2: Learn

Why should you be investing? 

What do you need to know before you get going?

How and where should you invest your money?

To invest your money wisely, you'll need some foundational knowledge. The often-surprising thing is, it's not complicated stuff. High-schoolers can begin investing with their summer job money by the end of this site, as can 35-year-old financial late bloomers.

 

To responsibly give you the suggestions we provide in Invest!, it's essential that we provide you with the practical basics of investing. Make your way through the three short and sweet sections of Learn, and you'll be good to go. Trust us.

 

The Basics

What is a…

Stock: a piece, or share, of a company. When someone buys a share of Apple’s stock, she is buying a tiny piece of Apple. Apple gets to use the money they get from issuing shares to improve their MacBooks and iPhones. As Apple earns more money, and its stock becomes more desirable, that share becomes more valuable: its price gets higher.

 

Now, the investor, the owner of the share, can choose to sell it for more than she paid for it. This is the pure foundation of investing. Holding stock in a company actually signifies partial ownership of the company. Stocks are sometimes also referred to as equities. The goal is always to sell the stock for more than you paid for it.

 

Bond: like a stock, when someone buys a bond, he is lending his money to the issuer of the bond (usually a company or the government). Unlike a stock, a bond has a fixed rate of return, guaranteed by the issuer. That rate of return is usually much lower than the returns one can hope for from investments in stocks. Risk is rewarded when it comes to investing, and stocks, which are riskier, have higher long-term returns than bonds.

 

The bond can be returned back to the issuer on its ‘maturity date’ for its face value. Example: If you buy a $100 bond, and it pays out a guaranteed 5% a year, you will be paid $5 a year. Let’s say the bond reaches maturity after five years. In five years, you will have been paid a total of $25, and can return the bond to the issuer for $100. You started with $100 and ended with $125.

 

Someone who owns a bond can sell it before the maturity date in the bond market. Let’s say stocks are having a bad year and generally falling in value, and you’ve got a bond that pays out 6% a year. Your bond is going to start looking pretty attractive to investors who are losing money in the stock market and lusting for the stability of bonds. You might be able to sell it now for more than you paid for it originally, without waiting until the maturity date.

 

Conversely, if the stock market is doing much better than the bond market, there might not be very high demand for bonds. You would hold on to your bond and continue to take your guaranteed payments, rather than sell it for less than what it’s worth to you. Your bond is less attractive because investors feel they can do better by investing in stocks.

 

Individual investors now typically buy bonds through funds, which are just bundles of several different bonds. By taking this approach, they diversify their risk in case one or more of the bond issuers defaults. Though bonds are generally  safer and more dependable than stocks, they carry the small risk of default, which is when the issuer can no longer afford to pay out the agreed upon amount.

 

When you buy a share of a bond fund, you don't have to wait for a maturity date or worry about selling your bond on the market. Your fund will grow in value, over the long-run, and when you're ready, you sell your share for (hopefully) more than you paid for it. It functions much like a stock- you buy and sell shares at your will- but remember, it's actually a bundle of bonds.

 

Mutual Fund: is commonly described as a basket of stocks. A mutual fund is just that, a group of some number of stocks; it could be 10, could be 1,000, etc.. When you invest in a mutual fund, your money is spread across the stocks of all of the different companies in which the mutual fund invests. (Just the same as we discussed with bonds.)

 

If I buy a $100 share of a mutual fund that invests equally in 100 different stocks, then each of those companies will get one of my dollars. This is one way to diversify risk. If one of those 100 stocks is Starbucks, and one day everyone realizes the coffee tastes awful, the value of Starbucks’ stock will likely plummet. However, I’ll still have at least $99 left! Not such a big deal. But, if I had put my entire $100 in Starbucks’ stock, I could've lost much or all of it.

 

Mutual funds are great for young investors. Young and/or beginner investors don't tend to have a lot of money. If I have $200 to invest and I want to invest in Apple, and a single share of Apple costs $130, I will be taking a lot of unnecessary risk.  If Apple's stock falls in value, so will most of my money. Instead, I could take my $200 and invest in a mutual fund that invests in lots of tech companies. I would then be invested in Apple, Samsung, Microsoft, etc.. Mutual funds allow investors with fewer dollars to invest in hundreds, if not thousands, of companies!

