in savings accounts or the 0% return by sticking that money under the bed. Especially since the last two won’t even keep up with inflation!
By going through the common “what” questions related to the various investment vehicles, we will gain a better understanding of the nature of these investments. If this type of discussion makes your eyes glaze over, skip to the “FINAL THOUGHTS” section at the bottom and get my simple investment suggestions for those not interested in spending a lot of time learning about investing.
WHAT are stocks?
Shares of stock actually represent actual partial ownership in a company. Corporations publicly issue shares of ownership in order to raise the capital needed to expand the business. Most likely if you own shares in a publicly traded company you own a very, very tiny fraction of ownership. This is true especially if you own the stock shares as part of a mutual fund (covered below).
Stocks are traded on exchanges such as the NASDAQ or the New York Stock Exchange. Brokers purchase (and sell) stocks through the exchanges and you purchase the stock through the broker.
WHAT does stock ownership entitle you to?
Stock owners, as equity owners of the corporation, are entitled to a prorated portion of the assets and income of the company. If the company were to liquidate, stock owners would be entitled to a portion of the assets although lenders would come first in their claims to the assets.
The company will choose whether to retain the earnings and reinvest them or to pay a portion of them out as dividends to their shareholders. Dividends can be received in cash or reinvested to buy more shares of the stock. In addition, dividends are taxed at special rates that are lower than ordinary income rates (such as those you pay based on your salary).
In addition to receiving dividends, the stock that you own may increase in value. For example, if you bought shares in Facebook at the beginning of 2016, you would have paid around $102 for each share. Today your shares would be worth $119 each. Unfortunately, there’s also a possibility when buying stock that you could lose your entire investment if the company goes bankrupt or lose a big portion of your investment if the company starts doing poorly. This is where the risk comes in!
WHAT are the types of stock?
There are two basic types of stock: common stock and preferred stock.
Common stock is the majority of what most people own and has typical voting rights and claims on ownership of the company’s assets and earnings.
Preferred stock is still ownership in the company, but does not have the same voting rights. Often a feature of preferred stock is a guaranteed dividend that is paid out before common shareholders are paid.
There are different classes of stock as well (even within these two types), but they are beyond the scope of this class and also really not needed for the beginning investor.
WHAT makes a stock go up or down in price?
Stocks are volatile to the actual versus expected performance of the company, industry outlook, investor attitudes and the economy as a whole. Ultimately, these factors affect the supply and demand of the stock, which causes the prices to fluctuate. Basically, a huge desire for many people to buy a specific stock will drive its price up because of the competition. If fewer people are interested in buying it, it will sell for a lower price.
While this sounds overly simplistic, the reality is that there are many other financial calculations and ratios that are constantly being run that generally balance the price of publicly traded stocks from being overvalued or undervalued based on the knowledge about them at any point in time.
WHAT are bonds?
Bonds, in contrast, do not constitute ownership but are actually a debt to the company. Technically, you are the lender and they are the borrower. Bonds can be issued not only by corporations but also by governments as well. Corporations use bond money to expand their business and governments use them to provide expanded services or infrastructure.
People invest in bonds in order to get a return in the form of interest and sometimes a gain from selling or redeeming the bond at a price greater than what they paid for it. If you hold onto a bond until it’s maturity date, you’ll receive back the full amount that they initially borrowed, similar to a loan. The main difference between a bond and a typical loan is that none of the principal is received from the bond until the end (the maturity date).
WHAT are the basic bond terms I need to know?
There are a few important terms you need to know when we talk about bonds:
- Issuer – the company or government that is issuing the bond(s)
- Face value – the amount borrowed that the issuer has to repay at the end of the bond term
- Coupon rate – the interest rate the bond issuer is paying on the bond(s)
- Maturity date – the date on which the bond issuer has to repay the face value of the bond(s)
WHAT are the advantages of investing in bonds?
