Investing Basics: What You Should Know – Part 1

We live in a world with flashing red charts, photos of stock market traders in despair, and sound bites from the media making the world of investing sound thrilling. I have a message most people do not like to hear.

Investing should be boring. 

In the words of Paul Samuelson, an American economist, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” 

Can you make some parts of investing exciting? Sure, but only after the basics are learned, a plan is in place, and you are consistently making progress towards your goals. 

Until then, stick with the basics. As with anything else in life, you can add complexity later. 

Also, investing is not for everyone. If you have $50,000 in credit card debt at 20%, there is a very good chance you should focus on paying down the credit card debt before investing.

Because investing involves committing money with the expectation of earning a future return, you likely should not start investing until you have excess funds not needed for today.

Saving and expenses are for today. Investing is for the future. Take care of today before you take care of the future. Otherwise, you could jeopardize today. And, make sure you have your emergency fund.

I am going to talk about a few investments as examples in this piece. This is not a recommendation to buy or sell these investments. This is for informational purposes only. It is not advice. You should do your own due diligence or speak with a financial planner familiar with your individual situation before making any investment decision. 

Although I will talk about investing, I’d encourage you to check out the Securities and Exchange Commission’s Introduction to Investing. The SEC protects investors and enforces the laws about investing. 

Investing Basics: Types of Investments – Stocks vs. Bonds. vs. Alternatives 

Although there is an entire world with a variety of different investments and I could spend multiple posts talking about each one, I will cover a few you are most likely familiar with or going to hear about. 

Stocks, also known as equities (the investment industry loves jargon!), are a share of ownership in a corporation. As an owner, you receive a share of the profits. Your shares of stock can also increase or decrease in price. In other words, you participate in the upside and downside of a company. 

For example, if you buy a stock for $50, and it increases in value to $100, you could sell it and make a $50 profit. Conversely, if you buy a stock for $50, and it decreases in value to $5, you could sell it and lose $45. If the stock goes bankrupt, you could lose your entire investment. 

Stocks tend to fluctuate more in value than most investments. Since stocks are riskier, investors are normally rewarded over the long term with higher returns. Risk and return are related. If an investment carries more risk, it generally has a higher expected return. 

For example, below is a chart of the S&P 500 returns by year from Macro Trends. The S&P 500 is an index of about 500 large-company stocks in the United States. The data from the S&P 500 is useful in this example because its data set goes back more years than other indices.

However, diversification outside the S&P 500 is important. I would prefer to use data from the All Country World Index, which includes stocks from around the world, but the data does not go back as far.

Source: Macro Trends

As you can see, there are plenty of years it has negative performance, sometimes greater than 20%. For example, during 2008, the S&P 500 declined in value by 38.49%. If you had $1,000 invested in the S&P 500, your portfolio value would have declined $384.90 that year, leaving you with $615.10. 

Now, it would have recovered if you, the investor, held onto it and did not sell. As you can see, it went on to have very good returns in subsequent years. But, the volatility can be uncomfortable. 

For example, between 2000 and 2009, the S&P 500 returned about 0% for ten years, often referred to as “The Lost Decade.” Imagine ten years of no returns. That’s another reason diversification is important. A portfolio of US stocks and foreign stocks has never had 0% performance for ten years.

Despite the negative years and uncomfortable ups and downs in the market, the S&P 500 returned just under 10% since 1928. 

Bonds, also known as fixed income, are debt issued by a borrower, typically a corporation or government. It’s an IOU. Instead of participating in the profits of a company, the borrower agrees to pay a certain amount, typically twice a year. They promise to return your principal, the amount borrowed, at maturity, which is when the bond comes due. 

Although bonds carry their own set of risks and fluctuate in value, they tend to be less risky than stocks. I’ll cover a few of the main risks, but there are others. 

Bonds have credit risk, which is the risk the borrower cannot repay the loan. US Treasury bonds are some of the safest in the world, backed by the full faith and credit of the United States. High yield bonds, or known by another name, junk bonds, are bonds with a low credit rating. There is more of a chance the borrower will default on the debt. 

Another major risk is interest rate risk. As interest rates go up, bond prices go down. For example, if a bond has a duration of 5 years and interest rates go up 1%, the bond will generally fall in price by about 5%. For every year of duration, bond prices will move approximately 1% in the opposite direction. 

Finally, inflation is another risk. Since many bonds pay a fixed amount, if inflation drastically increases, the amount you receive is not as valuable. For example, if you have a bond paying 5% and inflation goes up 10%, the payments you are receiving won’t buy as much. Putting it in real terms, if your groceries cost you $50 at the beginning of the year, but inflation is 10%, causing the cost of those same groceries to increase to $55 next year and you were relying on a bond payment of $50 at the beginning of the year, the $50 you receive the following year won’t fully cover the new $55 cost of the groceries.

