Once you’ve set up your investment account, what do you do next? Well, it’s time to choose what to invest in! How hard could that be right?
As it turns out it’s a lot harder than you might think to get it just right. We want to do our best to get a bunch of things right, or at least close to right, before making that first investment.
So before we rush into choosing a fund, we’re going to close down and understand what’s possible to invest in. The point of this is that when you create your own asset allocation, which is a list of what you want to invest in, you’ll fully understand WHY you want to invest in every single thing in that allocation.
It’s one thing to be recommended by me or by an advisor that “you should invest in X”, but the confidence and relief involved in making those informed choices yourself can give so much more peace of mind than a paid professional could ever offer.
My hope is that by learning the basics of investing, you’ll get to that point where you can confidently choose what you want to invest in.
Don’t worry though – you won’t be alone! Once you’ve prepared what you want to invest in, I’ll show you how to get feedback on it from me and others if you want another set of eyes on it. Getting feedback can be scary at first. One thing that helps is watching other people also get feedback. Reading the investment plan by others and then seeing recommendations to improve it was an excellent resource when I started learning how to invest, and I think you’ll get a lot of value from it.
All of that is still a way off though and won’t happen until your final month of the Bootcamp. For now, we’re going to focus on developing a solid understanding of what types of things you can invest in.
(pull up the ipad at this point)
At a high level when we talk about investing, there are two major categories: stocks and bonds.
Stocks, also called equities, are investments in individual companies. If someone owned all stock by a company, they’d own the entire company. By owning some of a stock, you’re a partial owner in the company.
You make money from that stock in two ways. If the value of the company goes up, the value of your stock goes up. Now, you wouldn’t actually make money until you sold your stock of that company.
The second way to make money with a stock is for the company to issue dividends back to its shareholders. Here’s how that works.
Let’s say own a single share of Apple stock, $AAPL. Apple has determined that they are making enough money and have enough cash leftover at the end of the year that they want to reward shareholders by paying them – which is called a dividend. Not all companies issue dividends. For example, Facebook, Amazon and Google offer none. The primary reason for a company to issue a dividend is because it provides assurance that the investor will get SOMETHING from investing in the stock – even if the price of the stock doesn’t rise.
[open up https://www.morningstar.com/stocks/xnas/aapl/dividends ]
Looking at the Morningstar page for Apple, we can see that they issued 4 dividends last year and 4 this year. Each was $0.73 or $0.77 per share. So if we owned a single share of Apple for $261.40 during the year we would have made somewhere around $3.04 in dividends.
That’s a little confusing though. What if we owned $10,000 worth of Apple stock? In that case rather than trying to sum up the individual dividends, we can just look at the “dividend yield percentage”, which is listed as 1.16% for 2019 so far. That means that we’d have made $116 in dividends on our investment.
I don’t recommend investing in individual companies – at least not as the bulk of your investments. If we check out $VFIAX, the Vanguard S&P 500 Index fund, we can see that it also offers a dividend.
In this case, the dividend is the sum of all dividends from the 500 companies that make up it’s investments. Some of these companies like Amazon and Facebook won’t issue dividends, while others will.
Ok, real talk for a second here. When I started investing I immediately started chasing two things – companies whose stock price I though would skyrocket, and companies that had a really big dividend.
The problem is you can’t know either of these. A company may have issued a big dividend in the past, but there’s no guarantee they’ll issue one in the future. Likewise, a company may have had a really great year, but that doesn’t mean their stock will rise in price again. Chances are much more likely that you’ve missed the boat on that investment.
The solution to this is to GET ON EVERY BOAT. If you invest in a diversified index fund, then you can be invested in those companies that have those great years – and you don’t even need to know the company exists to profit!
OK, so that’s the stock side. There’s another type of investment that has a market that’s just as large but not as widely discussed – bonds.
Bonds are essentially loans to a company or government where they agree to pay back the bondholder with interest.
For example, the MTA, the Metropolitan Transportation Authority that runs the New York Subway, needs money to do MUCH NEEDED upgrades. Having been to Japan and rode the trains there, makes our New York subway system feel 100 years out of date.
In order to fund a complete overhaul of the Subway system, they need, say, $100 billion dollars – no small amount! They know that once the new system is up people will ride in greater numbers than the current system, and they can start paying people back.
There are a few ways they can pay for this. They can raise current fares. The city can issue new taxes. They can take on outside investors. The state can issue more taxes, and the MTA can issue a “bond” for people to invest in.
After they tap all other routes to help pay for it, the MTA still needs 40 billion dollars. To get this money, the state of New York issues a bond that anyone can buy. Individual investors like you and me can buy it, investment companies can buy, mutual funds can buy it, hedge funds can buy it – anyone.
As an example, let’s say the MTA has agreed to pay back anyone who has loaned it money with a 5% rate of return year each year for 10 years. After 10 years you also get the initial amount you put in back.
That’s the plan at least, but that’s not always the case. Bonds aren’t a guarantee! If the MTA runs into cost overruns and have no place to turn, then a few things would have to happen. They would lower the 5% rate of return, let’s say to 3%. Also, the “value” of the bond would go down – meaning if you sold it you’d get less than you initially paid for it.
Unlike stocks, bonds never perform BETTER than they’re laid out. They can only perform worse. In the best case they payout what they agreed to. In the worst case the value of the bond goes to $0 and investors lost everything – as many bonds did during the housing crisis.
So how you invest in bonds without losing everything? There are a few ways. One way is to invest in US government bonds. These are ones issued by the US federal government that is much less likely to go out of business. Still though, that’s a lot of work. The easier solution is the same thing we did for stocks – invest in a bond index fund.
Vanguards Vanguard Total Bond Market Index Fund, VBTLX, invests in thousands and thousands of individual bonds – 9,010 at the time I’m writing this. Most of these are US Government bonds. By investing in a fund like this, if one bond out of these 9,000 loses value, you would only see a tiny drop in value – a few cents at most, and possibly no change.
Like with stocks, you can invest any amount in a bond fund like Vanguards Vanguard Total Bond Market Index Fund. If you invested $100, that $100 is still invested in over 9,000 funds.
Stocks are bonds are the workhorses of any portfolio. Companies create value and the price of their stocks go up. Bonds pay for people to loan them money – which they use to create value elsewhere.