How to be Rich(er), Ch. 1
I figured I'd pass along some of my limited wisdom about investing to those of you who have been asking me for advice lately. I want to warn you that I am by no means an expert and I do not have the solution to your particular situation. Hopefully, you will find this helpful. Please comment on the usefulness of this post. If it did not help you at all, I don't want to waste my time or your time with the remaining topics.
I think the best way to break down this topic is by the following "chapters"
1) Types of Investments
2) Mutual Funds
3) Investment Strategies for You
4) Researching Mutual Funds and individual stocks
I've covered the first chapter below. I'll try to hit the other three sometime in the next week or so.
Types of Investments
There are three main investment "vehicles" that you can choose between: Money Markets, Bonds, and Stocks.
Money market investments are similar to a savings account. These investments typically earn a small amount of interest (currently around 3%), but are backed by a very solid institution (bank). The risk of a well-known bank going bankrupt is very minimal, so you are not paid as handsomely for the risk associated with giving a bank your money. These assets also tend to be quite liquid. You can access your savings account at just about any time if you need money. Some money market accounts might require you to maintain a minimum balance or possibly limit the number of transactions you can make in a given month. Banks typically offer you a higher interest rate if you agree to deposit your money for a longer period of time, provided that you are not allowed to touch your deposit before the agreed upon date. These Certificates of Deposit (CDs) earn varying levels of interest based on how long you agree to leave the money on deposit. My guess is that at twelve month CD probably earns about 4% annual interest these days. A five-year CD would earn a higher annual rate since you are giving your money to the bank for a longer period of time. I have never purchased a CD, so I don’t know too much about them.
Another type of investment is a bond. These investments make a lot of sense theoretically, but individuals do not commonly utilize them. A bond is similar to a CD with a bank. You give the bond issuer (normally a company) a set principal amount (say $1000) and they agree to pay you that principal in the future at some specified date. In the meantime, you will also receive interest payments on the bond. Most bonds can be resold in the public market at any time. There are two main risks you have when you hold a bond. The first key risk is default. If the issuer of the bond cannot pay the stated interest or principal payments (via a bankruptcy declaration), they have defaulted and you probably have lost most if not all of your money. All publicly traded bonds are rated for their creditworthiness by several agencies (Moody’s, Standard and Poor’s, etc). "Junk bonds" are bonds with the lowest credit ratings. In order to get people to buy these bonds, higher interest payments are demanded. Since default risk is higher if the length of the bond is longer, higher interest rates are demanded on longer-term bonds. A thirty-year bond should have higher interest payments than a three-year bond since a lot more can happen in thirty years that may cause you to lose your principal amount than could happen in three years. Also, when you try and trade a bond in the secondary market (instead of buying directly for a company), the price of the bond relative to the principal value depends heavily on the credit rating of the bond. A bond that is deemed "junk" that will pay you $1000 in the future will probably sell for far less than $1000 since it will likely never get paid off by the issuer of the bond. A U.S. government bond will likely sell for close to face value since government debt is considered the highest quality debt. The second risk of a bond is interest rate movement. A bond that pays you 7% interest each year might be quite attractive today (assuming no default risk). In fact, you would pay more than $1000 for a bond that will pay you $1000 in ten years and 7% in interest each year in today's market since the present value of this bond at today’s interest rates exceeds $1000. However, if interest rates jump to 10%, that bond is no longer an attractive investment. The re-sale value of the bond will drop if interest rates rise since more attractive bonds become available. Conversely, if interest rates decline, the value of your bond increases. If you intend to hold a bond to maturity, then the only risk you need to be concerned with is default risk. Most individuals tend to stay away from the bond market because it can be quite confusing to understand (even though the concept of a bond is far simpler than common stock). Companies that have assets available for investment (insurance companies) are big players in the bond market because the returns are still solid and the risk is lower than in the stock market.
Stocks are definitely a more common and popular investment choice for individuals. Stocks provide you with a small piece of ownership in a company. You have claim to future earnings at the company and voting rights. However, you are last in line behind the bondholders in the event that the company goes bankrupt (and often get nothing in this event). Some stocks pay dividends to the stockholders as a method of returning earnings. Others retain all earnings and tend to be more active in mergers and acquisitions or in buying back their own stock over time with their profits. A stock will go up when a company increases their dividend or experiences solid earnings growth. Stocks also move based on general market or industry news and trends. Companies that have publicly traded stock come in all shapes and sizes. You can buy a stock in a consumer services industry. You can also buy energy stocks, insurance stocks, and many other types of stock. You can buy stock from large companies, medium sized companies, and small companies. I'll admit that I am not an expert on the stock market and struggle to explain a lot of behaviors. Even though I am mostly invested in stocks (through mutual funds), the concept of bonds makes much more sense to me.