Bonds have a few main purposes: pay current income, stabilize your investment portfolio, and act as a source for rebalancing. Bonds typically hold their value or increase in value during stock declines, so they can be sold to opportunistically buy stocks when stocks are cheaper.

Alternative investments are a “catch-all” category. It’s anything that does not fit the stock, bond, or cash definition. This is the sexy world of investments. Private equity, venture capital, hedge funds, real assets, and commodities are a few examples. Most people are okay never investing in alternative investments. In fact, there are limitations put in place for some investments where only individuals with a certain income or asset level are able to participate. 

How to Access Investments – Mutual Funds and ETFs

Although you can buy individual stocks and bonds, most people should invest in a basket of stocks or bonds through a diversified mutual fund or exchange-traded fund (ETF). 

A mutual fund or ETF is a basket of investments, such as stocks, bonds, or commodities. For instance, instead of trying to buy 500 stocks in the S&P 500, you can own an ETF that buys and sells those 500 stocks in the same proportion of the index. 

Although individual stock investing can be exciting, investing should be boring. If you are investing in only a handful of individual stocks, you are not investing.

You are speculating. 

Mutual Fund and ETF Differences

There are two major differences between a mutual fund and an ETF. 

Because mutual funds price once per day, they only trade once at the end of the day. If you buy it throughout the trading day, you will buy it at the price as of the end of the day. For example, if the S&P 500 was down 1% at 10 a.m. PST and you placed an order at that time to buy a mutual fund that tracked it, but then the S&P 500 was up 1% for the day at 1:00 p.m. PST (market close), you would pay the price at closing. Instead of buying it when it was 1% down, you would buy it when it was up 1% because with mutual funds, you always pay the price at market close.

An ETF trades throughout open trading hours. Continuing the example from before, if you placed an order to buy an ETF that tracked the S&P 500 while it was down at 10 a.m. PST, you would get the pricing as of 10 a.m. – not as of 1 p.m. like the mutual fund.

The second major difference is ETFs tend to be more tax-efficient than mutual funds. ETFs tend to not have capital gains distributions at the end of the year, whereas mutual funds do. Capital gains distributions are payments from the fund due to the fund selling stocks throughout the year. In a tax-deferred account like a 401(k), this does not matter, but in a brokerage or taxable account, it does. 

A mutual fund or ETF can invest in many different types of stocks. It can have US, international, or emerging market stocks. It can have small company stocks or large company stocks. It can have growth stocks or value stocks. It can have bonds that mature in 30 years or bonds that mature in 1 year. 

ETFs can also be very niche-focused. They could invest in only agricultural companies, cybersecurity companies, or companies that have women on the board. 

If you wanted to own stocks from around the world, you could own the Vanguard Total World Stock ETF (Ticker: VT). For full disclosure, I own shares of VT. As of this writing, it owns 8,807 stocks from North America, Europe, Emerging Markets, and other regions. It’s low-cost, tax-efficient, and broadly diversified. 

Since it’s impossible to know which companies are going to perform well, it’s normally best to own hundreds or thousands of stocks through a diversified index fund. Over time, the positive performing investments have more than made up for any negative performing investments. If you try to guess which companies are going to do well, you may end up with more losers than winners. 

If you want to speculate on a few companies, a good risk mitigation strategy is allowing the speculative part of the portfolio to never comprise more than 5-10% of your overall portfolio. Personally, I would only do this if I was already achieving my goals through the diversified part of the portfolio. You don’t want to risk something you can’t afford to risk. 

More could be said about selecting funds and how they work, but I’ll save that for another day. For this post, I wanted to provide a high-level overview. 

Market History

It’s important to understand what has transpired over the last few decades to make better sense of the market. 

Even though I said earlier I prefer using a global index instead of the S&P 500 to understand market declines, we don’t have as much data for a global index. Because of that, I will reference the S&P 500 again. I recommend looking at this calculator.  

You can input your portfolio balance, assuming it was all invested in the S&P 500, and it will show your portfolio balance after a major decline, how long it took to recover, and what your portfolio balance would have been more recently. 

For example, if you invested $10,000 prior to the Great Recession during 2007 and 2009, your portfolio would have been $4,320 at the bottom of the market decline and took 5 years and 5 months to recover. Despite the decline and long recovery time, your portfolio would have been worth $20,640 as of December 31, 2019.

Source: Nerd Wallet

As you can see, stock market investing can be painful at times, but it has always rewarded those who remain diversified, disciplined, and patient. 