There are many advantages to investing in bonds, including the fact that they provide a steady income stream, are less volatile than stocks and in the case of a company liquidating provide less risk in that you are more likely to get some of your investment back (as opposed to stock owners who are the last to get their claim on assets). There are also many bonds suitable for different time frames, such as for short, intermediate or long-term investing.
WHAT should I look for when considering investing in bonds?
All bonds are not equal in risk and quality. A number of companies, such as Moody’s, rate bonds based on risk and quality factors. These ratings go from AAA (best) to D (worst). Just like stocks, taking on more risk in the bond market can result in higher earnings, however, you may lose all your money if the company goes bankrupt.
In addition to the bond rating, different bonds have different tax treatment on the income earned:
- Corporate bond interest is fully taxable at a federal and state level at the same rates as ordinary income (such as salaries and wages).
- U.S. Treasury bonds are subject to federal income tax, but not subject to state income tax.
- Local municipal bonds are exempt from federal and state taxes (if you live in the state that issued the bond).
WHAT are mutual funds?
Mutual funds, simply put, are professionally managed pools of funds invested in a variety of securities. Mutual funds can have a variety of stocks only, stocks and bonds together, only bonds, etc. The purpose of purchasing a mutual fund as opposed to individual stocks and bonds is to easily diversify your investments and therefore reduce your risk.
WHAT are the types of mutual funds?
You are likely to find a mutual fund that meets your investment goals, as there are numerous different types. Let’s discuss just a few that are the most common:
- Money Market Funds – These funds are for short-term investments and generally invest in Treasury bills and certificates of deposit. They are low-risk but focus on liquidity over return.
- Index Funds – An index fund tracks a stock market index such as the S&P 500. The goal of this mutual fund is to simply match the return of the market, not to beat the market. The return will likely be slightly lower than the market due to management fees. Since the market overall has returned about 7% after inflation, you are likely to make a decent return in the long-term with an index fund.
- Bond Funds – A bond fund is a portfolio of different bonds, generally of the same type. There are bond funds that invest in municipal vs. corporate bonds, short, medium or long-term, and by investment grade quality.
- Balanced Funds – Balanced funds are those that include both stocks and bonds. An example of a balanced fund are the popular target-date funds found in retirement and college saving plans.
Some other types of mutual funds include international stock funds, sector funds, and real estate funds.
WHAT are the advantages of investing in mutual funds?
By investing in mutual funds, you can diversify your portfolio and have the opportunity to purchase a smaller segment of different industries and companies across the market. Professional management is another key advantage. Since most of us don’t have the knowledge (or money) to go out and pick individual stocks and bonds and create our own balanced portfolio, this is a huge advantage.
WHAT should I look for when considering investing in mutual funds?
The greatest indicator of the returns you will receive on mutual funds has been shown to be the fees that you are paying. When you are looking at investing in a mutual fund, be sure to know every single fee you will be paying to purchase the fund as well as the ongoing annual investment fees, referred to as the expense ratio. Popular discount brokers such as Vanguard and Fidelity focus on lowering the ongoing fees you pay. The average expense ratio for a mutual fund is over 1%, but many funds from discount brokers can be found for closer to .10%-.25%.
In addition to the fees, of course, the mutual fund should align with your goals, risk and the time period that you plan to invest. For example, if your goal is to save for retirement in 30 years, a balanced fund with a ratio of 70% stocks and 30% bonds would be appropriate but if your retirement is in 5 years, that fund would not be appropriate for your goals, risk and time frame. We’ll be discussing portfolio allocation in the next class.
EXCHANGE TRADED FUNDS
WHAT are exchange traded funds or ETF’s?
Exchange-traded funds are similar to mutual funds, but they are actually traded in an organized stock exchange (such as the NYSE). They incur the same trading fees as stocks upon purchase and sale but have some of the same additional benefits of stocks that mutual funds don’t offer.
WHAT are the advantages of an ETF?
