Friendships are similar to investing.
For me, I have a core set of really good friends. These are relationships that have been cultivated over years. They are the ones I turn to in times of need. They have similar passions and core values as me. But they also all bring something unique to our relationship that allows both people to be better people… they are diverse.
Then, there are my acquaintances. People that I know and I can hang out with, but we haven’t endured the experiences that I have with my core set of friends.
And then there are the passersby. These are the friends that come in and out of your life depending on your current life situation. Passersby tend to come from past relationships. For me, these are the friends and boyfriends of ex-girlfriends that I hung out with while in that past relationship, but never hung out with after the relationships were over. They came into my life for a bit but have since exited.
Investing is about having a core set of investments that you stick with for the longer term. Sometimes, you may pick stocks for your portfolio for a certain reason and hold them for a short time. Despite the type of investment, the ultimate goal is to be able to diversify (get different types of investments) and hold them for a long term.
Think of the core of investing as your really good friends… that core set that you encounter different experiences with throughout time. And then think of the passersby more like stock picking. These are hit and miss and they don’t stay in your portfolio or life for long.
Before we begin building our core group of friends, we need to learn how to treat people and how to be a good friend—the basics. For investing, it’s the same thing. By understanding the basics, we are able to be better investors and hopefully more successful investors.
The friendly investing supermarket
We constantly see commercials that talk about investments. We see the green line and think of a company called Fidelity. We see a gentle elderly man that says come talk to me… talk to Chuck for a company called Charles Schwab. And we see a talking baby that makes us laugh for the company E*TRADE.
They are great commercials and they intrigue us because we all have this desire to invest and see our money grow. But what exactly are these companies?
Companies like Charles Schwab, Fidelity and E*TRADE are what we call custodians. They hold your money and provide you a vast array of investment options. They are a supermarket for investors.
If we didn’t have these companies, life would be much more difficult. Let’s say we owned Coke stock and wanted to sell it to buy Home Depot. Without these companies, we would have to go the New York Stock Exchange and find someone that was looking to buy Coke and negotiate the price at which we were willing to sell and at which they were willing to buy. Then, we would take our money and find someone who wanted to sell Home Depot and continue the same negotiating.
At these custodians, we are able to buy mostly anything. You can buy stocks, bonds, mutual funds, ETFs, etc. The only limitation tends to be real assets. What this means is that these institutions don’t tend to hold actual gold bars or valuable art work.
So, think of these as your local Kroger or Publix for investing and the commercials should begin to make a lot more sense.
Rapid fire: Four must-knows before starting to invest
A common question that many people have when they begin to invest is where to put the money. Does it go in this IRA thing or what about a Roth, I’ve heard good things about that.
Sometimes the question is also “Should I buy an IRA?” But these are not investments. After you determine which supermarket you like the best, you have to open an account to hold your investments. The options are vast and they include IRAs and Roth IRAs.
Think of these accounts as your shopping basket. You have the choice of the race car basket, the traditional larger shopping cart or the carrying basket used for just a few goods.
Many rules are associated with each type of account, but here I will go through them via a rapid fire format to provide the necessary points to know in order to start. And I will use just four accounts, the ones I deem most common.
- Traditional IRA:Monies contributed before being taxed; Monies are withdrawn and taxed at your ordinary income rate; Can’t touch it (Makes me think of MC Hammer) till 59.5; Monies grow without incurring capital gains or dividend taxes; If under 50, can only contribute $5,500.
- Roth IRA:Monies contributed after being taxed; Monies are withdrawn and not taxed; Can’t touch it till 59.5; Monies grow without incurring capital gains or dividend taxes; If under 50, can only contribute $5,500.
- Brokerage (Taxable) Account:Monies go in after being taxed; Capital gains taxes and dividend taxes paid every year (if applicable); Can use money whenever you want.
- 401k:Similar to an IRA, but provided by an employer; If under 50, can contribute up to $17,500.
To own the company or its debt, that ‘tis the question
As an investor, we have the ability to own a company or we can own the company’s debt.
Think of it this way in relation to housing: do you want to own the house or the mortgage? The house will appreciate or depreciate in value… by owning the house you get that exposure. The mortgage has an annual interest rate in which you are paid. Over time, you get back the amount of the mortgage and your profit comes from the interest rate charged.
With the above example, we have risks on each side. Owning the home the risk is that you need to sell it and the value has gone down. With the mortgage, the risk is that the homeowner defaults and stops making payments. But, with the mortgage you have the benefit of getting the home in the situation of a homeowner defaulting. Thus, you can sell it and get some money back and you have also earned interest for some time.
Thus, owning the mortgage (in this scenario) is less risky.
Within the investing world, we have similar scenarios. As an investor, you can buy Coke stock and own a share of the company. If Coke Zero sales skyrocket and everyone wants one of those new cans… well, your value will likely rise. But if no one has a desire for personalized Coke cans, then your value will likely fall.
Or you can own Coke debt. They will pay you an interest rate every month (similar to a mortgage). But, let’s say one day no one wants Coke anymore (highly unlikely). The company would have to default on their debt and close the doors. But they still have many factories and equipment that they have bought over time. And, they still have outstanding debt (just like the homeowner with their mortgage). So, all this equipment and property would be sold and used to pay us debtholders back as much as they proceeds allow.
Here is a very basic risk spectrum for investments:
Finding the cheaper basket
With investing, we have options of what we can invest in and most people think that you have to invest only in an individual stock or bond.
But there are other options. A mutual fund or an ETF tend to be good options for beginners.
Think of these as baskets, baskets of securities. So, they each hold multiple stocks or bonds within the basket. We could buy a basket that holds Coke, Pepsi and Yum. The benefit is that we are able to buy these three stocks in one security for a price that is less than having to buy a share of each security by itself.
With these baskets, we get instant diversification. Diversification, at its core, is just owning multiple securities (and most desirably different types of securities) as opposed to just owning all of one company. This spreads your risk. Because, it is less likely that 3 or 10 companies fail at the same time as opposed to just one company. That’s diversification. And with these baskets, we get instant diversification because they all hold multiple securities within the one basket.
Now the difference. Mutual funds are trying to outperform a particular index (like the S&P 500 or Dow Jones). So, they have a manager who is buying and selling investments on a continuous basis. And, as an owner of the investment, you have to pay this individual. The total cost of a mutual fund tends to range from 1.5% to 3%.
With an ETF, we get a basket, but we aren’t trying to outperform any index; rather, we are just trying to track it. Instead of trying to win the Peachtree Road Race, we are just trying to stay with the group. And because of this, we don’t have to pay a manager and thus they cost much less. They tend to cost, on average, less than a half of one percent.
Some may ask ‘why do we want to just stay with the group?’ The answer is because research has shown that buying and holding the index (passive management) tends to outperform active management, mutual funds, over the long term (years).
Stick to the basics and simplify investing
By sticking to the KISS (Keep It Simple Stupid) mentality, investing can be a bit easier. It’s when we try to get too cute that investing becomes difficult and the results are not what we want.
When trying to be too cute, I think to my golf game. When I just go out and play the game in a basic manner, I tend to do better. But when I try to be too cute and hit shots that the pros hit or that I haven’t practiced, my game goes to hell in a handbasket.
So keep things simple and progress as an investor. Don’t expect that you can just dive right into the deep end and expect to swim. Start with the shallow end and work up to the deep end. You will be much more pleased with the results.