It is now time for an introduction to the third main way of investing. As you were able to appreciate in step 50 on handpicking stocks and step 51 on mutual / collective funds, both ways have some very strong advantages, most notably the possibility of making lots of money on the stock market. Yet the opposite unfortunately is also the case and rather more likely than the first scenario… As we’ll see below, the third way of investing aims to find a middle ground between making money on the market and avoiding losses.
Index investing – an overview
Imagine looking at a long list of all the stocks and shares in a particular market – an index (such as the S&P 500) – and buying shares of every single company in that index in the same proportion as their relative size in the market. By buying all the shares of all the companies in the index, you basically copy the market and therefore will almost exactly get the same returns as the market average. (It will normally be just a fraction below due to the small fees you pay). If the index goes up by 8% your return will be around 7.8%, if it goes up by 13% your returns will be around 12.8% etc. That’s what index investing does. Sounds simple and indeed it is simple.
Of course as a small investor you’ll never have enough money to buy shares of all the companies in the index, which is why index investing – like with mutual funds – pools money of different investors together in order to increase buying power. Continue reading “Step 52: Investing through Index Funds / ETFs”→
In the previous step we looked at the advantages and challenges of choosing the shares and bonds to invest in yourself. In this new step we look at an alternative which is designed to help you if you don’t want to choose your own investments, but rather rely on the opinion and experience of somebody else: Investing through collective or mutual funds.
As we’ll see, this type of investing has its own major positives and drawbacks so let’s get started with the details.
Mutual funds – an overview
In the case of collective or mutual funds, the money of small investors in pooled together in order to raise the total amount available to invest. A fund manager is appointed to manage these funds and he or she decides which shares and bonds to add to the portfolio, trying to make as much money as possible. This often means they buy and sell continuously, following the market, aiming to buy shares at a low price, sell them at a high price and rush selling if they see a fall in the market coming, to avoid their clients losing a lot of money. Sounds like a good tactic? On paper yes, but in reality there are two main problems with this type of investing. Continue reading “Step 51: Investing through Mutual Funds”→
Now that we’ve discussed the what of investing (stocks and bonds and what the differences between the two are), it is now time to learn more about the how of investing and in particular how one can enter the stock market and start investing. Hopefully by now you’ve at least become slightly curious about how this investing really works, whether or not you feel like this will be your thing to do.
Generally speaking there are three different ways you can invest in a stock market:
Handpicking shares (and bonds) of individual companies
Getting a collection of shares and bonds through collective or mutual funds
Passive investing through Index tracking or Exchange Traded Fund
We’ll look at each option in turn to find out more about each way of investing in detail. In this step we’ll start by looking at handpicking shares of individual companies. Remember that these steps are only an introduction to the complexity of investing, so don’t just take my word for it, but read up if you’d like to find out more. There are many good books, articles and websites around that will explain this all in greater detail.
To make things easier on me as well as on you when reading, I have decided to talk about “handpicking shares” where in reality I am talking about both shares and bonds (yes, you can call me lazy if you want..!) Continue reading “Step 50: Investing through Handpicking shares”→
In step 47 we looked at an introduction of what shares are, but they are only part of the stock market, there is another major player to be found on the stock exchange, which are of course bonds. In this step we’ll look at bonds in greater detail and find out why they might be interesting to invest in.
What is a bond
A bond is in essence nothing more than an IOU that a government or company issues when they borrow money. In the case of a bond, the debtor (i.e the government or company that issued a bond and therefore borrows money) agrees to pay back the full amount of the original loan, along with interest.
A bond is traditionally an official paper to confirm the loan and when bonds are issued, they usually have the following information:
Value of the original loan, i.e. how much money the bond was for.
Interest rate that the company or government will pay back yearly.
Redemption date: this is the date when the issuer of the bond will pay back the original loan. This is usually anything between 5 and 30 years.
Like with stocks, companies and governments often issue many bonds at the time in order to raise a total amount of money they need for a new investment or expansion.
Why do bonds exist
So why do companies issues bonds and not just borrow money from the bank? The main reason to choose for bonds is that companies can often agree lower interest rates with investors than they can with banks. It also means that they don’t need to adhere to the restrictions that many banks impose on entities when they borrow money. By issuing bonds it guarantees that companies have more flexibility and freedom when it comes to chosing between reinvesting or loan repayments.
So why not issue shares then? A drawback of shares is that a company cannot just continue issuing more and more stocks without annoying their investors as the more shares are out, the more owners of the company there are, the more reduced the Earnings Per Share (EPS) are: the same profit has to be divided amongst more investors. With bonds, companies don’t have this problem as they can issue more so long they can find new investors willing to lend them money. Of course the disadvantage of bonds over stocks is that the full amount needs to pay back, which as we saw in step 47 is not the case when a company issues shares.
What do bonds give
Bonds give investors the possibility of making money in the following two ways:
Interest payment – as with any loan, a debtor agrees to pay interest on an outstanding loan, so if you lend somebody $100 at an interest rate of 5%, you can expect to get $5 every year until the redemption date, when the bond will be paid back in full.
