How the Money Game Really Works.
Straight Answers About a Business that Sounds More Complicated Than It Is.
Not long ago I had a conversation a close friend I’ll call Frank. Frank is well-educated and informed, but he thinks the whole business of stocks, ETFs, mutual funds, etc is too complicated for him. Since he turned 45 a few weeks ago, he’s been worried about his retirement, so he asked me to take a look at his investments.
While going over Frank’s financial situation, I learned a few things that took me by surprise.
For starters, I noticed that all his savings were invested in mutual funds. This isn’t necessarily bad. But when I asked him what his average annual returns were, he looked puzzled and said “he really didn’t know, and never even asked.”
So I asked him if he had an investment adviser, broker or financial professional assisting him with his investments. Turns out he did, but the person he hired to look after his money uses what’s called an “Asset Allocation Strategy” to invest Frank’s savings. The strategy consists of splitting assets into several mutual funds. Each fund invests in a different asset class (I’ll explain what asset classes are later), and a portion of the money is invested in each class. For example, Frank’s money was split as follows:
- 40% in an S&P 500 Index fund;
- 20% in a Developed Markets (ex-US) stocks fund;
- 10% in an Emerging Markets stocks fund;
- 20% High Grade Corporate Bonds Fund; and
- 10% US Treasuries Fund.
Franks’s money manager’s job is to make sure the money remained invested according to the above formula. Each quarter, the manager helped Frank “re-balance” by taking money out of the funds that had gone up in value (thus going above the intended %), and putting more money into the funds that had decline in value (thus going below the intended %). This strategy seemed logical enough to Frank, but it has only one problem – IT AIN”T WORKING.
How do we know? Because we run the numbers! … To Frank’s surprise, he’d earned a meager 5.9% average annual compounded return over the past 20 years. When I told him the stock market’s return for the same period, as measured by the S&P 500 Index, was over 10%, Frank seemed puzzled – his look indicated to me he couldn’t understand why his money was doing so poorly. So I told him it was not unusual for people invested in Asset Allocation Strategies to have performed as he did.
In fact, according to an independent study by DALBAR, Inc., an independent research firm, since 1994, the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest. For the 30 years ending December 31, 2015, the average asset allocation fund earned a miserable 1.65% compounded annual returns vs. 10.85% for the S&P 500 Index.
Hearing this was somewhat of a shock to Frank. … So I asked him if he’d ever considered investing directly in stocks rather than mutual funds.
He said he never even though about it. According to his investment adviser and almost every “expert” on TV, “the whole thing is too complicated for small individual investors” like Frank.
WOW! … his answer was like a dart to my brain. It made me realize that investment professionals like myself have failed Frank, and probably millions of people like him. We have failed him because we have made investing in stocks sound much more complicated that it really is. And that’s a big problem.
For three important reasons. First, if people don’t understand how stocks, bonds and other investments work, they are not likely to invest in them. If they don’t invest in them, they’re not likely to get a fair return on their savings. If they don’t earn good returns, chances are they won’t have enough to retire, let alone enjoy their retirement.
Second, if people don’t understand how stocks and bonds work, they are more likely to settle for sub part investment strategies like Asset Allocation or even fall pray to “get-rich-quick” gimmicks.
And third, if people don’t invest in stocks and bonds directly, society loses. If only rich people, large institutional investors and foreign governments invest in American businesses and government securities, we end up with unsustainable concentrations of wealth and power – and eventually social unrest.
This article is intended to help you understand how stocks, bonds, mutual funds and ETFs work. Our goal is to help you make better, more informed decisions with your money.
a. What are stocks?
The stock of a company represents the ownership of a company. The entire ownership, or “equity” as is often referred to, can be divided into millions of shares of ownership, each one called a common stock. Whoever owns a share in a company (for example, Microsoft or Colgate-Palmolive), owns part of all its properties, profits, and everything in that company. If the company has 1,000 shares of stock, and you own 10 shares, you own one hundredth of the company, or 1% of it.
