INVESTING IN STOCKS & BONDS

 

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Stocks Are Ownership Stakes, Bonds are Debt

Stocks and bonds are financial assets, which are claims to cash flows from the investment in companies. Stocks and bonds represent two different ways for an entity to raise money to fund or expand their operations. When a company goes public and issues stock, it is selling a piece of itself in exchange for cash.

When an entity issues a bond, it is issuing debt with the agreement to pay interest for the use of the money.

Stocks are simply shares of individual companies. Here’s how it works: say a company has made it through its start-up phase and has become successful. The owners wish to expand, but they are unable to do so solely through the income they earn through their operations. As a result, they can turn to the financial markets for additional financing. One way to do this is to split the company up into “shares,” and then sell a portion of these shares on the open market in a process known as an “initial public offering,” or IPO. A person who buys Stock, is therefore buying an actual share of the company, which makes him or her a part owner – however small. This is why Stock is also referred to as “equity.”

Bonds, on the other hand, represent debt. A government, corporation, or other entity that needs to raise cash borrows money in the public market and subsequently pays interest on that loan to investors.

Each bond has a certain par value (say, $1000) and pays a coupon to investors. For instance, a $1000 bond with a 4% coupon would pay $20 to the investor twice a year ($40 annually) until it matures. Upon maturity, the investor is returned the full amount of his or her original principal except for the rare occasion when a bond defaults (i.e., the issuer is unable to make the payment).

The Difference Between Stocks and Bonds for Investors

Since each share of stock represents an ownership stake in a company – meaning the owner shares in the profits and losses of the company - someone who invests in the stock can benefit if the company performs very well and its value increases over time. At the same time, he or she runs the risk that the company could perform poorly and the stock could go down – or, in the worst-case scenario (bankruptcy) – disappear altogether.

Individual stocks and the overall stock market tend to be on the riskier end of the investment spectrum in terms of their volatility and the risk that the investor could lose money in the short term. However, they also tend to provide superior long-term returns. Stocks are therefore favored by those with a long-term investment horizon and a tolerance for short-term risk.

Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors for whom income is a priority. Also, bonds are less risky than stocks. While their prices fluctuate in the market – sometimes quite substantially in the case of higher-risk market segments - the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.

Which Is Right for You?

Many people invest in both stocks and bonds in order to diversify. Deciding on the appropriate mix of stocks and bonds in your portfolio is a function of your time horizon, tolerance for risk, and investment objectives.

Source: The Balance 

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HOW DO I START INVESTING IN STOCKS IN BONDS?

All investments come with risk. Before you begin investing money in the stock market, it is critical to know how much you can afford to invest and how much risk you can afford to take. 

The easiest and safest way for the everyday person to invest in stocks and bonds is through Diversified Funds such as mutual funds, index funds, and ETFs (exchange traded funds). All of these funds allow you to invest in the stock and bond market without having to do hard work of analyzing and picking out the securities. Fund managers do all of the hard work of finding the right mix of investments and all you have to do is invest your money in the funds.

Diversity reduces the risk of investing. It is riskier to invest in one single company than to invest your money into 10 different companies, because if that one company goes bad then all your money is gone. If your portfolio is diversified, the other companies can make up for a few companies that have went bad. 

 

Mutual Funds

Put simply; a mutual fund is a pool of money provided by individual investors, companies, and other organizations. A fund manager is hired to invest the cash the investors have contributed, and the fund manager's goal depends on the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year (very few funds actually achieve this; to find out why, read Index Funds - The Dumb Money Almost Always Wins).

Closed vs. Open-Ended Funds, Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.

  • Closed-End Funds
    This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.
  • Open-End Funds
    A majority of mutual funds are open-ended. In a basic sense, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.
    • Load vs. No Load
      A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No-load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.

What are the benefits of investing in a mutual fund?

Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. It provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.

How do I select a fund that's right for me?

Every fund has a particular investing strategy, style or purpose; some, for instance, invest only in blue-chip companies. Others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is absolutely vital; if you don't know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.

 

What Are Index Funds?

To understand what an index fund is, you first need to understand the definition of an index.  

An index doesn't actually exist in a sense.  Rather, it is an academic concept; an idea.  Basically, it amounts to a person or a committee of people sitting down and coming up with a list of rules as to how to construct a portfolio of individual holdings because, in the end, the only thing you can actually do is invest in individual common stocks or bonds, presuming we're limiting our discussion to equity and fixed income markets.

For example, the most famous index of all time, the Dow Jones Industrial Average, is a list of thirty blue chip stocks.  This list is to be made up of a representative collection of stocks that are important to the economy of the United States.

