***Please note: This post doesn’t contain ANY affiliate links. Not one!***
How Avoiding Stocks Costs You Money
The stock market can be a wonderful place, but it can also be very overwhelming, even if you want to get started with the most simple, user friendly, basic investing strategies. Especially if you have no experience. Many people are so intimidated by the stock market that they never invest at all. But this is a HUGE mistake.
It has been reported that more than half of millennials today are putting their retirement savings away in a savings account uninvested!
Which is a shame because historically investing in stocks long term will yield a much higher return on your money than if it were left in a savings account. Stocks have historically returned around 8-10% (annualized) while bonds tend to return around 5-7% (annualized).
(Read more here about how millennials’ fear of the stock market could cost them $3.3 million.)
But don’t worry if you’re scared to make the leap! I’m going to explain stocks today in basic investing terms and also how I walked myself through the process of investing the easy, hands-off way.
And I promise you can do it too.
Remember, in this scenario, doing something is definitely better than doing nothing.
First, what exactly are stocks?
When a company needs to raise money, it issues something called shares. When you buy that share, you own a piece of that business. Owning stock often entitles you to voting rights in that corporation (one share may equal you one vote or it could equal you 10 votes or 20 or etc.).
You may also be entitled to receive dividends if and when they’re distributed. Dividends are a cut of a corporation’s profits. However, many corporations reinvest those profits back into itself rather than paying dividends (called retained earnings).
Owning stock also entitles you to the right to sell your stock to someone else.
Separation of Ownership and Control
I have seen many articles discussing stocks mistakenly imply that owning stocks equates to owning company assets. This is not true in the sense that if you had invested a good bit of money in shares of a company, you can’t just walk in and take all the pens. You don’t actually own the pens, you own shares that the company has issued and the company itself owns the pens (assets), not you.
This is what is referred to as separation of ownership and control.
Private vs Public
When a corporation is first starting out, it is probably pretty small. Let’s say three people start it and are the sole employees as well. Let’s say they divided it so each person owns one third of the shares of the company. As they grow, they may need more funding and so they acquire more investors, this would decrease the amount of shares they own in the company.
Eventually, the company may need to raise even more money, so they issue shares that the public can buy. This is called an initial public offering (IPO). The prices of the shares are set by an evaluation of the company’s worth and also on how many shares the company is offering.
Prior to the IPO a company is said to be private. The IPO transforms the company from private to public.
The company will only get to keep the money raised from the IPO. Investors can continue to buy and sell after on an exchange like the NYSE (New York Stock Exchange).
The reason the price of stocks will continue to fluctuate for the rest of its life is because the estimated value of a corporation will also continue to fluctuate all its life.
Primary vs Secondary Markets
The primary market is when an individual directly buys shares from the corporation at its IPO. The secondary market is after that when the stocks continue to trade on an exchange between the buyers and sellers.
Types of Stock
There are two types of stock: common stock and preferred shares.
The majority of most stock issued is in the form of common stock. Common stock typically gets some voting rights. It also tends to yield higher returns over bonds.
However, in the condition that the company goes bankrupt, common stock owners are the very last to get any money back. Bond owners tend to have the highest priority in that scenario for receiving any money (that’s left) back. This means the common stock owner may get very little or even no money back.
Preferred stock usually comes with no voting rights but are usually guaranteed some kind of dividend in perpetuity. Many times with preferred stock, the corporation will also have the option to buy the stock back, at any time, for whatever reason. In the case of bankruptcy, they will get paid off before common stock, but still after bonds.
There are other ways corporations can raise money other than stocks.
They can also issue bonds.
Bonds are basically debt that an entity, usually the government or a corporation, issues. When an individual buys a bond, he or she is basically giving that entity a loan with an agreed upon interest rate. This means that bonds are an extremely safe investment strategy that will yield some fixed rate of return.
However, if a company really takes off with some astronomical growth, the dividend you could be receiving from the stock could theoretically grow into infinite. With bonds you are only entitled to repayment of your loan plus the agreed upon interest rate.
Again, I’d like to discuss that the riskier investment strategy of stocks tends to pay off in the long run over bonds (not to say that you shouldn’t have at least a small portion of your portfolio dedicated to bonds): stocks have historically returned around 8-10% (annualized) while bonds tend to return around 5-7%.
Easy Ways to Get Started with Basic Investing
There are, of course, many, many ways an individual could get started investing.
If you don’t have any experience though and don’t have any desire to spend a ton of time gaining experience, I would suggest hiring someone (or thing) to do it for you.
Many investment banks have robo-managed programs where you just have to enter your current age, your target retirement age and the amount of money you want to invest and they do the rest for you, immediately generating your invested, diverse profile and then monitoring it from then on out and auto-rebalancing as needed. My main retirement savings account is robo-managed and it is truly hands-off. It took 10 minutes to set up and I only need to think about it when I get paid and want to deposit more money into it.
As long as you have a general idea of basic investing terminology (read on) and investing strategies that historically yield decent returns, you can easily spot a good investment program that’s going to work for you.
Stock indices (or indexes) are bundles of different stock together. The price is then determined by taking the aggregate of all of the individual stock prices. There are many indices out right now, in many market sectors.
For example, you could have an index of tech companies, or car companies, and etc. You’ve probably heard of some of the major indices: the Dow Jones Industrial Index (DJIA) and the S&P 500. The DJIA is an index of 30 large American companies and the S&P 500 is a market-cap weighted index of the 500 largest American companies.
Indices can be traded either indirectly through future markets or via exchange traded funds (ETFs).
ETFs can be sold and bought like stock on the exchange (unlike mutual funds).
Diversification is going to be key in your quest for good returns on your investments.
