Stock Market Basics

For readers who are just starting out in the world of saving and investing, here are the basics of the U.S. stock and bond markets. (The financial markets of other nations can be quite different, so research them separately.) For more detail about the terminology, please look at our Glossary. There’s much more to learn if you want to become an active investor. But you can get an idea of the concepts here.

1. The corporation is an organization. It sells pieces of itself, called “stock,” in order to raise money to conduct business. (In other words, it takes money to make money, for corporations as well as people.) People who buy stock become owners (collectively with all the other stockholders) of the corporation.

2. Stock. When you buy a share of stock, you own a tiny portion of the corporation. The stock will increase in value if the corporation does well, and it will decrease in value if the corporation does poorly. Many people refer to stock as “shares” (as in shares of stock). If you want to invest in a particular stock, research it carefully.

3. Bonds. A bond is a way that corporations and governments borrow money. An investor lends them a fixed amount of money (e.g., $10,000), which is called the “principal.” They pay interest on the bond for a stated amount of time (e.g., 10 years), and then, if all goes well, they repay the principal (i.e., the money originally invested in the bond). Corporate bonds have “credit risk,” meaning the risk that the corporation might be unable to pay them. Government bonds are less likely to have this problem if they are issued by the governments of wealthy nations. But government bonds of less well-off nations can have significant credit risk. The riskier a bond, the higher the interest rate it will have. Be careful investing in bonds that offer a high return—the return reflects a higher risk that you won’t be repaid.

4. Mutual Funds. Mutual funds are a type of corporation used for investment purposes. Their business consists of investing in stocks and/or bonds. When you invest in a mutual fund, you are buying shares of the mutual fund. That gives you an interest in the fund’s holdings of stocks and/or bonds. The value of your mutual fund shares is based on the values of the fund’s holdings of stocks and/or bonds, and will increase or decrease as they increase or decrease in value. Most mutual fund shares are bought or sold at prices based on the values of their holdings of stocks and/or bonds at the close of the financial markets for the day. You usually buy or sell mutual fund shares by directly contacting the company that manages the fund.

Mutual funds can be index funds or actively managed funds. Index funds invest in a way that copies, or mimics, a financial market index, like the Standard & Poor’s 500 or the Nasdaq 100. Index funds have low costs and fees because they don’t have to pay professional money managers to strategize for them. Actively managed funds hire professional money managers to select stocks and/or bonds for them to invest in. These funds have higher costs and fees, because the professionals have to be paid to do the investment strategizing. Some actively managed funds are quite successful. But most do no better, or even worse, than index funds. An investor who is just starting out has relatively little, or nothing, to gain by investing in an actively managed mutual fund,

An exchange traded fund (ETF) is a special kind of mutual fund that can be bought or sold during the hours the stock market is open, at a price that normally reflects the most recent prices for its holdings of stocks and/or bonds. ETFs are bought or sold through stockbrokers.

5. The stock market and bond market are the principal financial markets for investors. They are open for normal trading from 9:30 a.m. to 4:00 p.m., East Coast Time. You can buy or sell stocks, bonds or exchange traded funds during these times. It is possible to buy or sell some U.S. stocks and bonds in other markets at other times. But the prices you get may be less favorable.

6. Stockbrokers are people and firms that serve as intermediaries in the process of buying and selling stocks. You can’t personally call or e-mail a stock market to buy or sell. You have to go through a stockbroker. (However, you can directly invest in or sell mutual funds--except ETFs--by contacting the company that manages the fund.) Stockbrokers charge commissions and/or other fees for their services.

7. Risks. You’ll probably have very little trouble getting information about the potential rewards offered by investments. You’ll probably have a harder time getting information about the risks (because people selling you investments tend not to emphasize their bad points). However, risk and reward walk hand-in-hand down Wall Street. The greater the potential reward, the greater the risk of loss. If you’re getting a glowing story about how great an investment is, but very little detail about the risk of loss, you will be at an informational disadvantage. You might be tempted to invest because you don’t know how bad the investment could be. Go back to cigarette ads from the early 1960’s. They’ll tell you that it’s enjoyable and sophisticated to smoke. But they’re rather short on information about heart disease, cancer and emphysema. Makes it tempting to light up—and that’s the idea. Make sure you know how an investment can go wrong before investing.