Some companies have only a few shares of stock and a few owners. Other companies divide their equity into millions or even billions of shares and have hundreds of thousands of stockholders. No matter the number, each share represents an equal portion of ownership in the company.
a. Why Would Anybody Buy Stocks?
For the same reason that they might go into any other business for themselves: To make money.
The owner of a stock is entitled to an equal portion of whatever the company earns in the future for as long as they own the stock. Normally, part of those earnings are paid out to shareholders as “dividends” – an equal amount to each share. The rest of the earnings are reinvested into the business with the hope of increasing earnings (and dividends) in the future.
c. How Big Are Dividends?
That depends on how much it earns and how the company handles those earnings. Some companies pay out a substantial portion of their earnings as dividends. Other companies pay no dividends or only a small percentage, particularly those that are expanding. Instead they reinvest all or a greater portion of their earnings back into the business. A company’s board of directors decides what dividends will be paid and when. These directors are your representatives.
The average dividend paid by the 500 largest companies in the United States as a group is about 3% of what the stocks are selling at (the market price per share). Thus, if you bought one share of stock in each you could expect to receive 3% on your money each year. Some pay more, some pay less.
Some companies try to pay dividends regularly. Colgate-Palmolive Corporation, for example, has paid a dividend every year for more than 50 years.
d. What Are Stocks Worth?
The price of a stock, like the price of clothing, coffee or other goods, depends on how much buyers and sellers are willing to pay or accept for them.
When a company first offers its stock for sale to the public (a process known as the “Initial Public Offering” or “IPO”), it sets a specific price for however many shares of stock it is offering. For example, on March 2, 2017, Snap Inc. offered about 200 million shares to the public for the first time at a price of $17 per share. The company, its founders and initial investors received about $3.4 billion.
But once the stock is traded in the market, its price is not fixed or pegged by anybody or any agency. It is determined by free and open bidding, by supply and demand. When Snap’s share were offered to the public on the New York Stock Exchange, the opening price was $24.
Supply and demand for a company’s shares is largely determined by one factor: expected earnings. If investors believe a company will earn higher profits in the future, they will bid up its stock price. If they believe the company won’t earn higher profits or lose money, the stock price will decline. Earnings expectations, in turn, are driven by factors such as earnings record, industry’s outlook, and the outlook for the economy in general. In fact, even the availability of easy credit for the purchase of stocks affects supply and demand and therefore prices.
Some people buy say, Apple stocks, for the dividend it pays annually. Others may buy it because they think the price is going to increase soon and they can make a quick profit. Given the unpredictability of all these factors, investors’ opinions about the value of any company’s stocks, and hence the prices they are willing to pay, change constantly. Sometimes stock prices change sharply.
e. What Are Preferred Stocks?
In addition to Common Stocks, some companies also issue Preferred Stocks. Usually offered at $100 a share, preferred stocks generally bear a set dividend rate, say $4 per share annually. Holders of preferred stock get those dividends before common stockholders get anything – that’s one reason why it is called “preferred” – but if the company has a good year, preferred stockholders don’t get anything more than the specified $4 dividend per share.
The stock is also called “preferred” because if the company is liquidated, holders of those stocks get a first claim on whatever assets may be left after creditors’ claims are satisfied. (Assets are property, such as plants, patents, inventory or claims that can be converted into money). Preferred stocks differ widely from company to company in their exact terms, but always offer some preference over common stockholders. Although preferred stockholders, like common stockholders, are part owners of the company, they often have no vote or voice in the election of directors.
f. When Should You Buy or Sell Stocks?
Deciding when to buy or sell stocks is just as important as what to buy or sell. This matter of timing is important to both investors and speculators.
But first, you must keep an important difference in mind. That is the difference between Investing and Speculating.” Investing is when you buy an asset for the earnings it will produce in the future. Speculating is when you buy am asset expecting that someone will buy it at a higher price from you later, usually in a very short time.
