So, you want to be an investor? If you finally have a few extra dollars to your name or just understand the benefits of investing, you should know a few things before you jump in head first.
1. You should know what the “price” of a stock or bond means.
This will get a little bit technical, so I apologize in advance, but bear with me. The “price” of a stock, bond, mutual fund or commodity (all of which fall under the category of "securities") contains relevant information on what everyone thinks about each security.
To what "information" am I referring?
Each stock represents a portion of a company’s future earnings. For example, if I expect the company to earn $100 and each stock is worth 1 percent of these earnings, I would pay $1 or less for the stock ($100*1%).
If the price of the stock is at $1.10 (above what I think it is worth), I don't buy it. If the price is at $0.90 (under what I think it is worth), I buy it. I “vote” for what I believe is a fair price for the stock using my dollars.
Now, I'm just one person and am by no means a genius. Luckily, there are millions of investors out there, some of whom are geniuses. So, how many "votes" are in the market?
During 2013, the average daily volume for the US stock market was $223 billion, which means 223 billion "votes" happen each day. For the bond market, it was around $810 billion. Adding both stocks and bonds together, around $1 trillion is traded every day. That’s a lot of votes.
With this many votes occurring each day, new information is quickly incorporated into prices as buyers and sellers voluntarily agree to sell or buy.
For each trade to occur, there must be both a buyer and a seller. That is, someone who thinks the price will go up (buyer) and someone who thinks the price will go down (seller).
Ultimately, the market combines every piece of knowledge between every investor into one single price. Amazing, huh? So, let's agree none of us are as smart as all of us, and every security is fairly priced.
2. Diversification is an investor’s best friend.
Diversification is a fancy word for investing in a bunch of stuff (usually stocks and bonds). There isn’t a precise formula for how many different stocks, bonds and other securities you should own.
Many argue it’s possible to diversify with as little as 40 stocks, but others say true diversification does not occur until you reach the 10,000 mark. I don’t know the true answer, but I do have a revealing story to communicate the value of diversification.
Let's say you have a portfolio of only automobile stocks. If the government decides cars are ruining the atmosphere and then bans all automobiles, prices for automobile stocks will drop. Therefore, your portfolio will drop.
However, if you also purchased bicycle stocks, only part of your portfolio will be affected. There is also a good chance the bicycle stocks will rise because more people would be forced to buy bikes.
This is diversification: lowering your risk by purchasing different kinds of stocks, bonds and other securities.
The easiest way to diversify is to invest in a traditional mutual fund or Exchange Traded Fund (ETF). These funds own many stocks and bonds, usually more than you could individually purchase.
How? Instead of only using your money to invest, these funds usually have millions (or billions) to invest. They often purchase thousands of stocks and bonds with these large piles of cash. You, probably, don’t have such large piles of cash and can only afford a few stocks and bonds.
Let’s all agree that diversifying through mutual funds or ETFs is an efficient way to use our money.
3. There are a few different approaches to investing: conventional (active) and index (passive).
Conventional management attempts to identify underpriced stocks and bonds. They usually do this by hiring smart people who sit at their computers all day and look at stocks, bonds, mutual funds and everything else.
These people are called analysts and they answer to the fund managers. After researching their assigned securities, analysts will state whether or not they think a security is underpriced or overpriced. The fund manager will then purchase or sell the security.
How do they predict if it is over or underpriced?
Analysts rely on their ability to predict the future. And, when I say predict the future, I mean predict what will happen to a company’s (or group of companies') earnings and price. In theory, if a company makes more money, its stocks are worth more.
This is supposed to go both ways. A good company should have good stock, and a bad company should have bad stock. However, it does not always work this way. Conventional management tries to predict how much the company will earn in the future, so the analysts can then determine how much each stock is worth.
"Buy low and sell high" may sound good in theory; however, outguessing the market is hard. Only 19 percent of stock mutual funds that survived all 10 years beat their index for the period ending in December 31, 2013 (starting in 2004). For the same 10-year period, only 15 percent of bond mutual funds beat their index.
An index is a group of securities the fund manager wants to use as his or her benchmark. For example, the S&P 500 is usually the 500 of the largest company stocks in the US.
If the fund manager is buying United States large company stocks, he or she may desire to be compared to the S&P 500. His or her job is to beat the S&P 500 every year. What the above stat means is only a few fund managers are able to do their jobs.
Even though they may not outperform their indexes, the analysts and fund managers get paid a lot. An analyst's average salary is around $85,000 and wizards make around $200,000, not counting bonuses. In 2012, the top hedge fund earner made $1.5 billion.
Unlucky for you and me, these costs are passed down to the investors in their mutual funds. Morningstar, Inc. pegged expenses for the average investor in open-end mutual funds at 0.71 percent, which may not look like much, but it adds up quickly.
On the other side of investing strategies, there is indexing. Indexing simply means the fund follows the index to a T. The fund does not have its own strategy; instead, it attempts to match the index's performance and only buys and sells when the index buys or sells.
There are not nearly as many analysts or fund managers, and there is no attempt to predict the future.
Each "index fund" holds a basket of securities that its appropriate index holds. There are hundreds of index funds. Index funds are usually low cost because they don't trade often and require fewer analysts and fund managers.
Their expense ratios usually range from 0.05 percent to 0.50 percent. It doesn’t make much sense to invest in the higher-fee index funds since they all invest in the same thing.
Remember that conventional management actively tries to beat the market by predicting the future. Indexing accepts whatever the market does, and usually has lower expenses.
With these three facts under your belt, you’re ready to begin investing. Remember, each security's price is filled with information; diversification is key, and the differences between conventional and index investing are vast.