 

Index Fund: is a type of mutual fund. It’s a basket of stocks. There is a key difference here, and it’s in the word index. You may have heard of the Standard and Poor 500, or the S&P. The S&P is an index of 500 of the largest companies in the U.S.A. The index is not itself a fund, it merely tracks the total value of those 500 companies’ stocks all together. One way to measure the strength or success of our economy is to follow the movements of an index like the S&P 500, Dow Jones, or Nasdaq.

 

The type of investing that we describe and encourage at WLI is called passive investing. Passive investing involves investing in index funds. Typical mutual funds are active and run by managers. The managers do their best to pick stocks that are going to grow in value more than others. On average, these managers charge enormous and excessive fees to compensate them for all of their stock-picking work! The bad news for their investors is that over periods of time greater than 5 years, these managers do not manage to beat the market, a.k.a. to beat indexes like the S&P 500.

 

Passive index funds, unlike active mutual funds, bring dramatically lower (read: cheaper) expense ratios (a term for fees). This is because they are not employing managers to handpick stocks that they hope will be winners. Instead, index funds track our entire economy or segments of it. Long-term, our companies get richer, our economy grows stronger, and our stocks rise in value. By cutting out the managers who are statistically unsuccessful over long periods of time across the board—and very expensive—we actually outperform other investors by just buying the market.

 

Portfolio: simply means the stocks, bonds, mutual funds and other assets in which you invest. If Gambler-Ross decides to invest in Nintendo, Uggs, his uncle's typewriter company, and an Enron bond, his portfolio will just be those four investments.

 

Feel good? Go Deeper before embarking on your personal finance journey.

 

Go Deeper

Fees and Taxes: Like we discussed in the explanation of index funds, high fees are most commonly associated with the active management of mutual funds. Cutting out yearly high fees can earn you tens or hundreds of thousands of extra dollars in your account over the coming decades.

 

There's really one term that you really have to know: expense ratio. The expense ratio is the amount of money you will pay for the privilege of investing in a mutual fund (including index funds). If I invest $100 dollars in a mutual fund that has a 1.0% expense ratio (which is charged each year) I will pay $1.00 for the right to have my money invested in that fund.

 

Let’s say you have a choice between a fund with an expense ratio of 1.0% and a fund with one of 0.2%. We’ll assume an 8.0% annual return. If you began investing $500 a month at age 20 in the high-fee fund, you would have about $1.3 million at age 60. Not bad, taken out of context! However, if you had chosen the low-fee fund you would have about almost $1.6 million at age 60. That’s a difference of about $300,000!

 

passive vs active investing long term expense ratio millionaire

 

A small 0.8% difference in expense ratios becomes a not-so-small fortune when compounded over time. In just the same way, taxes eat into returns over time: like with expense ratios, small costs compound into huge amounts over the years. You’ll want to invest in a tax-efficient way, and we’re here to tell you how to do it! (spoiler: it’s unbelievably easy)

 

Diversification of Risk: just means 'don’t put all your eggs in one basket.' Buying index funds, like you’ve learned, is one way to diversify away risk. Buying hundreds or thousands of companies means that if one or even several see their stocks plummet in value, your portfolio will be barely affected. However, diversification is more than just buying an index fund that tracks the S&P 500.

 

Reducing risk is important because though increased risk is associated with increased return, not all risk is simply useful. One can continue to earn respectable returns with less risk and less volatility through diversification. It’s really not difficult, either. To diversify risk, you will invest in index funds that track many different parts of the U.S. economy—energy, consumer staples, real estate, etc.—but also different parts of the world. This kind of diversification is made easy through the ubiquity of index funds and through websites like Wealthfront, which select about a dozen diverse index funds and invest in them on your behalf.

 

Time: Another way to decrease risk is through patience, which we’ve already discussed. Stocks are volatile in the short run, and you may invest a dollar today that is worth $0.99 tomorrow, or even $0.90 next year. However, stocks tend to grow in value over the long run, and we at WLI, as has become very obvious, enthusiastically encourage investing long term.

 

Inflation: Finally, understanding the concept of inflation is key. It's an interesting phenomenon because it is both extremely complicated and extremely simple. You've probably heard a politician talk about it negatively and you might've read an article that talks about it positively.