Speculators provide a valuable service in a free market because they are willing to take risks – the risk of a sudden price change – and thus provide liquidity, making it easier for investors to buy and sell. Suppose you own stocks of a small company (or even a big company for that matter) and due to recent news you expect the company’s earnings to fall in the near future. If every investor thinks and acts like you, you might not be able to sell the stock at anything near a fair price. But you may be able to sell your stock to a speculator willing to take the risk that, despite the news, the stock price will increase.
But no one should speculate unless he or she can afford to lose the money. On the other hand, everyone should invest. You’d be amazed to learn how many people lose money speculating in stocks and other businesses. It usually happens because they believe they are investing when they are in fact speculating. Remember the dot.com bubble, the housing frenzy of 2002-07, tele-free, etc.?
The difference usually comes down to facts vs. hope. An investor will look at the facts – including a company’s past earning record, current financial condition, and future prospects – to decide whether the price of the stock makes sense. A speculator will buy the stock of a company, regardless of price or value, based on hope. He or she will hear a rumor or a tip, or that such and such made a lot of money in X, and hope he or she can have the same luck. Right now Bitcoin is the latest crowd frenzy, but there is always something.
That’s why you need to pay a close, continuous study of financial markets and publicly traded companies. We believe there are always good candidates for long term investing, but there is always many speculative ventures being offered as well. The mathematics of investing are such, that the most important thing you need to do is to keep them away from speculative investments.
At times, even a solid company’s stock becomes so expensive, that buying it (or keeping it if you own it) amounts to simple speculation. That’s why you must keep an eye on the price of the stocks or other investments you own. If the price has risen so much that you would consider buying it, you should at least consider selling it.
a. What Are Bonds?
Bonds are loans. People who buy a company’s bonds lend their money to that company. The company agrees to pay them back at a set date, known as the maturity date. For the use of the money, the company generally agrees to pay a set interest of, say 3% per year. Bonds are usually backed by the company’s property or the general credit of the company.
Unlike stockholders, bondholders are not part owners of the company. They are creditors of the company. As creditors, their claims must be satisfied first if the company goes broke. They must get paid before the stockholders or owners get anything.
Because bonds have this priority claim, they are regarded as the safest kind of security. That’s why they appeal to conservative investors – pension funds, retired people, widows, or anyone who is willing to take a smaller return on his money in exchange for safety.
Bonds are generally safer than stocks. But of course, the safety of any bond depends on the entity that issues it. If the same corporation issued both stock and bonds, the bonds are inherently safer than the stock. But the stock of a financial strong corporation, like Colgate-Palmolive, for instance might be safer than bonds issued by a small company just starting.
And even though bond prices do not fluctuate as much as stock prices, they do fluctuate. It is possible to lose money investing bonds. The price of any bond may decrease significant if, for example, there is any suspicion that the issuing company is having a hard time.
c. Why do people invest in bonds?
People buy bonds for the same reason people buy stocks. To earn money. Bond investors make money in two ways. First, because bonds pay interest to their holders. For example, a bond may pay 6% interest annually. Thus, the owner of the bond will get 6% of the face value of the bond (usually $1,000) each year until the bond period ends (in the language of Wall Street “until the bond matures”).
The second way people make money in bonds is through price appreciation. Bonds are usually issued at a face value of $1,000 per unit. As a matter of tradition, they are quoted as though the price were a percentage of the face value. Thus, if a corporate bond is said to sell for 98 ½, that means the price is $985.00. If you buy a bond for less than face value and hold it to maturity or sell it at a higher price than you bought it for, you earn the difference.
b. What types of Bonds are there?
There are basically three types of bonds: Corporate Bonds, Government Bonds, and Municipal Bonds.
Corporate Bonds are bonds issued by private or public corporations such as IBM, Microsoft or Bank of America. Depending on the credit quality of the corporation issuing the bond, corporate bonds are usually classified into high grade bonds and high yield bonds. Large and financial strong companies like Apple or Home Depot issued millions of dollars worth of bonds. because investors feel fairly certain that such companies will pay back what they borrow on time, the interest rate paid by those high grade bonds is usually much lower than the rate paid by lesser quality companies.
