Investing Principles

Investing Principles

March 12, 2024

*This post highlights Chapter 3 from Mike’s book, Achieving Financial Fulfillment.

Trading is the buying and selling of securities with the hope of making a short-term profit. Investing involves the purchase of diversified investments and holding them for a long period of time.  Most of us would probably classify ourselves as investors by these definitions. Yet when we think of investing, we are more likely to act like traders. Why is that? Consider what you see and hear in the news. The financial media is full of headlines that are designed to catch your eye and your emotions. Article titles such as, “The Top 10 Stocks You Should Own Now” or “Five Things You Need to Know…”, appear often. These kinds of lists grab your attention because they share ideas that appear to be urgent. And don’t we all want to do the best we can with our investments?

We are not only influenced by the financial media. When your best friend tells you about a stock or mutual fund she bought that’s ‘making money’, doesn’t your brain tell you that you should do something, like consider buying it? This reactionary thinking may not lead to sound decision making.  Also, market volatility can be difficult for anyone to handle. You’ll notice in the chart below that both stocks and bonds can experience very high and very low returns in any single year. However, as you move into 5-, 10-, and 20-year investing periods, the range of cumulative returns is reduced greatly, and in every rolling 20-year period since 1950, stocks and bonds ended up with positive results.  It’s best to maintain a long-term focus because your emotions may drive you to get in and out of the market, leading to underperforming the average returns of the market over time.

 

 

Before you begin investing, it’s important to understand some of the standard investment terminology.

Stocks

When it comes to stock investing, focus on companies. In any given year there are many distractions, from the current state of the economy to geopolitical events to gas prices. All of that other data is either a head-wind or tail-wind for companies. For example, will the upcoming election impact how many 2-liter bottles of soda Coca-Cola will sell next year? It might, but odds are good it might not. Companies, unlike commodities such as gold or oil, are run by a management team (no matter how big or small) that are trying to deliver profits to their shareholders. So, investing over time is about going along for the ride as companies navigate the current economic environment and adjust to ever-changing conditions. Not all companies survive forever, so diversification is extremely important!

Stocks give you partial ownership in a corporation, while bonds are a loan from you to a company. In general, a stock investor hopes to have the stock price of the company appreciate in value and be sold later for a gain. Most bond investments are made to earn a fixed amount of interest over time.

When you buy stock, you’re actually purchasing a tiny piece of the company, called shares. For example, if the price of a stock is $25 per share and you invest $10,000, you will end up owning 400 shares ($10,000 / $25 each). As a partial owner you will share in the company’s successes (and failures), so if the stock price rises over time to $50 per share, your investment would have grown to $20,000 (400 x $50 each). You could sell those shares and realize a gain of $10,000, or you can keep holding them into the future.

Bonds

When you buy a bond (similar to buying a bank certificate of deposit), you are purchasing a security that is designed to pay you interest over time for a set period, after which it will pay back the full amount you bought the bond for, called the maturity date. Bonds may sound relatively safe but aren’t completely risk-free. If the company goes bankrupt during the bond holding period, you may stop receiving interest payments or may not get back your full principal.

Real-Life Example

To illustrate how the interest on a bond works, let’s say you buy a bond for $25,000, and it pays 2% annual interest for 10 years. That means every year you would receive $500 in interest payments (2% x $25,000). After 10 years you would have earned $5,000 in interest and then get back your initial investment of $25,000.

Cash

The money you keep in your bank checking or savings account is not intended for investment; instead it is set aside for easy access and potential future expenses. Most brokerage investment accounts also include a cash position that is used to purchase investments, and this is also the place where cash from the proceeds of an investment sale are received and held. Certificates of deposit (CDs), treasury bills, money market mutual funds and high-yield savings accounts are also considered low-risk investments. Some of these may be covered by the Federal Deposit Insurance Corporation (FDIC).

Mutual Funds

Mutual funds are collections of stocks, bonds, or other securities that might be difficult to put together on your own. These collections are called portfolios. The price of the mutual fund is determined by the total value of the securities in the portfolio, divided by the number of the fund’s outstanding shares. This price, called a Net Asset Value (NAV), fluctuates based on the value of the securities held by the portfolio at the end of each business day. Mutual fund investors only own shares in the fund itself and don’t actually own the securities inside the fund.

ETFs

Exchange-traded funds (ETFs) combine both the aspects of mutual funds and those of individual stocks. Like a mutual fund, an ETF is a pooled investment fund in a portfolio of investments. But unlike mutual funds, ETF shares trade like stocks on an exchange and can be bought or sold throughout the day. In addition to low fees, most ETFs have low turnover (buying and selling within the fund), which helps to keep down the amount of capital gains realized and passed on to the individual investor. This may be a way to reduce or minimize your income tax burden.

Standard Deviation (volatility)

Understanding this measurement can provide useful insights when choosing investment options, as not all returns are created equal. Standard deviation is a common statistical measurement of volatility that tells you how far apart all of the values are from the average (or mean) value. Two investments can have the same average return over time but may have taken very different paths to get there.

Real-Life Example

Investment #1:  Year 1 Return of 8%,  Year 2 Return of 12% = Average return of 10%

Investment #2:  Year 1 Return of 0%,  Year 2 Return of 20% = Average return of 10%

As you can see, not all returns are created equal! The volatility would be much greater with Investment #2, even though they have the same average return. In my opinion, dealing with volatility often causes people to make decisions that may not be in their best interest. If you don’t think you would react well with a fund that has wild swings, perhaps you should consider one with a lower standard deviation.

Inflation

Just 45 years ago in 1979, a gallon of regular gas cost $0.86, a first-class stamp cost $0.15, and the Dow Jones Industrial Average hit a high of 907 that year.

907? Really, is that all? The same Dow Jones that as of this writing has been as high as 39,000? Maybe this was just a really great period of time to invest. Maybe there were no significant world events to cause a setback…or were there? What about President Reagan being shot, the 1987 Stock Market Crash, September 11th, the Lehman Brothers bankruptcy in 2008, or the COVID-19 pandemic?

The point is that costs tend to rise over time, and investing in stocks, as evidenced by the Dow Jones, would have allowed you to keep ahead of inflation and grow your money in spite of all the negative world events. Stock investments tend to increase over time because of great companies and their management teams, but make sure you understand the risks before investing!