Basic Concepts of Investing
by David Bender (Retired)
In the America of today learning about
how money works will give you a greater return
on you education than almost any other study
Buying and Selling Stocks
Whether you are buying or selling a stock a transaction takes place. When you sell a stock somebody else just bought it. When you buy it somebody else just sold it. A transaction only happens when you have someone willing to sell and someone else willing to buy.
You will need a Brokerage account in order to buy and sell stocks. Investors often use Full-Service Brokers while Traders prefer using a Discount Broker. A Full-Service Broker costs more but they can give you valuable investment advice, Discount Brokers cannot.
All stock transactions take place on Exchanges. You can either ask your broker to make the Trade for you or place the Order yourself on a broker’s website.
You may deal directly with a Mutual Fund company (there are several good ones) in order to buy and sell funds.
Exchanges are a place where sellers list how many shares of a stock they want to sell and how much they want for each share. The 2 best-known exchanges are the NY Stock Exchange and the NASDQ. Your broker will show you 3 things.
- The Asking Price – The price somebody is willing to sell their shares for
- The Bid Price – The price people are offering to pay for a share
- The Current Trading Price – The last price that they transacted at
The difference between the Bid and Asking Price is known as the Spread. In an orderly market the spread will usually be only one or two cents. But there are a couple of factors that can make it bigger than that.
- Very few people willing to sell or buy that stock
- People being unsure if it is going to change direction (If the price has been climbing, it may start going down and visa versa)
- A lot of uncertainty about what the price should be (when the price is rising or falling rapidly the spread will grow quite large)
Looking at the spread can give you a feel for the degree of risk you are taking if you want to buy or sell.
The Trading Price
In an orderly market there will be several transactions taking place every second. Usually you will see a Trend developing over time where either the Prices are tending up or heading down.
Prices go up when people believe that others will want to pay even more for it and they can sell their shares for more than they paid for them. Prices go down when people no longer want the stock and want to sell it.
The main reason people sell is they believe that its price has peaked and will either not grow any more or will start falling.
Both trend directions become self-fulfilling prophecies. Trends are controlled by two principles: Greed and Fear. When people see the price of a stock going up or down they believe that the people buying or selling it know something that they don’t so they jump on the bandwagon. This, in turn makes others do the same and soon you have a trend developing. Often there is no real basis for the trend except that everybody wanted to take advantage of whatever was happening.
These typically are short-term trends and are followed by a rebound in the price towards where it had been before the frenzy of buying or selling.
Long and Short-Term Trends
Trends are a general pattern of a stock’s price going up or down over time. The length of time becomes important because a Trader may only be interested in very short-term trends (what’s going to happen in the next few minutes or hours) whereas an Investor might be interested in long-term trends (over the next few years or even decades). Charts are very handy for helping us spot trends.
Charts are not only supplied by your Brokerage but also by independent free charting services like Google or Yahoo Finance.
A normal chart will plot the trading price of a stock over time. At a glance you can see if it is going up or going down. Interactive Charts give you the ability to change the time frame. Typically they can be set so the entire chart covers just one day or a week or 3 months or a year. Often you can extend or reduce those settings. Even if you are a short-term investor it is sometimes helpful to look at a longer period of time to get a sense of the general trend.
Most charts come with some built in tools for doing Technical Analysis. This is a method of estimating the duration of a trend and at what the selling price the trend might end. There are a few of these tools built into the free charts. There are also some specialty charting services and brokerages that provide some additional advanced analytical tools.
Remember there are no crystal balls that can see into the future. All these tools do is give you a feel for the likelihood of something happening. Since they look at different metrics (money flow, the number transactions, changes in price, etc.) it is considered a good practice to use several different types of analytical tools together to help make your buying and selling decisions.
There is another commonly used approach for making long-term investing decisions. It involves looking at the strength and financial health of a company. These are collectively known as its fundamentals. If you favor this approach the best way to get that information is to talk to your stockbroker. Both mutual funds and ETFs (Exchange Traded Funds) buy stocks using this approach.
Investing in shares of individual companies is inherently more risky than investing in funds. A company can suddenly have a problem or a new competing product may appear that changes the value of its stock. [Many commuter rail services went broke when commercial airlines became popular. When I was young GM was considered a Blue-Chip stock. It would have gone broke if President Obama hadn’t stepped in.]
Because each fund invests in dozens or even hundreds of different companies they are usually immune to that type of problem. Specialty funds, known a Sector Funds, still carry some of that risk because they have very little diversity in the companies they invest in. [Funds that only invested in oil lost a lot of value when the prices of oil fell from $140 a barrel to $40. Funds that exclusively invest in Greece almost went way down when Greece declared bankruptcy.]