8. Investment Strategies. There are about eight and one-half zillion investment strategies. The large majority of them are (a) inconsequential (i.e., they won’t give you much of an advantage, or any, in the long term), (b) expensive (i.e., they require you to buy and sell investments often, which means large transaction costs that can significantly reduce your returns), (c) bunk (i.e., stupid, also referred to as dumb), or (d) fraudulent (i.e., a way to steal your money). Are there investment strategies that will prove superior in the future? Possibly, but you’ll have a hard time separating them from (a) through (d) above. Most professional money managers do not get returns higher than the stock markets as a whole and some do worse. That’s why investing for a return around stock market averages is a rational strategy. In general, most investors should stick to a simple strategy of investing on a diversified basis for the long term. See our recent blog on why the investor who does average is likely to do well. http://blogger.uncleleosden.com/2007/06/why-average-investor-does-well.html.

Also, take a look at the Investment Guidelines in Uncle Leo's Den at www.uncleleosden.com/Step11InvGuidelines.html.


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How to Maximize Your Investment Gains

Profiting from investment consists of two things: (a) making money; and (b) keeping it. There is risk in almost every investment--even federally insured bank deposits are subject to loss of value from inflation--and risks can cause losses.

Risk and reward walk hand-in-hand down Wall Street. The higher the potential rewards of an investment, the greater the risks it involves. If you invest in something that offers large potential gains, understand that it's likely to have high risks of loss as well.

From time to time, you may hear of investments that are sure bets. When someone offers you a chance at one of these sure bets, put your hand on your wallet and go for a walk around the block from which you don't return. There are no sure bets in the financial markets.

Maximizing your investment gains involves a balancing of risks and rewards. Look for investments with reasonable returns and moderate risks, and you have a good chance of making money and keeping it in the long run. At Uncle Leo's Den, our investment guidelines (http://www.uncleleosden.com/Step11InvGuidelines.html) and our suggested model financial plans (http://www.uncleleosden.com/Step16aModelPlans.html) help you to balance risk and reward.

So, if you are an ordinary investor, what are good investments? We mean the ones where you have a reasonable chance of receiving gains and then keeping them. Here are some ideas:

1. Stocks and stock mutual funds: stocks give you ownership of a small piece of a company. Stock mutual funds own a large number of different stocks, and give you a tiny bit of ownership in all the stocks that the mutual fund owns. Stocks are generally a good long term investment. Of course, we all know that the stock market fluctuates. But if you ride through the ups and downs, you'll likely do well over the years. Stock mutual funds smooth out some of the ups and downs by giving you a diversified pool of investments. As a mutual fund investor, you put your eggs in many different baskets, and therefore have a smaller chance of taking major losses from any particular stock.

2. Bonds and bond mutual funds: bonds are an investment where you invest an amount of money (the "principal") in the bond. The company or government that issued the bond pays you interest from time to time, and eventually repays the principal. In this sense, bonds are like bank certificates of deposit (except they aren't federally insured, although U.S. Treasury bills, notes and bonds are safe). A bond doesn't offer great potential for gains. However, it tends to have low risks, especially U.S. government bills, notes and bonds. A bond mutual fund holds a number of different bonds and helps to diversify your bond investments. You would invest in bonds and bond mutual funds to provide stability to the value of your financial portfolio. Every portfolio should have some stable assets, especially as you get older.

3. Lifecycle or target date mutual funds: these mutual funds hold both stocks and bonds. They are a blended mix of financial assets and are designed to give you the potential of stocks for good long term growth while somewhat stabilizing the value of your portfolio by investing some assets in bonds. The company managing these funds does the investment selections for you, so all you have to do is pay in your money and let them do the rest of the work.

4. Real estate: we now understand that real estate is not a wonder asset that will make everyone rich through no effort whatsoever on their part. Real estate historically has increased in value more slowly than stocks (about 1% after inflation versus approximately 3% after inflation for stocks). Nevertheless, everyone needs a roof over their heads and buying real estate is a good way to pay for that roof while adding to your investment portfolio. Owning a home provides some diversification away from the financial markets, and the home could serve as an asset of last resort in retirement, especially if you own it free and clear of debts.

5. Education: last, but certainly not least, is education. The gap in earnings between those who have a four-year college degree and those who don't has been growing over the years. The U.S. economy has shifted away from traditional manufacturing to knowledge and informational based activities, and it rewards those who know how to utilize knowledge and information. A college education doesn't provide everything you need for a job or a career. But it teaches you how to learn. You have to absorb information faster and on a more sophisticated level in college, and therefore you learn how to learn. That skill is highly rewarded in an economy based on knowledge and information. Education is one of the best investments you can make. Don't worry a great deal about which college you attend. Statistically speaking, there is little evidence that going to an expensive Ivy League school will make you significantly wealthier than attending a good state university. Just make sure you graduate.

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