 The shares are weighted based on stock price and adjustments are made for things such as stock splits.  The stocks on the list are selected by the editors of The Wall Street Journal.  Historically, the DJIA has been highly passive as changes are somewhat rare.  The Dow Jones Industrial Average has beaten many other indices, including the S&P 500, over long periods of time by a meaningful margin on a compounded basis even though the year-to-year results deviate and frequently appear small.

Speaking of the S&P 500, it is now, perhaps, the most widely discussed index in the world.  Short for the Standard and Poor's 500, it was first launched in 1957.  The S&P 500 has a more complex methodology than the Dow Jones Industrial Average.  I've written extensively about the fact that, in the past decade, the S&P 500's methodology has been quietly changed in ways many inexperienced investors won't understand but that, had they been in place in the past, almost assuredly would have lowered the returns the stock market index generated.  Investors today are largely clueless that what they are getting is not their grandfather's S&P 500.  At some point, you enter a Ship of Theseus paradox and you have to wonder, at what point you are dealing with an entirely different thing.

In any event, an index fund is simply a mutual fund that, instead of having a portfolio manager making selections, outsources the capital allocation job to the individual or committee determining the index methodology.  That is, if you buy a Dow Jones Industrial Average index fund or ETF (an ETF, or exchange traded fund, is a mutual fund that trades like a share of stock throughout the day rather than settling at the end of the day like an ordinary mutual fund; often same portfolio, same underlying holdings), you're really just handing over the job of managing your money to the editors of The Wall Street Journal.

 If you buy an S&P 500 index fund, you're really just handing over the job of managing your money to a handful of people at Standard and Poor's.  In the end, you still own a portfolio of individual stocks, it's just held in a pooled structure with a portfolio manager over it who is responsible for getting results as close to the index as possible (known as "tracking").

What Are Index Funds?

Exchange-traded funds are one of the most important and valuable products created for individual investors in recent years. ETFs offer many benefits and, if used wisely, are an excellent vehicle to achieve an investor’s investment goals.

Briefly, an ETF is a basket of securities that you can buy or sell through a brokerage firm on a stock exchange. ETFs are offered on virtually every conceivable asset class from traditional investments to so-called alternative assets like commodities or currencies. In addition, innovative ETF structures allow investors to short markets, to gain leverage, and to avoid short-term capital gains taxes.

After a couple of false starts, ETFs began in earnest in 1993 with the product commonly known by its ticker symbol, SPY, or “Spiders,” which became the highest volume ETF in history. There are now estimated to be over $1 trillion invested in ETFs and nearly 1,000 ETF products traded on U.S. stock exchanges.

Types of ETFs

  • Market ETFs: Designed to track a particular index like the S&P 500 or NASDAQ
  • Bond ETFs: Designed to provide exposure to virtually every type of bond available; U.S. Treasury, corporate, municipal, international, high-yield and several more
  • Sector and industry ETFs: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
  • Commodity ETFs: Designed to track the price of a commodity, such as gold, oil, or corn
  • Style ETFs: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
  • Foreign market ETFs: Designed to track non-U.S. markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index
  • Inverse ETFs: Designed to profit from a decline in the underlying market or index
  • Actively managed ETFs:Designed to outperform an index, unlike most ETFs, which are designed to track an index
  • Exchange-traded notes:In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes
  • Alternative investment ETFs: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing

How ETFs work

An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.

Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.

Advantages of ETFs

The appeal of ETFs to individual investors is:

  • Buy and sell any time of the day: Mutual funds, in contrast, settle after the market close
  • Lower fees: There is no sales load, however, brokerage commissions do apply
  • More tax efficient: Investors have better control over when they pay capital gains tax
  • Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders (limit orders, stop-loss orders, buy on margin) which are not possible with mutual funds

Disadvantages of ETFs

While superior in many respects, ETFs do have drawbacks, including:

  • Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund
  • Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread
  • Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies
  • Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale are not technically available to reinvest for 2 days.

Investing strategies

Once you have determined your investment goals, ETFs can be utilized to gain exposure to virtually any market in the world or any industry sector. You can invest your assets in a conventional fashion using stock index and bond ETFs, and adjust the allocation in accordance with changes in your risk tolerance and goals. You can add alternative assets, such as gold, commodities, or emerging stock markets. You can move in and out of markets quickly, hoping to catch shorter term swings, much like a hedge fund. The point is, ETFs give you the flexibility to be any kind of investor that you want to be.

What the future holds

Innovation has been the hallmark of the ETF industry since its beginnings less than 25 years ago. Undoubtedly, there will be new and more unusual ETFs introduced in the years to come. While innovation is a net positive for investors, it’s important to realize that not all ETFs are created equal. You should investigate carefully before investing in any ETF, carefully considering all factors to ensure that the ETF you choose is the best vehicle to achieve your investment goals.

Sources: The Balance , Fidelity