My previous post covered the subject of the Time Value of Money, and the significance of compound interest. But now we’ll take those concepts and apply them to real world systems and develop some strategies on how safely navigate the world of securities investing.
The Stock Market:
Wall Street this, DOW Jones that; S&P this, Dividends that, what does all this even mean? The stock market is all over the news and everyone talks about wishing they “Bought Amazon at $100.” But have you been too afraid to ask what it is that everyone is actually talking about? If you already understand this part, then scroll past this section, but I want to at least provide a simple overview before moving forward.
While there are many many factors that go into a stock price, we’ll focus on what it actually is. Let’s use Amazon as an example. When Amazon first started as an online bookstore, Jeff Bezos would have to use his own money to run the company. But when it continues to grow and he had to buy more books, he has two options when he runs out of money and needs $1 Million dollars: he can go to the bank and get a loan that he will have to pay back, or he can find 10 investors who will pay him $100,000 each to have a 2.5% portion of the ownership of Amazon. Bezos now has a $1 Million in cash to use to grow the business, but now he has to share the profits with 10 other owners. He get’s to keep 75% and they share the other 25%.
Later on, Amazon gains in popularity as more people start using the internet and Amazon starts selling many things instead of just books, so he needs to hire much more staff and have much more inventory. He can’t just get another set of multimillionaires who will give him $100,000 because now he needs hundreds of millions of dollars now to work with. So that is when he files paperwork with the SEC (Securities & Exchange Commission) to get placed on the NYSE (New York Stock Exchange) or the NASDAQ to publicly list his company as available to the general public for partial ownership.
Let’s say when Jeff Bezos brought in that first group of private investors, the ownership of Amazon was broken up into 40 pieces of ownership: Jeff Bezos had 30 and each of the external investors had 1 each. Well now that Amazon is going to the public for more owners, they took that 40 pieces and broke up each portion into 1 million pieces and then sold them at $10 a piece? Well if people went and bought every single one of these pieces, then Bezos would have received $300 Million dollars and the other initial investors would have received $10 Million each. But usually the initial owners don’t sell all of their ownership like that.
If you were to buy one of those pieces of Amazon at $10, you would own 1/40,000,000 of the entire company of Amazon, and that is what a stock share represents; you are buying partial ownership of a company.
But what about the price? Why does it go up and down? Well since these shares are now open for the public to buy, and after all the shares are initially all bought up, it creates a secondary market where you are buying the share from someone else, who they had bought it from someone else previously. But in order to find the people who own these shares of Amazon and are willing to sell them, we need a centralized network for all of us to meet at, and that is what the stock market is. The stock market is just this digital meeting place where everyone who is willing to buy or sell shares of companies go to make a deal. So in theory, you could find someone on the street and ask them if they want your 1 share of Amazon and ask for $50 for it, but how does anyone know if that’s a good deal or not? That is another benefit to the stock market is it’s calculating all the buying and selling requests people are making and is presenting the average number that is satisfying all those requests.
Stock Market Summary:
That in a nutshell is how the stock market works. When you “Buy Amazon” what you are literally doing is buying a tiny sliver of ownership in Amazon, which means you get a portion of the profits, which are called Dividends (Apple has been giving about 1.5% of it’s stock price back to investors through dividends per year). Stock ownership also means you technically have company voting rights, so you could show up at the owners meeting and cast a vote for the next board of directors or something if you really wanted to.
How all this ties into the power of compounding growth is even though stock shares don’t have interest rates on them, over time they typically tend to increase exponentially over time.
Crazy fact: the S&P 500 (the largest 500 companies in the U.S.) has averaged 9.8% growth per year over the past 90 years; that includes the crash of 2008.
While each company is different and grows at its own pace, on average, stocks go up almost 10% per year. That is why being in the stock market is one of the easiest methods of obtaining exponential growth on an investment.
Now that we know how in general the stock market works, how do we use it?
In its most simplistic form, using stocks for investing is as simple as buying shares of companies for a period of time, and selling them off to other buyers when they are worth more. But how do you choose which stocks to buy? There are so many ways to look at a company to determine if it is worth buying, but one of the most common ways is called “growth investing” where you actually observe the financial metrics of the company and compare it to industry average. When a company shows increase in revenues, profitability (usually depicted in the form called as “earnings per share” or EPS), debt reduction, and many other stats, it is typically assumed that the value of the company is set to increase, and thus the demand for shares of this company will increase. This means if you buy it now, there is a good chance in the near future somebody else is going to be willing to pay even more for your share and you make a personal profit.