Those are the three main investment "vehicles" for your money. Historically (over the past 75 years), stocks have provided the highest average annual return on investment. This should make sense because stocks represent the riskiest and most volatile type of investment. You should demand higher returns for higher risk. Within the stock investments, small cap stocks (smaller sized companies) return more per year than large cap stocks. A small cap stock is most likely to boom and hit it big time (Wal-Mart was once a small cap stock) or completely fizzle out (many dot com stocks), so this hopefully makes sense as well. If I remember my college corporate finance textbook correctly, small cap stocks have averaged an 11% annual return over the past 75 years and large cap stocks have average around 8-9%. However, in bear markets and during recessions, the stock investments have performed far worse than bonds and money market securities. You run a much greater risk of losing a significant amount of money in recession markets if you are heavily invested in stocks. Bonds are next in terms of average return on investment. Investment grade bonds have earned roughly 5-7% per year over the past 75 years. Government bonds have earned less during this time and junk bonds have earned more because of the risk associated with these securities. The down years are not quite as harsh as they are for stocks, but for the additional protection in bad years, you are sacrificing better returns when the market is strong. Money markets have the worst average annual returns among the types of investments I have outlined above. While they never lose money, you miss out on a lot of potential gains by only using money markets. I strongly suggest that you only keep enough in money market investments to cover short-term needs plus emergency funds (i.e. to cover you for a couple months if you lose your job). As you near retirement age, it is wise to put more of your money into money market funds since you can’t afford to take on as much risk anymore.
There are a couple ways to get involved with stocks and bonds. The first is to buy a specific stock or bond. The second way is to get involved through mutual funds that buy a specific class of stock or bond (or perhaps diversify across the entire market). You pay a fee (expense load) when you own a mutual fund since you are paying an expert to manage your money, but you diversify a significant amount of risk compared to owning one specific stock or bond.
I'll elaborate more on mutual funds in my next entry on this topic since I think most people in my age bucket (under 30) with less than ~$100k in savings should invest primarily (if not entirely) in mutual funds if they want to get involved in stocks and bonds and do not understand much about investing.
I think the best way to break down this topic is by the following "chapters"
1) Types of Investments
2) Mutual Funds
3) Investment Strategies for You
4) Researching Mutual Funds and individual stocks
I've covered the first chapter below. I'll try to hit the other three sometime in the next week or so.
Types of Investments
There are three main investment "vehicles" that you can choose between: Money Markets, Bonds, and Stocks.
Money market investments are similar to a savings account. These investments typically earn a small amount of interest (currently around 3%), but are backed by a very solid institution (bank). The risk of a well-known bank going bankrupt is very minimal, so you are not paid as handsomely for the risk associated with giving a bank your money. These assets also tend to be quite liquid. You can access your savings account at just about any time if you need money. Some money market accounts might require you to maintain a minimum balance or possibly limit the number of transactions you can make in a given month. Banks typically offer you a higher interest rate if you agree to deposit your money for a longer period of time, provided that you are not allowed to touch your deposit before the agreed upon date. These Certificates of Deposit (CDs) earn varying levels of interest based on how long you agree to leave the money on deposit. My guess is that at twelve month CD probably earns about 4% annual interest these days. A five-year CD would earn a higher annual rate since you are giving your money to the bank for a longer period of time. I have never purchased a CD, so I don’t know too much about them.
