Welcome to Week 2 of our investment series! This week is all about understanding the different types of investment choices we have when picking how we will invest our money.
Getting started with investing is a big step, and breaking down the key distinguishing features of the terms you will likely see when you get started is critical in the evaluation process.
This blog is going to do just that, let’s get started!
One of the most fundamental, and sometimes confusing aspects of investing, are the asset classes we have to choose from.
We hear about stocks, bonds, mutual funds, Exchange-Traded Funds (ETFs), options, Certificates of Deposit (CDs), commodities (gold, silver, etc.), and countless other investment choices are thrown about with no real description as to what they are.
Here are some other common statements I hear from those around me:
- “I am invested in tech” or “Do you think buying gold is a good idea?”
- “My stocks have been doing really well. What do you think about bonds? I’ve heard a lot about that recently.”
- “Stocks are too risky for me. I want something safe.”
These are not necessarily bad or incorrect statements, but we need to dig a bit deeper and debunk some of the assumptions made in these statements.
Not all stocks are equally risky, nor are all bonds equally safe. The real question that needs to be answered is, what do the investments need to accomplish for you?
We will talk more about risk next week, and this week’s material is designed to explain exactly what these assets really are, at their core.
Understanding why and what we need from our investments is important in choosing what vehicle we will put our hard-earned money into. If you missed it last week, you can check out my blog post about Why do we invest? here.
Let’s start with the one we hear about the most, stocks.
The stock market has been far and away the most covered portion of the investment world. With the amount of information, change, and material to cover, it is an easy topic to talk about on a daily basis.
What is a stock?:
Simply put, a stock is an ownership stake of a particular business or company. Stocks are sold as “shares”, and the owners of the stock are called shareholders.
Stocks are purchased with the hope that the company will continue to grow and/or be more profitable in the future. As any company owner would hope, we want the company to do better in the long run, and have it generate more money for us.
The money used to purchase a stock becomes available to the company itself as capital funding to grow the company and expand its operations.
A company usually releases an initial amount of stock through an Initial Public Offering (IPO) based on how much of the company they want to sell through the public markets.
Since there are limited shares of a company, they must be traded between buyers through a market, in this case, the stock market. This also explains why prices go up and down based on the demand of the stock.
The only way someone can buy a stock is if someone else is willing to sell it. Same for selling, you can only sell if someone else wants to purchase your portion of the company.
While the analysis of stocks is incredibly complicated, the price direction of a stock really boils down to one simple question.
“Does the majority of the market (or are there more buying than selling) think this company will do better or worse in the future?”
Because of this, a stock can theoretically have an infinitely high price or go to zero. Those are the two options.
Of course, we don’t know to what degree or how fast stock prices will go towards those limits, but this adds to the excitement and dramatic nature of owning a stock.
At times, economic conditions can sway the participants of the market (you, me, Wall Street, etc.) to drive that question in an overwhelming yes or no manner. The media feasts on this opportunity to tell a dramatic rise and fall narrative.
Look at this chart of the S&P 500 (the 500 biggest companies in America) over the past 5 years.
We all know how we felt about the future of many companies in March 2020. It wasn’t good.
Now of course it gets much more granular when looking at a specific company or a specific industry, but the concept remains the same.
Let’s look at this theoretical situation.
Assume both Company A and Company B are trading at the same price. If we believe Company A is going to perform better than Company B, we would rather purchase the company we think is going to perform better.
Think is the keyword in the statement. We have no idea as to what may unfold in the world, the United States, or within the company itself. This fact is why nobody holds the Magic 8 Ball and can accurately predict which stock will always be the best.
There are ways to reduce the risk of a single company when investing, and we will come back to that a little later on when we talk about Mutual Funds and ETFs.
Another way to reduce risk other than simply hold more companies is to hold different forms of investments, such as bonds.
Before we get there though, be sure to subscribe to the blog and get next week’s article when we dive more into risk.
What is a bond?:
As exciting and deep as the Stock Market is, the Bond Market is actually larger in size and has more activity on a daily basis than the Stock Market. I simply want to make this point because bonds are usually viewed as “boring” in the investment commentary we hear.
So why do bonds get the boring label?
Well, because they are kind of boring.
A bond is simply a loan to a company, with the person holding the bond earning interest over time as determined by the terms of the bond.
It is really no different than taking out a loan on your home or car. You get something now and pay interest over a period of time to have the thing you’re buying sooner.
From the context of a bond, the company is receiving the loan from you, and you get the interest.
Funds from bonds issued are usually used to expand the company, through equipment purchase, expanding their facilities, or other uses that will allow the company to have some financial flexibility rather than spending cash.
This is similar to raising capital through issuing stock, but with one key difference. They don’t give up ownership of the company by issuing a bond, whereas stock would dilute the ownership of the current stockholders.
Another reason they issue bonds is to avoid being subject to the terms of a single bank or investor and instead spread out the loan across many investors.
This is good news for us as investors and allows us to potentially earn a higher interest rate than the bank is paying us in interest on our cash savings.
I say potentially earn because if a company goes bankrupt, you are not necessarily guaranteed to get your money back. We will cover more on this topic in the risk post coming up next week.