The need to diversify:
But what if you’re wrong, like really wrong, like what if you put all your money in a company that has really promising financial growth metrics and then it comes out that the company was lying about its financials and fraudulently reporting revenue on sales that did not happen? What happens when the company files for bankruptcy and the share price you bought of this company at $90 goes to zero? You’d lose it all! This isn’t even that much of a hypothetical scenario because this very thing happened in 2001, with the infamous Enron scandal. To make things worse, Enron executives pushed hard on employees to invest most of their retirement accounts into Enron stock because “put your money where your mouth is and do a good job for the company and you profit too!” Over 20,000 people lost their jobs, and most of their retirement because they lost it all with Enron’s collapse.
That is an extreme example for why it is imperative to diversify your investing. If you had shares of 50 different companies and one of them happened to be Enron, sure you’d lose some money, but it would only be a small loss and your other investments would then compensate for it.
But it’s not just about the number of stocks you have, but it’s also the kind of stocks you have. If you have shares in 50 different oil drilling companies and Elon Musk starts selling 50 million electric cars for $5,000, and everyone gets rid of the gas powered cars, then all 50 companies are going to go down. So you need to pick some big companies, some small companies, some international companies, some tech companies, some health care companies, etc.
How to diversify:
One rule I have loosely followed came from the financial guru, Dave Ramsey, is to break your investing equally into 4 categories: Large companies (Apple worth $900 Billion), Medium size companies (Dr. Pepper worth $17 Billion), Small size companies (Trivago worth $229 Million), and International companies (Credit Suisse worth $48 Billion).
One thing that should be added to that mix is investing in bonds as well. Bonds are debt securities that either the U.S. Government issues out or even companies issue out and pay back at pre-determined interest rates. These bonds can be lumped together as an asset class and you can own a piece of a bond to provide more stability.
There is another benefit to bonds in that if the overall stock market starts to crash, as it will do on occasion, people start to lose trust in the current future prospects of companies and look for something more stable, like bonds, and thus, your bond holding because more valuable to other buyers.
So by having multiple types of stock holdings and bond holdings allows you to stay balanced regardless of what season the economy is in.
Mutual Funds & ETFs
I can see your anxiety: sure this all kind of make sense, but how are you going to pick all these companies and diversify properly and keep track of all these things? Doesn’t it still seem too daunting of a task even if its starting to make sense in theory? Well don’t worry, the next few sections will show how you can overcome most of these hurdles and really simplify the process. But it is important to understand what is going on with all these investments before you jump into these next sections so you at least have the contextual framework to make an informed decision.
So you want to have a diversified portfolio, but not only is it intimidating to pick these companies, but also you don’t have $20,000 to go buy shares of 50 different companies, so what can you do? The solution can be found in Mutual Funds and ETFs.
What a mutual fund is, is simply an account that in it holds shares of hundreds of other companies. For instance, there’s a Mutual Fund account called the T. Rowe Price Blue Chip Growth Fund (TRBCX), and in it are over 100 of the biggest U.S. companies, including Amazon, Apple, Google, Boeing, etc. So when you buy a share of this Mutual Fund, you’re actually getting part of each of these companies, all together! There are hundreds of these Mutual Funds, with each having their own unique focus. So the one I showed focuses on “blue chip” companies, which just means the biggest of the biggest companies. But you can get Mutual Funds that hold up a bunch of small sized companies as well. So if you wanted to follow the Dave Ramsey method of diversification, you could literally do that by just buying shares of 4 different Mutual Funds that focus on each of those four classes of stocks, and your portfolio could then be holding 1,000 different companies and you may have invested only a few hundred dollars into it.
But this method does come at a cost. You see, Mutual Funds don’t just exist on their own, they are their own entity as well, and it is somebody’s job to decide what companies should the Mutual Fund have and how much should the Mutual Fund have. That is the fund manager, and they don’t do this for free. So expect to be incurring 1% in fees per year (they don’t bill you, but rather take it out of the valuation of the mutual fund, so it’ll lose 1% of it’s growth value per year).
