I hope we can all agree there are three ingredients for building wealth regardless of how much money you make. When these three elements are combined and mixed seamlessly, they have the power of creating an explosive reaction that will yield fantastic results for you. On top of it all, you have the power of “compounding” which acts a catalyst to accelerate the rate at which your money will grow with time. This all sounds great but you can’t help but think about all the investment vehicles that are out there and how in the world you’re supposed to know the one(s) you should choose to make sure you increase your chance of achieving financial independence. Assuming we got the capital down and we definitely see the value in starting earlier how do we pick the appropriate choices that will maximize our rate of return?.
In a previous post, I showed the value of time; however, when you add the other two pieces and try to do the math, it’s important to realize there’s no way you or I can predict the future in terms of rates of returns we’ll realize in our investments. To say we’ll see a 4,6,8,10% is somewhat inaccurate; nevertheless, data suggests the stock market has returned on average a 7% for long-term investors. If you still feel uncomfortable with this number don’t sweat it, use a number you like and just run with it. In my opinion, all models are wrong but there are some that are useful.
I know you’re probably about to start yelling at me saying … dude, past performance is not an indicator of future performance. To those of you thinking this way, I would say … You’re absolutely right and you just made my day; however, for the purpose of performing sensitivity analyses you need to make an assumption and you might as well use a historical average. As long as you’re aware this is not THE magic number you should be fine.
Since we are talking about the stock market why don’t we start with its definition. According to Investopedia, “the stock market refers to the collection of markets and exchanges where the issuing and trading of equities (stocks of publicly held companies), bonds and other sorts of securities takes place, either through formal exchanges or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership.”
I kind of like the end of that definition … “slice of ownership”.
A couple of keywords jump out that are worth expanding such as stocks and bonds; however, there are other ways you can go about investing. From a high-level standpoint, let’s look at the most popular ones:
- Mutual funds
- Exchange Traded Funds (ETFs)
Each of these options has its positives and negatives. Understanding how they all work in terms of risk and return is imperative so that you can make informed decisions that are in line with your personal goals. Look at the following chart, what’s your take on it?
I hope you’re not thinking … “Holly crap, I’m going to put all my money on stocks because that’s the vehicle that will give me the biggest bang for my buck”. Instead, I would like you to think about your goals, your personal situation and some questions that might come handy:
- What are the fees and expenses of the underlying options within the investment vehicle(s)?
- Is there a cost to get in and a cost to get out?
- Are there any management fees and if so how much are they?
Since neither of us has control over what the market can or will do, I encourage you to focus on the only thing you can control, i.e INVESTING COSTS. I truly believe that getting answers from these questions will increase your overall chance of success regardless of the investment vehicle (to some extent) you end up going for.
Let’s dive into some of them …
Stocks, or equity investments, are pieces of the corporate pie. When you buy stocks or shares, you own a slice of the company and you get to be called a stockholder or shareholder. Why would you buy a stock? … just like any type of investment, you expect to get something in return. Having said that what can a stock do for you and what rights do you have as a shareholder? Well, you can …
- Participate in the company’s success via increases in the stock price
- Receive dividend that the company might declare
- Sell your shares to somebody else
- Vote in shareholder meetings
When a company issues stock, it gets the proceeds from that initial public offering (IPO). After that, shares of the stock are traded, or bought and sold amongst investors. The price of the stock is not fixed. Based on offer and demand (in some cases driven by irrational behavior) they move up or down which can cause a gain or a loss for us investors. In general, stocks tend to provide greater returns than bonds simply because there are more unknowns. The less you know the higher the risk so, if you want to be invested 100% in stocks fasten your seatbelt and be ready for a bumpy ride!
Bonds are loans that investors make to corporations and governments. We, as lenders, earn interest, and the borrowers get the cash they need. The interest is paid over a fixed term or period of time and when the bond matures at the end of this term, the principal is repaid to the investor. That’s why bonds are also known as fixed-income securities. That’s one reason a bond seems less risky than stocks whose return might change dramatically in the short term.
Bonds can be purchased as new offerings or on the secondary market, just like stocks. A bond’s value can rise and fall based on a number of factors, the most important being the direction of interest rates. Bond prices move inversely with the direction of interest rates. Why? simple. Imagine you purchased a bond that pays 3% semi-annually for a period of 3 years and you want to sell it. Now assume, interest rates have gone up such that available bonds in the market are paying 5%, why would an investor buy a lower interest bond? In this case, the value of your bond would drop, hence it would be trading at a discount. The opposite is true. If interest rates were to drop your bond value would go up making it trade at a premium. The bottom line is this. The market value of a bond will fluctuate as interest rates rise and fall.
Most investors, including me, agree that it’s smarter to own a variety of stocks and bonds than to gamble on the successful performance of just a few equities. If you want to keep things simple without spending a lot of time and money then I got one answer for you … mutual funds.
A mutual fund is a pooled investment vehicle managed by an investment firm like Vanguard, Fidelity, T.RowePrice and others. These companies allow investors to have their money invested in stocks and bonds. Since a fund can own hundreds of different securities, its success is not dependent on how one or two holdings do. As a result, mutual funds (when done right) allow small investors to get diversification from day one.
My favorite mutual funds are the ones investors refer to as passively managed index funds. Instead of hiring a fund manager to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible.
Because index funds hold investments until the index itself changes, they generally have lower management and transaction costs. They offer broader diversification by giving you exposure to potentially thousands of securities in a single fund and since they generally don’t trade as much as actively managed funds might, they typically generate less taxable income, which reduces the drag on your investments.
Just to be clear, I don’t want to give you the impression that mutual funds have no risk. Despite the diversification you get, gains or losses can still be realized just like you would with individual stocks or bonds.
Exchange Traded Funds (ETFs)
ETFs or exchange-traded funds are another favorite of mine. These guys act like mutual funds in many respects, but instead of being valued and traded after market closing, they are traded on the stock exchange during the trading day just like shares of stock. For every passively managed index fund, you’ll find its corresponding ETF.
You might be asking yourself, given the option of picking one or the other which way should you go?. It’s simple, it depends. For instance, in 401ks you’re limited to the options available in your employer’s sponsored plan; however, you get more options in both tax-deferred accounts like IRAs or HSAs and of course taxable accounts. For example, all holdings in my 401k, IRAs and HSA are passively managed mutual index funds; however, my Betterment account holds low-cost index funds in the form of ETFs.
The discussion between mutual funds and ETFs is one that gets a lot of attention. Since there are pros and cons with each option instead of making this post longer than what it needs to be, I’ll write a separate post on this particular topic.
- Spend less than you earn so that you have the capital to invest
- There are different investment vehicles such as stocks, bonds, mutual funds, ETFs and others that I considered alternatives. I’ll cover the latter in future posts.
- Focus on the only thing you can control … Investment costs!
- The two investment vehicles that I strongly recommend and that happen to be the ones where I park the core of my portfolio are passively managed index funds in the form of both mutual funds and ETFs.