Let’s look at it in this simple example.
It doesn’t make sense for investors to not make more than what the bank is paying us in interest and it doesn’t make sense for the company to pay the bank more interest than they have to. This is why bonds exist.
Consider it a middle market for companies to grow. It is no different than if you were to make a loan between yourself and someone other than a bank. (Definitely not recommending that!)
The word market is an important word too, as bond prices can change over time based on many factors.
Some factors that drive bond prices are the overall interest rate set by the Federal Reserve, the credit quality of the bond issuer, and what other bonds are available in the overall market.
While bonds don’t produce the daily excitement stocks have due to their finite shelf life and more easily calculated return, this is actually a very good thing for investing.
It gives us a little more calculated risk than a share of stock would and allows us to add more stability to our overall portfolio.
This also usually means a lower average rate of return, but that is the price we pay for less risk. More on that next week.
Put it all together now. What is a Mutual Fund or Exchange-Traded Fund (ETF)?:
Researching and making wise investments in single, or even just a handful of stocks and bonds can be a lot of work.
To help combat the risks associated with this and help eliminate the time-intensive research needed for investment in individual stocks and bonds, Mutual Funds and ETFs were created.
Mutual Funds and Exchange-Traded Funds (ETFs) are what most individual investors will make use of in their investments.
In exchange for a fee, a Mutual Fund company will take on the task of researching and buying many smaller investments inside of a single fund for purchase by an investor.
Think of a Mutual Fund or an ETF as a basket of stocks or bonds, and sometimes both within the same fund. They really are just that, a collection of investments held together as one.
While Mutual Funds and ETFs are conceptually similar, they do operate in slightly different ways.
Let’s start with Mutual Funds, they have been around longer and are what most are familiar with.
A mutual fund aims to decrease risk by adding many investments into a single holding.
If we go back to our stock example of Company A and Company B, and put them inside of a Mutual Fund, we are no longer subject to the risk of either company on its own.
Let’s say Company A and Company B are competitors, and the success of one may contribute to the decline of the other.
Additionally, each company is at risk of having bad PR, fraud, recalls, or their technology becoming obsolete and irrelevant.
We’ve all seen examples of this in the news, or maybe have experienced a recall of a product we have purchased.
If we only hold one of the companies, we are making a bet it will be around longer, and in a more substantial way than the other. We would be trying to make more money based on whichever company we thought would be a better choice.
By choosing to invest in a mutual fund, we now own one-half share each of Company A and Company B inside of our one mutual fund share.
This chart shows what we have effectively done.
Now, let’s say Company B has a defect in their product and will be spending millions or billions of dollars to recall the product and get replacements to their customers free of charge, or issue a refund.
Profitability drops, customer trust has dropped, and the future of Company B is not looking so bright. The stock price drops.
The chart below shows the same three scenarios we had in the first chart, now with the stock drop of Company B reflected and the subsequent rise of Company A.
Company A rises, because customers may now choose their products instead of Company B’s. This brightens the future of Company A in the eyes of investors.
You can see with the mutual fund, the value didn’t drop as Company B did. The tradeoff is, it won’t rise as much as Company A, either.
Mutual Funds share in the gains and losses of multiple companies. Most mutual funds have hundreds or thousands of companies all in one, easy-to-purchase basket.
This reduces the risk of choosing just the losing companies and gives us a better chance of holding at least some of the winning companies.
By holding Mutual Funds, we hoping to reduce the risk of only choosing the losing companies, like Company B.
There are many different choices to be had in the Mutual Fund space. Funds usually focus on a particular element of a company and package them all together.
This focus can be on the size, industry, geographical location, or similar factors that would allow one to easily distinguish what exactly is in the fund.
Mutual Funds may also track the common indices such as the Dow Jones, the S&P 500, or other largely known groupings of investments like the Bond Index. Same concept, just with a different filter as to what goes inside the fund.
Some Mutual Funds (Usually called Allocation, Target Date, or Model Funds) will choose to invest in a mix of stocks and bonds to further reduce the risk of the specific asset class. More on this next week.
ETFs function in a very similar way to Mutual Funds by creating baskets of investments, with the main difference being you can buy or sell them at any given point throughout the trading day.
Mutual Funds can only be bought and sold at the end of a trading day once all of the individual investments have been priced.
ETFs usually have lower fees, but also generally have less overall choice in how specific you want to be invested.
Mutual Funds usually will cost more in fees than ETFs (at times ridiculously high fees), so be on the lookout for what you will be paying to hold them. With this though, comes additional options for being invested in very specific markets.
Each has its pros and cons. Mutual Funds are usually a little less maintenance and are usually easier to rebalance (we will cover this in a future blog, subscribe here) since you don’t have to worry about rapid changes in the market during trading hours.
Ultimately, if you choose to go with either, it will come down to your preference and the level of management you will be doing on a regular basis.
That’s it for this week. I hope you learned a thing or two from this post, and have a better understanding of what exactly these asset types are.
Send any questions you may have by completing the form below, and I will be sure to get back to you.
See you next week at the same time, in the same place as we dive deeper into what investment risks we are up against, and what those risks mean as we look to grow our money.
Until next time,