Another downside to Mutual Funds is that there is a minimum amount to enter the fund, which is usually around $2,500 ($1,000 for retirement accounts), but then after you can buy more shares at $100 increments. There are sometimes even what are called “load fees” that charge you to enter the fund as well.
So Mutual Funds can be a bit costly to get in and you may need to save up in order to get into one.
Don’t panic! You don’t need to save up thousands of dollars to start! Just stay with me here, now we’re starting to get to the exciting parts of investing, and we’ll start with the Exchange Traded Fund, or “ETF.”
ETFs are very similar to Mutual Funds, in that they hold shares of hundreds of different companies, that allow you to diversify your investing, but there’s a twist: there is no active fund manager. Huh? Well let me explain. What an ETF is, is an account that just simply follows a particular index and invests whatever is in that index. An index is just a sub-category of the overall market. So like when we say “The DOW is up 20 points today” what we’re actually referring to is the Dow Jones Industrial Average, which is an index of 30 of the largest companies in the U.S. that come from multiple benchmark sectors of the economy. These 30 companies become a shorthand representative of how the overall U.S. stock market is doing. A more accurate representative of the condition of the U.S. stock market is the S&P 500, which is the largest 500 companies in America.
So you can find an ETF that just follows the DOW or the S&P 500, and you’re all set! One of the most famous ETFs is called the “SPY” and it follows the S&P 500, so when you buy shares of the SPY, you’re getting partial shares of all 500 of those huge companies.
Which there are many different indexes, and there are many different indexes that are designed to weigh their allocation within an index. What this means is that there could be two different ETFs that both follow the S&P 500, but one is designed to have more shares of Tech companies, while the other has more shares of Pharmaceutical companies. You still get shares in the 500 companies, but are weighed differently
Since there isn’t an active manager of the fund, there are essentially no fees (there are some trading expense fees, but it’s like, 0.05% to 0.25% usually). Plus there’s no minimum amount to get into one, and typically a share price is around $50 (the SPY is currently over $270 per share though).
If you wanted to use ETFs to diversify your investing and you wanted to invest in the four different sectors (large, mid, small, & International), you could literally do that by buying these four ETFS: QQQ ($164), XMLV ($45), FNDA, ($39), & EWL ($36). For a total of $284 and you would have partial shares in 1,126 companies! Oh and what about bonds? Ya you can get ETFs that hold bonds as well. The BND is an ETF that follows the whole U.S. Bond market and holds over 17,000 bonds, and the price for one share of this is about $81.
The one notable drawback to an ETF is it is treated as a normal stock, and it’s price fluctuates throughout the day and is subject to market fluctuations since it’s in the open market. This contrasts to the Mutual Fund in that the Mutual Fund’s price is simply the average price of all shares of companies that it holds and priced at the end of the trading day.
Well that was a lot! I hope you’re still hanging in there, if it all still feels pretty crazy and confusing, don’t worry, you don’t have to be a master stock picker to benefit from the stock market; you just need to be prudent and patient.
To summarize all this, we know that having a good growth rate and plenty of time can produce significant results, and on average the stock market grows about 10% per year even when accounting for bad years, but it is important to not “have all your eggs in one basket” so proper diversification into multiple sectors allows you to even out & minimize your risk exposure. Diversifying between large, mid, small and international sectors allow you to balance growth potential without being overly exposed to a whole industry’s downturn, meanwhile bonds can be used to reduce exposure to whole market crashes. The method of how to diversify has been made simple with ETFs and Mutual Funds that give the ability to own a little bit of many companies that otherwise would have cost thousands of dollars to emulate.
So if you want my personal opinion on all this, just use ETFs as means to diversify your portfolio and don’t over complicate it. Just have a few different ones in your portfolio within each of the 4 major sizes of companies plus bonds, but you only need to have like 10% of it being in bonds if you’re a millennial. You want to cut down as much fees as possible since they eat into your growth percentages.
In my next post, we’ll be looking at how do you actually buy these stock shares, and what you can do to reduce your tax implications through retirement accounts. We also will be looking and how technology has changed investing so that most of these strategies I’ve talked about here can now be automated and has made prudent investing significantly easier to achieve.