Exchange traded funds have lower ongoing expense fees when compared to mutual funds since they don’t need as much active management. In addition, they do not trigger as many taxable events (such as capital gains) so that your money may have a better opportunity to grow over a long period of time. ETF’s also have the other advantages of mutual funds including diversification and professional management.
WHAT should I look for when investing in an ETF?
The same considerations for investing in a mutual fund apply to investing in an ETF. Specifically, these include looking at your goals, risk and time period you wish to invest. The other main factor you will want to look at are the expense ratios.
Now that you know a little bit about these different types of investments, you are probably still wondering how you would even go about purchasing any of these investments and where to begin!
Fortunately, it’s really very easy to start investing. The first place you should start is by looking at any accounts you already have set up, such as retirement accounts. Analyze what you currently have in existing accounts, specifically the:
- risk those investments currently hold
- their current rates of return (their performance), and
- expense fees you are currently paying
After seeing what you already have, set up an account at a brokerage firm. Examples of brokerage companies include Charles Schwab, Etrade, Fidelity, TD Ameritrade and Vanguard, just to name a few that you’ve likely heard of. I recommend Vanguard, as they are a discount brokerage with much, much lower fees.
There are also many apps that can help you get started in investing simply and robo-advisors. Robo-advisors are an alternative to an actively managed portfolio by a professional that instead use computerized, automated services to choose and monitor your investments for you based on your goals and time frame.
Once you’ve set up the account, you simply deposit funds and request the purchase all online. It is very important to consider the trading fees that you will pay each time you purchase stock, as they can cut into your investment returns in a very significant way. Just read through the information about the investments and it will tell you exactly how much you’ll pay for an initial fee, the expense ratio and the fee if you were to sell the investment. Definitely consider starting with a basic index fund that tracks the S&P 500 if you are investing in a taxable account. For those getting started with a retirement account (such as a 401k or IRA), consider a target-date retirement fund for the year you plan to retire.
I must say here, though, that I don’t recommend investing in individual stocks or individual bonds at all, as I feel it just doesn’t balance the risk and return unless you already have significant other diversified investments and this represents a small portion of your investments. However, it is still important to understand the basics of individual stocks, since they are the ultimate make up of the mutual funds and ETF’s.
Brokerage firms will track your purchases and reinvested dividends and capital gains for you and issue you a 1099 statement at the end of the year to use for your tax returns. You’ll just give that document to your tax advisor, or put the information into your own tax software and pay the additional tax owed on your returns. Don’t be intimated by this part either-taxes on basic investments are not that complicated!
In the next class, we’ll cover the concepts of risk and asset allocation as a way to help you get started with your investments.
It’s as easy as 1-2-3 (plus a few extra numbers for the setup!), but it’s not rocket science. The best way to get started is to just simply START and keep learning as you go!
EXAMPLE: THE SMITH FAMILY
The Smith family’s long-term goals, especially their retirement and college funding goals, require them to invest in funds that will earn a higher rate than simple savings accounts and short-term bonds. They have a small amount in retirement amounts currently and plan to invest more in the future. Taking a look at their current 401(k) account shows that they are invested in a simple Target Retirement Fund, which is appropriate for their situation. They do not have the desire or time to spend to analyzing individual stocks and bonds and are satisfied with the current performance of the fund and the associated fees for now.
Your homework assignment is to analyze your personal knowledge of investing and the things that may be holding you back from investing.
- IMPROVING – Write down your fears about investing on a blank sheet of paper. Research some of your additional questions about investing or read a basic investing book. Review your financial goals and commit to educating yourself about investing so that you can achieve your long-term goals.
- INVESTED – Same as above.
- UNSTOPPABLE – Same as above.
File your notes about your investing fears and goals in your Financial Plan binder under the tab “Financial Goals”.
HANDOUT: Investment Vehicle Summaries
I compiled the basics of the investment vehicles in this short handout summary for you. To download click on the preview below!