Small, not yet established companies don’t have the track record to make investors believe they will get their money back and on time, so they demand a high rate of interest to put their money at risk – hence the term high yield bonds.
Government bonds usually refer to bonds issued by the U.S. Federal Government. Federal Bonds pay interest and principal back to bondholders from the tax revenues the Federal Goverment generates. Because the U.S. Federal Government has the power to tax American people and businesses, it is regarded as the safest investment there is – that is, people who lend money to the US Government (by buying US Bonds or Treasuries), are confident they will be repaid with interest and on time.
Municipal Bonds are bonds issued by States or municipalities. State and municipal bonds are not considered as safe as federal bonds, but they are attractive to many investors because the income they generate is exempt from federal taxes.
III. MUTUAL FUNDS
a. What Are Mutual Funds?
Mutual funds are investment vehicles (usually organized as Trusts or Corporations) that allow you to pool your money together with other investors to purchase a collection of stocks, bonds, or other securities. This collection of bonds or stocks often referred to as a portfolio. Mutual funds, like other publicly traded companies, issue shares to the public. The price of mutual fund shares is determined by dividing the market price of the all securities in the portfolio by the number of the fund’s outstanding shares. This price, also known as its net asset value (NAV), fluctuates based on the price of the securities held by the portfolio at the end of each business day. Note that mutual fund investors do not actually own the securities in which the fund invests; they only own shares in the fund itself.
b. What types of Mutual Funds are there?
Mutual Funds can be classified in different ways. One way is by the way they are managed: Active or Passive.
- Actively Managed Mutual Funds. In the case of actively managed mutual funds, the decisions to buy and sell securities are made by one or more portfolio managers. Every mutual fund establishes an investment goal and sets forth the strategy it will follow to pursue that goal. A portfolio manager’s primary job is to invest the assets of the fund according to the objectives and conditions set forth in the fund’s prospectus. The portfolio managers attempt to invest the fund’s assets in a manner that will enable the fund to outperform its benchmark, which is generally some widely followed index, such as the Standard & Poor’s 500.
- Passive Mutual Funds. Passive Mutual Funds simply invest in the same securities that are in the index they choose. For example, the Vanguard S&P 500 Index Fund tracks the the Standard & Poor’s 500. The fund, by contract, must invest its assets in the same securities and in the same proportion as those tracked by the S&P 500 index.
Another way to classify mutual funds is by the assets in which they invest: Some funds invest in stocks, others invest in bonds, while others invest in a combination of the two.
c. Why would someone buy Mutual Funds?
Again, people buy mutual funds to make money. Companies that sponsor mutual funds usually highlight the following advantages of mutual fund for small investors.
- Low Minimum Amount Requirement. Mutual funds can be a smart and cost-effective way to invest. Individual purchase minimums can be as low as $100, although they very by fund —most funds won’t let you buy shares unless you start with at least $2,500. Minimums are often waived or reduced if investors buy a fund within a retirement account or use certain brokerage features like automatic investments to regularly invest over a set time period.
- Diversification. Buying shares in a mutual fund is also an easy way to help diversify your investments, which is really another way of saying that you won’t have all your eggs in one basket. For instance, most mutual funds hold well over 100 securities. For someone with a small sum to invest, they say, building and managing a portfolio containing that many securities could potentially be highly impractical.
- Professional Management. As a mutual fund investor, you get the benefit of having a professional manager reviewing the portfolio on an ongoing basis. Professional portfolio managers and analysts have the expertise and technology resources needed to research companies and analyze market information before making investment decisions. Fund managers identify which securities to buy and sell through individual security evaluation, sector allocation, and analysis of technical factors. For those who have neither the time nor the expertise to oversee their investments, this can potentially be invaluable.
- Liquidity and Convenience. All mutual funds allow you to buy or sell your fund shares once a day at the close of the market at the fund’s NAV. You can also automatically reinvest income from dividends and capital gain distributions or make additional investments at any time. For most stock funds, the required minimum initial investment may be substantially less than what you would have to invest to build a diversified portfolio of individual stocks.