Another type of investment is a bond. These investments make a lot of sense theoretically, but individuals do not commonly utilize them. A bond is similar to a CD with a bank. You give the bond issuer (normally a company) a set principal amount (say $1000) and they agree to pay you that principal in the future at some specified date. In the meantime, you will also receive interest payments on the bond. Most bonds can be resold in the public market at any time. There are two main risks you have when you hold a bond. The first key risk is default. If the issuer of the bond cannot pay the stated interest or principal payments (via a bankruptcy declaration), they have defaulted and you probably have lost most if not all of your money. All publicly traded bonds are rated for their creditworthiness by several agencies (Moody’s, Standard and Poor’s, etc). "Junk bonds" are bonds with the lowest credit ratings. In order to get people to buy these bonds, higher interest payments are demanded. Since default risk is higher if the length of the bond is longer, higher interest rates are demanded on longer-term bonds. A thirty-year bond should have higher interest payments than a three-year bond since a lot more can happen in thirty years that may cause you to lose your principal amount than could happen in three years. Also, when you try and trade a bond in the secondary market (instead of buying directly for a company), the price of the bond relative to the principal value depends heavily on the credit rating of the bond. A bond that is deemed "junk" that will pay you $1000 in the future will probably sell for far less than $1000 since it will likely never get paid off by the issuer of the bond. A U.S. government bond will likely sell for close to face value since government debt is considered the highest quality debt. The second risk of a bond is interest rate movement. A bond that pays you 7% interest each year might be quite attractive today (assuming no default risk). In fact, you would pay more than $1000 for a bond that will pay you $1000 in ten years and 7% in interest each year in today's market since the present value of this bond at today’s interest rates exceeds $1000. However, if interest rates jump to 10%, that bond is no longer an attractive investment. The re-sale value of the bond will drop if interest rates rise since more attractive bonds become available. Conversely, if interest rates decline, the value of your bond increases. If you intend to hold a bond to maturity, then the only risk you need to be concerned with is default risk. Most individuals tend to stay away from the bond market because it can be quite confusing to understand (even though the concept of a bond is far simpler than common stock). Companies that have assets available for investment (insurance companies) are big players in the bond market because the returns are still solid and the risk is lower than in the stock market.
Stocks are definitely a more common and popular investment choice for individuals. Stocks provide you with a small piece of ownership in a company. You have claim to future earnings at the company and voting rights. However, you are last in line behind the bondholders in the event that the company goes bankrupt (and often get nothing in this event). Some stocks pay dividends to the stockholders as a method of returning earnings. Others retain all earnings and tend to be more active in mergers and acquisitions or in buying back their own stock over time with their profits. A stock will go up when a company increases their dividend or experiences solid earnings growth. Stocks also move based on general market or industry news and trends. Companies that have publicly traded stock come in all shapes and sizes. You can buy a stock in a consumer services industry. You can also buy energy stocks, insurance stocks, and many other types of stock. You can buy stock from large companies, medium sized companies, and small companies. I'll admit that I am not an expert on the stock market and struggle to explain a lot of behaviors. Even though I am mostly invested in stocks (through mutual funds), the concept of bonds makes much more sense to me.
Those are the three main investment "vehicles" for your money. Historically (over the past 75 years), stocks have provided the highest average annual return on investment. This should make sense because stocks represent the riskiest and most volatile type of investment. You should demand higher returns for higher risk. Within the stock investments, small cap stocks (smaller sized companies) return more per year than large cap stocks. A small cap stock is most likely to boom and hit it big time (Wal-Mart was once a small cap stock) or completely fizzle out (many dot com stocks), so this hopefully makes sense as well. If I remember my college corporate finance textbook correctly, small cap stocks have averaged an 11% annual return over the past 75 years and large cap stocks have average around 8-9%. However, in bear markets and during recessions, the stock investments have performed far worse than bonds and money market securities. You run a much greater risk of losing a significant amount of money in recession markets if you are heavily invested in stocks. Bonds are next in terms of average return on investment. Investment grade bonds have earned roughly 5-7% per year over the past 75 years. Government bonds have earned less during this time and junk bonds have earned more because of the risk associated with these securities. The down years are not quite as harsh as they are for stocks, but for the additional protection in bad years, you are sacrificing better returns when the market is strong. Money markets have the worst average annual returns among the types of investments I have outlined above. While they never lose money, you miss out on a lot of potential gains by only using money markets. I strongly suggest that you only keep enough in money market investments to cover short-term needs plus emergency funds (i.e. to cover you for a couple months if you lose your job). As you near retirement age, it is wise to put more of your money into money market funds since you can’t afford to take on as much risk anymore.
There are a couple ways to get involved with stocks and bonds. The first is to buy a specific stock or bond. The second way is to get involved through mutual funds that buy a specific class of stock or bond (or perhaps diversify across the entire market). You pay a fee (expense load) when you own a mutual fund since you are paying an expert to manage your money, but you diversify a significant amount of risk compared to owning one specific stock or bond.
I'll elaborate more on mutual funds in my next entry on this topic since I think most people in my age bucket (under 30) with less than ~$100k in savings should invest primarily (if not entirely) in mutual funds if they want to get involved in stocks and bonds and do not understand much about investing.
posted by GaryGinew at 10:55 AM
2 Comments:
Thanks for the long post, Ginew! I'll read it and ask some more questions after I take a nap. :)
Wow!
Gary, I would like to tell that I understood everything you wrote and that it all makes sense to me now, but I think I'm still clueless. All i know is that when I invested I followed the plan with higher risk (small cap, etc.). And I'm hoping someday soon it will allow me to retire:)
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