Sometimes we all need a good reminder of the basics. When I talk with friends, family and clients about investing and financial planning, I often mistakenly assume my audience knows more than it really does. I start into my dialogue on what I think is a relatively simple concept, only to realize too late, that my audience doesn’t have a clue what I am talking about. Of course, this is one-hundred percent my fault, not theirs. People don’t often like to admit when they are lost or confused, and will just nod along and act as if everything makes perfect sense. This seems to be especially true when it comes to talking about money and finances. With this in mind, I want to go back to the basics of “Investing 101”, to make sure we are all starting with a good solid foundation and understanding of the fundamentals.
What is a stock?
We all love to talk about “stocks” and the stock market, but do we really understand what a stock is? At its most basic level, a stock is simply partial ownership of a publicly traded company. If you own one share of stock out of 100 total shares outstanding, you own 1% of the company. As a partial owner (i.e. stock holder) of a company, you have certain rights and risks, as follows:
- The right to a pro-rata portion of the company’s profits (i.e. dividends).
- The right to vote for company policies and/or directors at the annual stock holders’ meeting.
- The right to participate in any upside movement in the stock price.
- The risk of participating in any downside movement in the stock price.
- The right to sell your interest (shares of stock) at any time.
Why would a company issue stock?
Now that we know what a stock is, the question is, why would a company issue stock in the first place? Why wouldn’t a company prefer to keep all of the ownership equity and control of the business to itself? The main reason a company issues stock and sells a portion of its business to outside investors is to raise money for operations or to buy out the current owners/founders of the company. Issuing stock is called “Equity Financing,” and the funds raised can be used for company or product expansion, upgrading equipment, marketing, research & development, and so on. Many firms prefer to use equity financing when possible because, unlike debt financing (i.e., bonds, which we will discuss shortly), there is no mandatory interest obligation to pay to investors. Once the stock is sold, the risk now lies with the investor. The company has received its cash and has no further mandatory obligations to the stock holder.
What is a bond?
Now let’s talk about bonds. When a company sells bonds, it is called “Debt Financing.” Bonds, just like stocks, are another way for a company to raise funds. However, buying a bond does not make you an owner of a company, it makes you a creditor to that company. Instead of buying a portion of the company, you are simply lending the company a specific amount of money for a specific amount of time, and in return you get a specific amount of interest. It does not matter how well the company does; bond holders will only receive the interest they are promised, and a return of their principal at the end of the term. Conversely, it does not matter how poorly the company does; bond holders will receive the interest payments they were promised and get back their initial investment, so long as the business is still in operation at the time the debt comes due. And if the company does happen to go out of business, bond holders are first in line (after the government) to receive whatever assets are available. Stock holders are last in line and often get nothing in this situation. The key take-away here is that, as a lender (bond holder), you have both limited upside and downside potential. That is why, generally, bonds are considered safer investments than their investment cousins, stocks. A company might decide to issue debt (bonds) instead of stock either because it is unable (by law or by prospectus) to issue more stock, or because it does not want to dilute the current ownership and give up any more control of the company.
What is a Mutual fund or Exchange-Traded Fund?
Okay, now that we know what an individual stock is and what an individual bond is, let me explain why you might be better served not buying either one directly, and instead, may be better served buying these securities through a mutual fund or Exchange-Traded Fund (ETF).
One, if not the main, tenet of investing is “Diversification.” Also known as “not putting all of your eggs in one basket.” However, for the average investor, diversification can be hard to come by, as it takes an immense amount of time, energy, resources and skill to pick enough individual stocks and/or bonds to be considered truly diversified. And once you’ve picked the securities, you are by no means done. Now you have to monitor and track these stocks and bonds and decide when to sell, and when to buy new stocks and bonds to replace them. Most people have trouble finding enough time in the day to do their laundry, so how are these same individuals supposed to make enough time to be full-time investment managers as well? The good news is, there is a wonderful solution to this problem.