 

Inflation is essentially the change in prices over a certain period of time. The Consumer Price Index (CPI) tracks the prices of a basket of consumer products: a car, some t-shirts, a hamburger, etc. If the price of the basket of those goods goes up by 3% from one year to the next, then inflation that year is 3%. Right now, in 2016 U.S.A., inflation is close to 0. On average, over the past 100 years, inflation has been about 3% per year. Economists disagree on whether inflation is good or bad, and the general consensus is that it depends: sometimes it's good, sometimes it's bad. But, a little expected inflation is generally thought to be healthy.

 

Why should you care about inflation? Well, things get more expensive each year. If I have a dollar this year, and a Coke costs a dollar, I can drink a Coke. Great! If Coke increases prices by 3% next year, and I still only have $1.00, I can't afford a Coke! D@mn! If I had saved my dollar in an average savings account, I would've earned interest of just $0.0006. Less than a single cent! I'd still be unable to buy a Coke. But, if I had invested my dollar and received the average annual return of 8%, I'd be able to buy a Coke and have money left over. 

 

inflation adjusted long term growth investment vs saving comparison

 

Investing is better than saving in a savings account not just because of its higher return, but because of its inflation-beating returnSaving your money is not enough. Your money will actually lose value each year. Investing your money outpaces inflation and grows your money in real terms. 

 

When you read the word real, often in the phrase real return, you should understand that the related number has been adjusted for inflation. If I grow a dollar into $1.02 in one year, my nominal return is 2%, or $0.02 in this case. Nominal means just the number, no adjustments for inflation. If inflation was 3%, my real return would be negative. $-0.01, or -1%. Though I grew my money in nominal terms I lost money in real terms. Important, right?

 

You've passed the halfway point! Absorb some Final Lessons before starting to Invest!

 


 

Final Lessons

Passive vs Active Investing:

As we mentioned before, active investing involves a manager (really a team) picking stocks that will grow faster and greater than others. Over short periods of time, many managers do this extremely well and make their investors a lot of money. However, study after study has shown that over long periods of time, more than a few years, these managers suffer losses that cancel out their previously stellar returns.

 

For individuals like us, how would we know who to pick year by year, when to leave them, and whom to trust next? These managers charge fees that eat into your returns and add up to tens, if not hundreds, of thousands of dollars over time.

 

Mutual fund managers charge a fee for their services. This is called an expense ratio. It is taken from the money that you invest in the mutual fund. This can be anywhere from 0.05% to more than 2% per year. So if you invest $100 in a mutual fund with a 1.0% expense ratio, the manager will take $1, even if your money doesn’t grow in value. Only 99 of your dollars will ultimately be invested.

 

Then, whether your money grows in value or shrinks, he will take another 1% the next year, and the next year after that, as long as he’s investing your money for you. Naturally, we hope that by investing in an active fund, the manager will make our money grow larger than it would in an index fund by a margin larger than the expense ratio, but statistically speaking, it doesn't over long periods of time.

 

This is possibly the most important area through which we guide you on this website. The difference in cutting out an expense ratio is worth hundreds of thousands of dollars. In Invest! we walk you through exactly what you can do about cutting out fees, taxes, etc.

 

Passive investing, on the other hand, is investing that keeps up with the market. A passive portfolio is made up of index funds that track indexes like the S&P 500. The passive managers of an index fund don’t spend time and money handpicking stocks they hope might turn out to be winners. Instead, their funds hold every stock in the index, proportionally, and adjust when the index adjusts.

 

By choosing a passive approach, you will pay extremely low fees and neither underperform nor outperform the market. This means that over long periods of time you can reasonably hope to earn a return of about 8% a year by holding a portfolio mostly made up of stocks-- for us, that means index funds. There will be months and years when you lose money, which is OK because there will be months and years where you earn much more.

 

You don’t need to gamble on a stock that you or someone else thinks will be a winner. You can simply buy the market, diversifying away the risk associated with investing in individual companies. Because you pay such low fees (easily less than 0.20%), you actually outperform the herds of investors who pay exorbitant fees for active management and find the long-term results severely disappointing.

 

The graph below shows that cutting out just 1% in fees can amount to an extra $150,000 after 40 years! 

 

passive vs. active long term growth investment comparison

 

The difference after 20 years in the above graph would be $12,906; after 50 years,  it would amount to a whopping $403,708! It can be worth more than a million dollars in situations where the investor contributes more each month than the one in this hypothetical.

 

You wondered, you learned...

*These graphs assume an annual return of 8% before fees in both the active and passive portfolios. Returns are compounded annually and, where applicable, inflation is set at 3%/year, following historical averages.