What is Investing?
Many people ask me about investing. How do I get started? What should I invest in? These questions always lead to longer discussions with folks. During these conversations, I often note that many people are aware of many of the products available. Few understand how or why they work. The investment industry is full of products so complicated that even the savviest Wall Street banker cannot understand them at times. As a consumer, you should never buy a product you can’t understand. With this in mind, I want to step back and discuss some investment basics as well as how I approach the market.
Investing is basically putting your money to work for you. A home is an investment. Your education, that’s an investment too. If you’ve started a small business, you know that had to make an investment in to your idea. You put money into investments because you want something in return. People have the same expectation in the markets, though many forget that the should have a goal first.
The most basic part of investing is knowing why you're investing and how long you plan on putting the money to work. Investing is not a straight line growth. You’re going to gain money and then some lose money. Investments is about trading risk for returns. If you don’t need to touch your money for decades, you can take on more risk. If you need your money back in a year, why chance losing it in the short term? A retirement plan will be different than planning for college or a new home.
Before we delve into how, when, why, and where to invest, we need a bit more history in order to understand the process.
History of Investing
The Royal Exchange first opened in London in 1571. Kowing this is important since it gives you an idea of how long the industry has had to evolve. Products have been invented to fill niches. Laws have been passed in response to abuses. If you think modern Wall Street shenanigans are anything different then the behavior in the past, you would be wrong. Stock brokers were actually banned from the Royal Exchange during the 17th century because of their behavior.
Bad behavior on the part of unscrupulous people has caused rule after rule was added upon every layer of the law. This is how the modern complexity of the markets evolved into what they are today. The New York Stock Exchange, while not the first stock exchange in the United States, opened in 1792. It followed many of the same rules established over time and eventually evolved to what we know today. These rules exist because people wanted to grow their money without being taken advantage of.
The Fundamentals of Investments
Capitalism is a form of economic Democracy, and this is why markets and exchanges exist. If you believed in a company, you voted with your dollars. Not every company or product would make the investor money, however. For every success like Amazon.com, there are ten times more failure like Pets.com. As the risk to an investor increases, so too does the expected reward. There are two fundamental ways to invest in a company, both with different degrees of risk. You can loan a company money, or you can become an owner of that company.
Loaning Money – Bonds
You can loan money to a company or a government by purchasing a bond. A bond will pay out a periodic interest payment out to whoever holds the bond at the time. Think of your credit cards… you’ve borrowed money and have to pay a small amount of interest for the privilege. The bond is the reverse of that.
A bond’s payment determined by the prevailing interest rates, how long the money is leant out, and the creditworthiness of the lender. Just like you have a credit score, bond issuers are rated in a similar fashion. Longer term bonds from companies with lower ratings are going to have higher returns compared to short term loans to larger, more established companies. Again, there is a risk and reward trade off.
Many bonds are sold at a ‘par’ value of $1,000. While the money is out on loan, there are periodic interest payments to the investor. These payments are called a coupon, and typically pay the investor twice a year. As an example, if you bought a $1,000 bond with a 7% coupon, you would get $35 twice a year for a total of $70 that year. Bonds allow investors to create an expected income stream, which is a reason why they are also referred to as fixed income investments.
The coupon payouts are based on the current interest rates, the risk involved, and the timeframe of the investment. Once the bond term is up, the bond holder’s initial investment is returned to them, which would mean that you would receive your $1,000 back in the example above. Loaning money is the more conservative of the two approaches. You can usually expect to have your money returned to you. If the entity you leant money to were to go bankrupt, your debt is considered a senior obligation… a fancy way to say that your loan has to be paid back before the company pays off it's other debts.
Ownership – Equity Stake
When you think of investments, most of you are thinking equities, which are commonly known as stock. The reason most people thinks about stocks is because they're ‘sexy’. The news covers people who make it big by taking huge risks. You don’t hear about dot com billionaires making their money on bonds. When people make it big, they make it big with stocks.
The reason people can make it big with stocks is that equity is an ownership stake in a company. Think about starting your own business. You put your money into the company. You take the risks if it fails… But if you make it big, you get to keep everything. Considering that 95% of businesses fail in the first five years, you can see why the rewards for success can be so high.
When investing in a stock, there is unlimited potential for growth. Unfortunately, there is no protection from losing your entire investment. As a part owner of the company, you’re allowed to vote on the direction the company is heading. You’re also receive part of the company profits in the form of dividend payments. These payments are not guaranteed and cannot be counted on the same way a fixed income payment can.
Large established companies tend to have stable share prices with reliable dividend payments. Smaller companies can offer explosive growth, but also are the kind of companies that fail first. There are as many possibilities for investment growth as there are companies. Making choices on investing in individual companies is a risky proposition. One where most people will lose money on.
So Where Should I Invest?
When stocks do well, there is a tendency for investors to sell their bonds and rush into the stock market. When the markets become turbulent, people flee stocks and move to bonds. So how do you anticipate these market movements? You shouldn't... and you can’t. Most sophisticated hedge fund managers actually lose money for their clients (even if they are making a killing on fees). Accepting what you don’t know is an important aspect of investing.
The most basic part of investing is building a plan for your goals. As an advisor, my job is to keep you on track towards those goals. Part of that is investing. Since neither you nor I can predict the future, my job is to create a portfolio that balances risk with returns. This means that I have to spread the money out in as many places as I can. This is diversification.
Here, I talked about the how the markets evolved and the two fundamental investment types available. In our next conversation, Investment 102, I’ll explain how I balance risk and returns. From there, I will explain the products you can use to spread risk around. Hopefully, you’ll walk away from this with a better armed for future investment conversations.