Mutual funds and Exchange-Traded Funds (ETFs) are Investment vehicles that pool the money of many different investors to buy a diversified portfolio of stocks and/or bonds. So, instead of taking the time and effort and committing the resources (not to mention the stress) involved with picking, buying, monitoring, selling and replacing individual securities (stocks or bonds), you can get instant diversification by simply buying a fund that already owns or will purchase securities on your behalf. When you buy a mutual fund or Exchange-Traded Fund, every dollar you contribute is automatically split between the securities (usually numbering in the hundreds if not thousands) underlying the fund. This systematized approach saves an incredible amount of time and relieves a lot of the stress involved in investing. There are many different flavors when it comes to picking investment funds, so whether you are an active investor or an index investor, want to buy U.S. securities or foreign securities, prefer government bonds or junk bonds, there is a choice for just about everyone.
What is Rebalancing?
Now we are really getting somewhere. We know what a stock is, what a bond is, and how investment vehicles such as mutual funds and ETFs work to simplify the investment and diversification process. The next step in Investing 101 is to systematically and methodically rebalance your portfolio over time. “Rebalancing” is just a fancy way of saying selling what is up the most (or down the least) to buy what is down the most (or up the least), and to come back time and time again to your original allocation and risk profile.
When you purchase shares of mutual funds or ETFs, you will end up with some mix of assets in your portfolio depending on the funds you choose to buy. Most investors try to put together a combination of funds that not only provides diversification, as we discussed already, but also provides exposure to asset classes that perform differently under different market conditions. This is called asset allocation, and most of us think of it in terms of the percentage of stocks versus the percentage of bonds and/or cash that we hold in our portfolio. Many people in the investment industry believe that obtaining the right mix of assets, or asset allocation, is the most important piece of the investing puzzle; the effort to determine the correct risk tolerance, in order to create that optimum balance is, therefore, a primary focus for many of us.
Over time your original asset allocation will change. Without doing anything yourself, the percentage you have in each investment vehicle will change as markets move up, down and sideways. And, since you likely started your investment process by picking your ideal mix of investments, you will want to come back to this ideal mix as things inevitably, and without your control, change. For example, if you started with a portfolio of 50% stocks and 50% bonds, and the stock market has been going up, your stock allocation will be higher than 50%, and your bond allocation will now be correspondingly lower than the 50% target. To rebalance, you will need to sell some stocks and buy some bonds to come back to your original ideal mix of 50/50. This is simply a way to make sure you always sell high, buy low, and keep the emotion out of investing as much as possible.
What do Cash Reserves and Insurance have to do with investing?
One of the most important, and most overlooked part of any long-term investment strategy, is to ensure that you have adequate cash reserves and insurance. Without proper cash reserves and insurance, you are never truly an investor; you are always a gambler. While investing always has some element of gambling to it, you have the option of investing with the odds and statistics on your side (i.e., “investing”), or being the sucker who might get lucky, but usually doesn’t (i.e., “gambling” or “speculating”). And the way you become an investor (and not a gambler) is by having adequate cash reserves set aside for an emergency or opportunity, and sufficient insurance to protect you and your loved ones, so that you are never forced to draw from of your investments at the wrong time.
Smart investing, where you have put the odds in your favor, means investing for the long-term, and without adequate cash reserves and insurance, you are always one emergency away from blowing up your long-term investment plan. You can come up with the greatest financial plan and investment strategy on the planet, but if you don’t have the time to see it through, because you are forced to access your investment assets sooner than planned, it is impossible to consistently keep those odds in your favor. That is why cash reserves and insurance are king in any realistic financial plan or strategy. Think of them as portfolio insurance, which will enable you to leave your long-term investment assets invested for just that, the long-term.
We hope, now, that we are all on the same page as to the fundamentals of investing, and that we can continue to build on these concepts and take our conversation to greater heights with more complex concepts in future posts. However, I would highly encourage those who still don’t feel they have a firm grasp of the basics to speak up. It’s your money and you need to understand the risks and potential rewards of what is being done with it. So don’t just nod along out of fear of looking silly, because the only silly questions are the ones never asked.
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