The securities industry is interested in taking control of your investable funds–yes, to relieve you of the worry; but also, to generate profits for themselves. The best way to protect yourself is to have a basic understanding of the investment landscape. That’s what Investment Boot Camp is all about. So, let’s start with the basics. That is, the basic tools that are available, in one form or another.
STOCKS: Stocks represent ownership in a company, and they are traded in units called “shares”, generally on exchanges, but not necessarily so. When a company grows and requires more capital, the original owners may offer some shares to the general public, in what is called an “IPO”, or initial public offering. New companies, which are in an expansion mode, generally do not pay dividends. Other companies may pay dividends out of their earnings, which can be distributed in cash or re-invested in additional shares, at each individual investor’s option. The Corporate Board of Directors votes quarterly as to whether it will pay (“declare”) a dividend, how much, or whether to pay any dividend at all. Dividends are not necessarily guaranteed in any quarter, regardless of whether they were paid in any prior quarter(s).
BONDS: When a company issues bonds (sometimes referred to as “debentures”), it is incurring debt. Bonds are traded in what are called “par value”, which is the redemption value of specified units, and they are generally denominated in thousand dollar (or Euro, Pound, Yen, etc.) amounts, such as: $1,000, $10,000, $25,000, etc. Most bonds have a stated “coupon” rate, which represents the percentage of interest that the corporation is contractually required to pay annually, and a maturity (or termination) date. Bonds are generally assigned credit ratings by any of a number of rating agencies; however, the three primary ones are: Moody’s; S & P (Standard and Poor’s) and Fitch. Generally, bonds trade on an “over-the-counter” basis, rather than on an exchange.
NOTE: Why do companies issue bonds–and incur contractual payment obligations–rather than stock, when they need additional capital? Let’s say that a company has one million shares of stock outstanding, and the company has “Equity Capital” of (is valued at) $10 million. The stock would then be trading at $10.00 per share. Someone who owns 1,000 shares, worth $10,000, would own one-tenth of one percent of the company. If the company issued another one million shares, however, the ownership of each and every shareholder in that company would be cut (“diluted”) in half. The 1,000 share owner, assuming no change in his/her shares owned or the market price per share, would still own $10,000 in value, but of a (then) $20 million company.
Stocks and bonds are the two basic types of securities. Over the past century, the securities industry has devised other ways to offer “packaged investments” that can provide a diversified assortment of stocks and/or bonds, and sometimes derivatives that may include investments in he commodities and/or foreign exchange markets. With derivatives, you own part of a futures or option contract, but not the actual underlying securities. These include: mutual funds; ETFs (exchange-traded funds); UITs (unit investment trusts); variable and indexed annuities; closed-end funds; market-linked CDs; etc.
For this blog post, I will stick to mutual funds and ETFs. The other investment options, which I have cited, may have some of the same benefits as funds and ETFs; however, there might also be additional risks, hidden fees and excessive disclosure documentation. I had avoided some of these products when I was working as a financial advisor; because, with more than 30 years in the securities business, I just couldn’t feel comfortable with offering them to some clients. That’s especially the case for market-linked CDs, which seem to be targeted to more conservative investors.
Mutual Funds: Mutual funds enable the investor to purchase one or several investments, each of which offers a diversified portfolio, that are usually professionally-managed, as noted above. Some funds, however, are not actively-managed and are merely composed of a stock and/or bond index. Although funds can be purchased as a specific quantity of shares, they are generally traded in dollar amounts. All purchases and sales are executed through the issuing company (i.e. American Funds, Fidelity, Franklin Templeton, Vanguard, etc.). The price of most transactions is set at the close-of-business (4PM EST or EDT in the U.S.) Funds that are issued in other countries would be executed during the respective normal business hours in those countries.
Some funds are purchased with a fee (“load”), while other (“No-Load”) funds do not have one. I believe that a fund’s consistent performance over a period of years, within its category ( i.e. large company, utilities, global, etc.) is more important than whether there is a fee involved in the purchase. For instance, a fee of, let’s say five percent, for a consistently good-performing fund, spread over a ten or twenty year investment horizon may very well outweigh the initial fee. On the other hand, an investor with a very short time horizon, say two or three years, probably shouldn’t be assuming market risk anyway.
ETFs: are mutual funds that trade on an exchange and, just like stocks, the price changes throughout the day. Purchases and sales are always transacted in a specified number of shares. Like stocks and mutual funds, if there are dividends paid, they usually can be taken in cash or reinvested to buy additional shares. Oftentimes, ETFs are based on a specific stock and/or bond index and, as such, the portfolio would contain the good and bad components within the particular index.
I have found ETFs to be an excellent way to invest in a specific country, such as Australia or Israel, where there may not be any mutual funds available. Likewise, it is a good way to fill-in a particular market segment, such as health care or technology, which your portfolio might be somewhat lacking, or you wish to add to. I fully believe in the value of ETFs in a portfolio; however, for some of the primary indices (i.e. Dow Jones Industrial Index, S & P 500, NASDAQ, or EAFE*, etc.), the respective ETFs are often used by institutions to make a quick purchase or sale of a particular market segment. So, at times, there can be some volatility.
NOTE: EAFE is the major global developed markets stock index, excluding the U.S. Canada is also excluded due to its close linkage with the U.S. markets.