Even when investing in Mutual Funds a good Portfolio will have a mix of Conservative and Aggressive funds in it to create Diversity in your holdings. Diversity is your best defense against the unexpected.
The 4 Types of Funds
- Bond – Very Conservative – They do best when we are going into a recession.
- Value – Conservative to Aggressive – They do best when we are coming out of a recession.
- Growth – Aggressive – They do best when the market is hot.
- Specialty/Sector – Generally Aggressive – These funds invest in Sectors of the market. They could be geographic like a China fund, or an industry like Technology or an ideology like Non-Military funds. They do best when that sector is growing.
Depending upon your age, a healthy portfolio should be made up of a different percentage of all 4 types of funds. The younger you are the more Aggressive you can afford to be.
Mutual Funds vs. ETFs
Mutual Funds are generally for the long-term investor. ETFs are for the trader or short-term investor.
Mutual Funds are only bought and sold either by the fund company or a Broker. They come in Load (you will be charged a fee for buying them) and No-Load (There is no fee for buying them) types. When you buy funds with a Load from a full-service broker they will both educate you and advise you. When you buy No-Load funds you must do your own research. People who prefer No-Load funds may prefer to look at ETFs.
ETFs are Exchange Traded Funds. They are like no-load mutual funds except that you can buy and sell them just like stocks at any time during the trading day. The price of mutual funds is set only once a day at the close of trading.
Cycles in the Market
The price of stocks varies like the waves (short-term variations) in the ocean. With each wave the water goes up the beach and goes back out again. In the Market this can happen several times a day. Then there are the tides (longer Trends) that move in and out so slowly that you need charts to see them but over time they have much bigger effect on the price than the individual waves. Traders watch the waves, while the Investors watch the tides.
To track the general movements of the stock market as a whole, analysts use Indexes (a group of company stocks that they watch). A common index used to track the market is the S&P 500 (500 of the top companies as selected by Standard & Poors).
Despite the ups and downs, historically the index of the S&P 500 doubles in value every 4 to 8 years, with an average of 6 years. This has been true for the last 120 years for any 30-year period. The longer your investment horizon the more you can depend upon this being your average growth. The shorter your investment horizon the more it resembles the waves in the ocean. [Since the market crash of 2008, the market has not followed a normal growth pattern.]
Some people just invest in Index Funds. These are funds that are made up of same companies used to create an index. There are many Indexes and funds that follow them (energy, biotech, technology, shipping, etc).
Mutual Funds – The Real Rate of Return (ROR)
The amount of money that a fund makes or looses in a year is called its ROR. It is usually represented as a percentage of your original investment. The Real ROR of a Mutual Fund and of some stocks and bonds is higher than the chart would indicate. What you see on a chart is just the trading price but there are actually 3 different things that make up the real ROR:
Appreciation – That’s price you see on the chart. This is usually the only ROR for stocks.
Capital Gains – A fund buys and sells stocks and bonds. Capital Gains is the profit that the fund makes with those sales.
Dividends – Their bond holdings pay regular Dividends. That money is also passed along to you.
Both the income from the Capital Gains and Dividends are generally used to buy you more shares in the fund. So even though the price of the shares may only change a little, your ROR will go up faster because you have more shares. E.g. the chart of a bond fund may stay flat but it might have a ROR of 6% because of the Dividends that it pays.
Ways to Improve Your ROR
Dollar-Cost-Averaging and Rebalancing
These are investment strategies that often will increase the Rate of Return of your investments.
- Dollar-Cost-Averaging involves investing a fixed amount of money every month in one fund.
- Rebalancing involves buying and selling different funds to maintain a predetermined percentage balance between Conservative and Aggressive funds in your Portfolio.
If the normal expected average ROR is 12%, using these investment strategies might increase it by 1 or 2%.
Investment Growth Calculations
The Rule of 72
It states that if you divide 72 by the ROR, it will give you approximately the number of years that it will take for an investment to double in size. So a 12% ROR will double in size in 6 years (72/12=6).
When you invest, Compound Interest is your best friend. When you borrow money it’s your worst enemy.
For simplicity let’s say your investment doubles every 5 years and you have invested $10,000. After 5 years it could be worth $20,000. After 10 years, $40,000. In 15 years, $80,000, and in 20 years $160,000; the last 5 years are usually the most important. As you can see the sooner you start the more money you have at retirement age.
If a 15-year-old invests just $3 a day for only one year, they will have an extra million dollars waiting for them during their retirement. It’s all about time, baby.
Retirement (The Elephant in the Room)
It is now clear that people who do not have an additional source of income will not be able to stop working. It is also clear that once you are over the age of 65, it is hard to find decent paying work. Since Social Security is not increasing, for most people it will come down to either investing for their retirement or not retiring. But the problem is even worst than that because prices of everything are continually going up. The most important reason for investing is to ensure that you will be able to retire in comfort.