Let’s discuss some of the more difficult times:

The Great Depression

One of the greatest well-known crashes began in September 1929. The Dow Jones Industrial Average dropped 23% in two days on October 28 and 29. The market went on to rise and fall in value for the next few years. At it’s low, the market dropped over 89% in less than three years! We’ve never seen such a large decline since, but it’s important to remember when investing in stocks nothing is guaranteed. Historically, investors have been compensated with higher returns because they can go through times when stocks fluctuate wildly. 

Stock Market Crash of 1987

October 19, 1987, also known as “Black Monday”, is where the Dow Jones fell over 22%. Unlike other crashes that spanned months or years, this one took place over a few days. After the crash, stock market exchanges implemented circuit breaker rules where trading would be slowed or halted during large declines in stocks. 

The Dot-com or Tech Bubble of the Late 90s and Early 2000s

The Nasdaq Composite rose dramatically in the late 1990s up until March 2000, when the bubble burst. It fell over 76% between March 2000 and October 2002. The late 1990s were a time where anything with “Dot-com” in the name seemed to take off. There were grand visions of companies taking advantage of the internet and changing our entire existence. There were feelings of mania and euphoria. Unfortunately, most of these companies were not profitable and had no clear plans to profitability. Eventually, reality overcame speculation and it came crashing down. 

Cisco is an interesting company to learn about because it went public in 1990, had tremendous performance in the 1990s, but crashed during the Tech Bubble and has never fully recovered to its former peak, despite almost 20 years passing. In fact, at its peak, the company was worth about $569 billion, but today is only worth about $164 billion. It’s an excellent example of how people can be irrationally exuberant and stock valuations can get ahead of themselves. 

The Great Recession or Financial Crisis of 2007-2008

The S&P 500 declined over 55% between October 2007 and March 2009. During the Financial Crisis, home values declined, people had trouble making payments, and foreclosures were common. As people defaulted on their loans, the banking system spiraled out of control. Lehman Brothers, a global financial services firm started in 1847, went bankrupt on September 15, 2008, a few months before the stock market bottomed on March 9, 2009. It was the fourth-largest investment bank in the United States before going bankrupt.

Coronavirus Stock Market Crash of 2020

This was the fastest crash in history, starting in mid-February 2020 and lasting until early April 2020. At its low, the S&P 500 dropped about 34%. It recovered fairly quickly, largely due to the growth in technology companies. Like past declines, nobody knew when it would end and the market began recovering despite terrible economic numbers, such as the unemployment rate. It’s important to remember the stock market is forward looking while economic data is backwards looking. It’s natural for there to be a disconnect. 

Although there have been other notable historical events, these are the ones you will likely hear people reference the most. Knowing how much the market declined and what happened at the time should help put future events in perspective during your investing years. 

Below is another good chart from Invesco to put past declines in perspective. Overwhelmingly, markets go up, but markets can fall very quickly and it’s good to expect to go through a 20% decline two or more times every decade. Instead of trying to avoid it, you can understand it’s simply a part of investing. 

Source: Invesco

Although many people may find stock market history boring, it’s important to understand what investors have been through. Without it, you have no idea or expectation for the future. Although the future will always be uncertain and unprecedented, knowing markets have fallen 89% can help put the next stock market decline in perspective. Hopefully, it allows investors to make smarter decisions during market declines and avoid abandoning stocks at the worst possible time. 

After all, you only lose money if you sell. Until then, it’s a paper loss. 

Summary – Final Thoughts

Investing should be boring. Although you can find ways to make it exciting, most people who start by making it exciting usually learn it should be boring. If you can skip that step, you’ll likely save yourself from a few costly and anxiety-filled mistakes. 

Over time, stocks have been drivers of growth and creators of wealth. While bonds normally don’t offer the same opportunity for growth, they help stabilize the portfolio. While stocks are zigging, they often are zagging. In other words, they provide diversification, so 100% of your portfolio is not going up or down at the same time. 

Although you can invest in individual stocks or bonds, research has shown diversified mutual funds or ETFs often have better performance than people trying to pick hot stocks or time the market. Remember, if you own one stock, that stock can go bankrupt and you can lose all your money. If you own thousands of stocks, the only way you can lose all your money is if they all go bankrupt, which is very unlikely. 

Although market declines can be scary, it’s important to put it in context. Markets have fallen 89% before and yet, investors still can have positive returns. The future will always be uncertain. Unprecedented events will happen. That is the nature of investing in stocks – nothing is guaranteed; however, knowing your market history can help provide peace of mind during troubling times. 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for Full Disclaimer

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