Diversification is basically not putting all your eggs in one basket. Own stocks in different corporations of different sizes, sectors, countries. Own bonds too. And etc.
And keep adjusting as you grow older. The older you get, the less risky your investments should be, since you’re getting close to retirement and therefore have less time to recoup any losses. Mutual funds and ETFs both love diversification. But, in my opinion, ETFs are better than mutual funds. Let me explain.
Mutual Funds Explained
Mutual funds are a big pool of diverse assets that are actively managed (meaning that it is run by a fund manager(s) that buy and sell the assets). Individuals can then buy a share of that pool of assets. So his or her big chunk of money buys a whole lot of little chunks of the assets included in that mutual fund.
Since they’re actively managed, mutual funds come with the expenses associated with active management. In addition to those commission fees, there may also be redemption fees, and operational fees.
The price of a mutual fund is only set at the end of the day and you can only buy or sell a mutual fund at the end of the day after that price has been set.
Mutual funds also have a wide array of assets you can invest in. There are endless types you can buy into: equity mutual funds, country mutual funds, more stable mutual funds, more risky mutual funds, and so on and so forth.
ETFs are sort of like mutual funds’ cooler older sibling. Genetically, they’re almost identical, but they are, in reality, very different. They are an easy way to invest in the stock market, and also in many commodities.
ETFs are also like big baskets that are full of shares in whatever index that ETF is supposed to be tracking. Shares that trade, just like stocks. ETFs can trade on an exchange at any time during the day, unlike mutual funds. When you buy into an ETF, you buy into that pool of assets, so you get a little (or big if you have way more money than me) sliver of all of the assets included in that pool.
And, just like mutual funds, there are many options of ETFs to choose for you. ETFs are usually pretty simple to use and their trading and annual charges are also usually pretty low, especially when compared to an actively managed mutual fund.
Want more info? Check out this article that also explains mutual funds and ETFs.
Physical ETFs vs Synthetic ETFs
ETFs are great, but nothing is ever truly perfect. I would be remissed if I didn’t briefly touch on some of their pitfalls.
First, let’s use the common example of gold. Let’s say you want an ETF for the gold market. Sometimes ETFs don’t buy every share of everything in the index, instead they buy only what they think they need to roughly parallel whatever that market is doing. In other words, the goal would be to track the gold market. So, if it goes up 12%, the ETF should also roughly go up 12%.
ETFs that buy most or all of the shares in an index are often referred to as physical ETFs. ETFs that don’t do this are called synthetic ETFs. These are really something different all together since they actually aim to track the gold price by investing in other things than the actual physical gold (like futures and options).
Synthetic ETFs are generally going to be a riskier option. An individual should only use a synthetic ETF if he or she has a really, really good idea on how that market works. Most of us should stick with the less risky option of physical ETFs.
Although, if you wanted to invest in a commodity, sometimes you have no choice but to invest in a synthetic ETF. This is often seen with food, because, obviously, a lot of food can’t just be harvested and stored in a vault for years like gold. So, the only ETF option there is going to be a synthetic one. And again, still not a good idea unless you really know that market.
Short and Leveraged ETFs
There are two more kinds of ETFs I’d like to discuss: short and leveraged.
Short ETFs are for when you want to make a bet on a market performing in a certain way. So if you say, the market is going to fall 10% and it does, your short ETF should deliver a 10% profit to you.
Leveraged ETFs are also a bet on a market performance, but with this one, it aims to amplify the size of your profits. Let’s say you have a 2x leveraged ETF on the market going up. That means if the market goes up 10%, your ETF should deliver a 20% profit to you. You potentially double the profit (can go the other way too though for you, potentially doubling your losses).
Leveraged ETFs may seem great, but I want to take a minute to really simplify some complicated financial stuff that goes on with them at the end of the day. Very, very basically, due to the rebalancing they do every day when they’re doubling or tripling numbers because the market went up or halving numbers because the market went down or whatever, a leveraged ETF can get very substantially diverted from the underlying actual index that it was supposed to be tracking.
There are also a few other caveats with synthetic, short and leveraged ETFs, but I think you probably got the general idea of don’t use them (unless you know what you’re doing, can’t stress that enough).
ETFs vs Mutual Funds
ETFs almost never incur annual capital gains taxes the way mutual funds can. You only pay taxes with an ETF if and when you sell your shares for a profit. This is a major tax advantage over mutual funds.
Mutual funds have also been known to incur significantly higher fees than ETFs. As mentioned previously, ETFs are usually associated with much lower costs.
For these reasons, I believe ETFs to be the easy, smart way to go with investing.
Investment Strategy Suggestions
So, obviously everyone is going to be different here because I’m sure not all of you reading this are at the same age or under the same life circumstances. But I have a few general statements that I hope might help guide you to your best portfolio.
- DON’T invest if you have any debt with a high interest rate (like a credit card debt at say 18% interest rate). Put all your money towards getting those debts down first.
- The older you are, the less risk you should take (aka the older you get, the more you invest in safe bonds)
- Diversification is a good step towards getting a good return
- Mutual funds and ETFs are easy ways to create a diverse portfolio
- I prefer ETFs over mutual funds because they are more tax efficient and business dealings are not limited to only the end of the day
- I think the best option for the majority of young people who want to invest with a moderate risk level is a portfolio that is robo-managed comprised of stocks and bonds, re-allocated appropriately as the individual ages.
- My personal retirement account is robo-managed and comprised of 90% stocks (ETFs) and 10% bonds. It is simple to use and deposit money, costs are very low, it requires almost none of my time, and I am confident I will get a better return in the long run than if my money were in an bank account without being invested
Like this article? Read more about my invested retirement savings account here.