The Cost of Living
The real Cost of Living has been doubling every12-15 years. So if you’re planning to retire in 15 years, it will probably cost you twice as much as it does today to keep the same standard of living. In 30 years it will cost 4 times as much. If a person needs $3,000 a month to retire today, in 15 years they will need $6,000 a month and in 30 years, $12,000 a month just to keep the same standard of living as they have today.
Since good investments double on average every 4-6 years, while the Cost of Living takes 15 years to double, it becomes clear why a person should invest for retirement as soon as possible. This is one way of leveraging your money.
Planting A Money-Tree
To create a Money-Tree, plan ahead and give it a lot of time to grow. Remember it will double on average every 5-6 years. To make it last forever do not withdraw more than the ROR of your portfolio each year or as a rule of thumb, 3% of your portfolio’s value.
The 16-Year Plan
If you invest a constant amount of money each month, after 16 years you will be able to stop investing and start withdrawing twice as much as you invested each month. For example, if a person invests $1,500 a month for 16 years, after that they can start withdrawing $3,000 a month. Over their lifetime the amount that they can withdraw will keep increasing and will actually keep up with the increase in the cost of living. Not only that when you die it will keep on giving to your children.
This plan is excellent for a high school graduate who can still live at home an invest everything he makes. If he wants to go to college he will have a steady income without working in his 30’s. This extra income will be very handy when they have a family to support.
Investing for your children and Grandchildren
You will give your children the freedom to live the life that they want if they know that their retirement and that of their children is already taken care of.
The rule of thumb is that however much you need to invest for your own retirement, it will take 1/10th that to cover a child’s retirement and only 1/100th that to cover a grandchild’s retirement. Let’s say you are young enough to be able to cover your retirement needs by investing $200 a month. If you start at the same time investing for a future child, you can fund their retirement by adding only $20 a month and a future grandchild for an additional $2 a month. You can pass this money on to them both inheritance and income tax-free if you use the Stretch Provision.
The Stretch Provision
A provision in the tax code that allows you to pass a Roth IRA on to your heirs so that when they withdraw the money from the account they won’t have to pay any income tax on its growth. It must be set up through your broker.
Options – Calls and Puts
Calls and Puts can be thought of as two types of insurance policies that investors can take advantage of.
Calls – Guarantee that you can buy a stock at today’s price sometime in the future. Let’s say you think a stock is going to go up in price but you’re not sure. Instead of buying the stock you can buy a Call, for about 1% of the price of the stock. That Call will give you the right to buy the stock at today’s price in the future if you decide you want to. That way you can keep the bulk of your money free until you make a decision.
Puts – Guarantee that in the future you can sell a stock at today’s price. Let’s say you own some stock and you’re afraid that its value may fall. You can buy a Put that will guarantee that you can sell the stock at today’s price even after it falls.
Since Calls and Puts cost money to buy, you need to calculate if the expected change in the value of the stock is worth the cost of the Option. If you do not make use of the Option, you may be able to sell it to somebody else. If you do not use it and just let it expire will not get your money back. The closer you get to its Expiry Date the less it’s worth.
Unlike stocks, all Options have a built-in Life span. At the end of which they Expire.
Some Traders buy and sell Options just like they would stocks. They buy a Call and if the price of the Underlying Stock goes up they can sell it for more than he paid for it. If the stock starts to go down they might sell it for less than they paid for it in order to salvage some of their investment. It’s the same with Puts, just in reverse.
Option Tax Strategies
Traders like stocks that are very Volatile. These stocks can go up or down a lot and back again in the same day. These Traders can use Options as an important tax strategy.
When you do your taxes, if you sold a stock at a loss, you can use that loss to offset your Capital Gains. But if you decide to buy the stock back again in less than a month it is called a Wash Sale and you loose the ability to use that loss as a tax write-off. So if the sock turns around and starts to climb, instead of buying the stock back some Traders will buy a Call on that stock and then sell the Call for a profit after the stock goes up, thereby keeping the Loss write-off in place for their taxes while making a profit on the stock’s gain.
People have developed some complex strategies for buying combinations of Options so that they never loose but they also severely limit the amount that they can make.
I’ve given you the touchstones to a wide range of topics around investing. It will give you enough to start asking good questions. Every person’s situation is unique and what is right for one may not be right for another. There are some areas that I did not mention at all, like how to get out of debt quickly, but you have enough here to begin.
I will be available to answer general questions for free or do your personal financial needs analysis for a fee. A financial education is power. In the America of today learning about money will give you a greater return on you education than almost any other study.
I have other writings that deal with debt reduction, insurance, financially strategic thinking and even the politics of money. Banks and other large financial institution will take advantage of your ignorance to your disadvantage. It could end up costing you millions of dollars over the course of your lifetime.