- Tax Considerations. The stocks or bonds held within the fund often pay dividends or interest. Stocks or bonds can also be sold by the fund manager after rising in value. These types of events can help generate income for the fund, which by law must be paid out to investors in the form of periodic distributions. For the most part, investors who own shares in the mutual fund at the time these distributions are made are responsible for the taxes on that money. Investors who own mutual funds (not within an IRA or another tax-advantaged account) may be subject to three different types of taxes:
- Dividend income, which is generally taxed at your ordinary income tax rate
- Capital gains from the sale of securities, which can be taxed at your ordinary income tax rate or the more favorable long-term capital gains rate, depending on how long the securities were held by the fund
- Capital gains when you sell or exchange shares of the fund at a profit; those capital gains could also be taxed at your ordinary income tax rate or the more favorable long-term capital gains rate, depending on how long you held those shares
d. What types of Fees do investor pay to Mutual Funds?
There are a variety of fees that may be associated with mutual funds. The most common one is the management fee. This could range from 1.5% of assets under management per year to as low as 0.01% for some Index Funds. In addition, some funds charge a commission or transaction charges whenever you buy or sell their shares. These commissions are known as loads. And there are funds that charge a redemption fee if you sell shares you’ve only owned for a short time.
Investors also pay ongoing expenses to cover the cost of operating the fund; this includes investment advisory fees (paying the fund manager and the research staff), as well as transaction costs associated with buying and selling securities within the fund. When evaluating a fund, remember that fees play a factor and may potentially detract from a fund’s performance over time.
e. What is an ETF?
Exchange Traded Funds (ETF) are funds that trade like a stocks. ETFs combine the popular features of both. Like a mutual fund, an ETF is a collection of stocks or bonds. And like a stock, you can buy and sell an ETF throughout the day on the stock market. Similar to mutual funds, ETFs are diversified mixes of stocks or bonds that are managed by a portfolio manager or team.
IV. FINANCIAL PROFESSIONALS
a. What are Broker-Dealers and Investment Advisers?
A Broker-dealer acts as your intermediary when you want to buy or sell. Typically, they get compensated by charging a commission (or mark-up) each time you buy or sell a stock (or a bond). Some broker-dealers provide tools and research to help you make informed decisions. It is, of course, in their best interest if you make money on your investments over time because, if you do, you are more likely to stay on as their client. But they have no obligation to make sure you make the right investment decisions.
An Investment Adviser, as the name suggests, acts as your adviser. Investment Advisers, unlike broker-dealers, have a legal obligation to act on your best interest, to look out for you so to speak. They are usually compensated with a percentage of the amount you invest with them. Typically, around 1% annually. So, if they are advising you on, say $100,000, you’d pay them $1,000 each year. Obviously, if your money grows, they get paid more. It is not only their legal obligation to act in your best interest, they have an immediate economic incentive to do so.
b. What to Do if You Want to Know More?
We have tried here to answer some of the most common questions and provide at least a basic guide for anyone who wants to start investing for a better financial future. Contrary to popular opinion, we believe buying stocks directly is still the best way to achieve financial success (not mutual funds). Therefore, we recommend investing regularly in a group of good companies and holding them for a long period of years (or at least until the company loses its competitive advantage or a better opportunity appears.
If you want to learn more, or wish to start investing directly in a portfolio of stocks, please e-mail us at email@example.com.
The information provided herein for educational use only. It is not intended as investment, legal or tax advice. Abbilon Investments, LLC is an investment adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills. The information provided in this article does not represent any offer or solicitation to buy or sell securities. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Before investing, consider your investment objectives, charges and expenses. Abbilon’s internet-based services are designed to assist clients in achieving discrete financial goals. They are not intended to provide comprehensive tax advice or financial planning with respect to every aspect of a client’s financial situation and do not incorporate specific investments that clients hold elsewhere. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature.
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