Investment Basics is a project aimed to help people learn about investing.
If you have some savings sitting in a bank account earning no interest, you may be thinking: “that’s not right, my money should earn something!” You may know about the stock market, but you would like to learn how investing actually works. Part of MCM’s Investment Basics series, this article should help you understand the basics of investing in less than 10 minutes.
The first thing to understand is what you will own when you invest in markets. The most common investments are stocks and bonds. They are very different from each other.
Stocks are shares of ownership in a company. For example, a share of Apple Computer (the symbol for the stock is AAPL) represents a tiny portion of Apple’s ownership capital, or equity (so ‘equity’ basically means the same thing as ‘stock’). As an investor in AAPL stock, you would own a portion of Apple Computer, the company. If the company’s business is going well over time, you stock investment should grow. While some stocks pay cash dividends, most of stock returns in recent decades came from their prices rising. But of course, any business might go through good and bad periods, so stock prices go up and down reflecting this.
Bonds, on the other hand, are borrowing-lending obligations. By buying a corporate bond, you lend your money to the company (or to the U.S. government if you buy Treasuries). The company is then obligated to repay you at a future time (called ‘maturity’), with interest usually paid to you every 6 months. So naturally, bonds are less risky – the company must pay the money back no matter how bad its business may be (unless it’s really bad and the company is bankrupt).
Why do companies sell their stocks and bonds? Because they need capital to continue to grow their businesses. Think of AT&T or Verizon that need, say, to upgrade their cellular networks from third to fourth generation. They need to buy new antennas, to lease towers and buildings across the country, to create new software, to hire people to do all this – all before a single person can pay for using their 4G cell phone. So the company first obtains the capital in the markets so that it can invest it in the new network.
Such pooling of capital made possible the development of modern industries from computers and telecom, to airlines and automobiles, to railroads and the steam engine in the 19th century, and so on. That’s what capital markets are about – they channel savings like yours to companies that need capital.
To see how the whole stock market is doing, you can look at an index. The first stock index, the precursor of today’s Dow Jones Industrial Average, was designed in 1885 by The Wall Street Journal editor Charles Dow. Today, the most widely used U.S. equity index is the S&P 500 which consists of 500 U.S. companies. To see “what’s going on” in the market – major indexes, news, etc., my favorite portals are Yahoo Finance and Bloomberg Business.
Both stocks and bonds are publicly traded. Stocks are traded on exchanges such as the New York Stock Exchange. To buy individual stocks, you need a brokerage account – you can easily compare brokerage firms here. Where firms like Ameritrade and E*Trade were among the first to offer online trading in the 1990’s, all of them are mostly online these days, with phone support, and some have a network of offices. Brokerage firms charge fixed commission for each trade – typically around $10 per online trade.
Now, for unpleasant part: investments are risky. One type of risk is company-specific risk – risk that the company faces tough times, or even dies (goes bankrupt). Such high-profile companies as Enron (an energy-trading business) and Worldcom (telecom) went bankrupt in early 2000’s. During the Great Recession and financial crisis of 2007-09, an investment firm Lehman Brothers went bankrupt, and bailout acquisitions, at low stock prices, were orchestrated for Countrywide Financial, Merrill Lynch and AIG. One way to reduce company-specific risk is to diversify your investments – to have a broad set of companies in your portfolio, rather than just a few. At least 20 companies, across multiple industries, are typically needed for adequate diversification.
Also, the whole stock market is still risky. The market goes through booms and busts, or volatility, due to economic cycles, recessions, global events, etc. While we might expect the stock market to deliver an average annual return of about 6-8% over a long period (say, 20 years or longer), stocks can go down a lot in any given year or two. As you may know, in 2008 for example, the S&P 500 plunged by about 40%. That’s where asset class diversification comes in. Adding bonds to your portfolio should dampen stock market volatility. While bonds earn a lower return than stocks over time, they are more stable and also tend to do well when stocks decline. To illustrate this, I show in the chart above the S&P 500 index and the Core US Aggregate Bond Index (AGG) over the past 10 years.
Funds and Expenses
So, you know quite a bit about investing at this point. Suppose that you decided to make your savings grow to help achieve your long-term goals (say, to buy a house, or for retirement). You want to create a diversified portfolio of, say, 50% stocks and 50% bonds. You can do it yourself by researching companies and buying stocks and bonds in your brokerage account – and just pay trade commissions. Or, you can buy “ready-made” stock and bond portfolios – mutual funds or ETFs. In either case, a long-term, buy-and-hold approach tends to work best for most investors.
Mutual funds grew in popularity in the U.S. since the 1950’s. Actively-managed funds typically involve total expenses between 0.5% and 1% per year on the money you invest (assets). Think about it this way – the fund company has to pay brokerage commissions to buy the investments, to pay people to do investment research and distribution, and to make a profit. Index funds that simply invest in an index (such as the S&P 500) are cheaper – and Vanguard that provides index funds only, tends to be the most cost effective. A more recent development, exchange-traded funds (“ETFs”), are cheaper still, and also trade just like stocks so you can buy/sell them during the day (you can only buy/redeem mutual funds at end-of-day). Using ETFs, you can invest in the S&P 500 index, for example, by buying the SPDR S&P 500 Index ETF (SPY), managed by State Street Global Advisors, for 0.09% per year. In bonds, you can invest in the Core US Aggregate Bond Index (AGG), managed by BlackRock, for about the same annual fee.
Note – to invest in a retirement account such as 401(k), you wouldn’t need to a broker account. Typically, a fixed list of mutual funds will be offered to you through the plan administrator chosen by your employer. This may be a topic for a future article.
This article is for educational purposes only, does not constitute investment advice, and represents opinions of the author and not necessarily of Model Capital Management LLC. Investors should independently evaluate particular investments and strategies, or seek individual advice of an investment advisor. There are risks involved with investing including the loss of principal. There are no guarantees with respect to performance or outcome of any security, investment strategy, or projection made or discussed in this article.