Capital gains – similar to shares an investor can decide to sell their bond to somebody else, meaning the new investor takes over the loan. Since bonds are traded on the market, their prices can go up (or down). Bonds can be sold for more or less money than was originally lent to the company or than what the original investor paid, so as with shares, one can make and lose money on the buying and selling bonds.
What affects the price of bonds
The fluctuation of bonds prices is usually a result of the following three main factors:
1. Interest rates of the national and global economy
Investing in anything on the stock market always brings a risk as well as a cost with it. You pay fees somewhere along the line, be that to a stock broker or your brokerage account.. at some point you’ll pay. Added to that, bonds might cease to exist if the company or government goes bankrupt. So if you get 5% interest on a savings account with you bank, you’d be silly to buy bonds at 4%, as not only will you get less money on it, you will also run a higher risk of losing your money and you haven’t even paid for any costs at this stage. When interest rates of the economy go up, bonds have to offer more interest, otherwise people will invest their money in their own savings accounts. Add in inflation rates being high or low and you can imagine that it might be more interesting to put your money in stocks instead of in a low-interest bond.
2. Risks associated with the bonds
Every bond issuer is different and is either more or less likely to actually pay back the loan. If the entity goes bust, you simply won’t get any money back. Safer bond issuers might be more interesting as they are less likely to go bankrupt, although returns (i.e. interest rates) are generally lower than on bonds from more risky entities. To indicate how safe a bond is, there is a credit quality rating or bond rating, which ranges from AAA (highest level of safety) to AA, then A, BBB, BB and B and continues with CCC, CC and finally C, which indicates a low quality bond. During different economic times, people are willing to take more or less risk.
3. The remaining life span of the bond
Bonds that have a long life span have a higher risk of a payment default (the issuer not being able to pay) or a change in their credit rating. A company might be very healthy at the moment, but what will they look like in 30 years’ time? Because of the associated risk, longterm bonds usually have a higher interest rate to correct for the increased risk or insecurity. Bonds getting closer to their redemption date can go up in prices as they become more interesting to have as the chance of payment default or bankruptcy of the company goes down.
Two last warnings
Remember that if you bought a bond of $100 for $110 (thinking you’d either get enough interest on it to counter for the $10 difference, or would be able to re-sell at an even higher price), since the bond was originally issued for $100 at the end of the its date, you will only be given $100 by the issuer! If on the other hand you purchased it for $90, you will make $10 on the bond by its expiry date.
If a company has issued both bonds and stocks, then their bondholders must be paid interest before any profit can be given to the share holders. At the same time when you buy a bond, you won’t be given any part of the profit.
Step 48 – Understanding bonds – in detail
Like in the previous step, we are for now just finding out about bonds and how they behave on the market.
Type in bond prices + a company to find out more about the characteristics of bonds, such as their interest rates, maturity date / redemption date, and current prices. See how this evolves over time. Don’t worry about the actual details or number, just try to get an idea of how bonds trade on the market.
It’s harder to find information on bonds in the news, as news items tend to focus more on shares since they sound more exciting due to their prices fluctuating more. Try and see if you can find some information on bond prices, defaults and other information on bonds.
And that ladies and gentlemen is the introduction to bonds. Does the whole stocks-and-bonds-story still sound little confusing? Good, as the next step is completely focussed on comparing the two in greater detail.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.
Here starts a new part of our 100 steps to financial independence, with this being the first step in a mini-series on investing.
If you are serious about money, it is worth understanding more about the stock market and at least get a basic idea of what it is and how it works, before you decide for yourself whether investing will be something you would like to start doing. Investing is often a long-term decision and depending on the risks you are willing to take, you might or might not feel that investing is the right thing to do for you.
Let’s start with one of the key components of the stock market: shares (also known as stocks) and find out what they are, why they exist and how they make or lose us money.
What is a share
A share is basically a very small part of a company. If you have a share, it means you own a part of that very business and the more shares you have, the bigger the part you own of that company. Continue reading “Step 47: Understanding Shares”→
We’ve got to the last income stream of the 7 different income streams: rental income. This type of income can come from any asset that you own and rent out. The most obvious and well-known form of rental income is the renting out of a building, such as a house or apartment for private use (having tenants living in your property) but it can also be for commercial use, such as the renting out of an office space or shop.
Rental income isn’t limited to the rent of a building however, you can also rent out other assets that you have, as the recent increase in local initiatives such as rent-my-lawn-mower or rent-my-toolbox-for-a-day prove. So as always: don’t limit yourself by thinking that rental income isn’t something you could ever make any money with as you might well have something that somebody would like to borrow from you and they might happily pay for it if they can’t or don’t want to buy their own version of it, due to financial reasons, or a sense of minimalism (living with less) and is there really a point in buying a drill if you know you’ll only ever use it two or three times a year? Continue reading “Step 39: Income stream 7: Rental Income”→
Time to look at our 5th possible income stream, which is dividend income. This type of income is based on company profits paid out to the shareholders of that company. Before you dismiss this type of income as not your thing, read on and then jump to the investing steps later on, as you’ll find that investing can be more or less risky, depending on the risk that you feel you can deal with and you can start with very little money, yet over the years build up a considerable portfolio.
Now back to the dividend income. If you have shares in a company, you basically own a tiny part of that company. If that company then makes a profit, some of that profit goes to the owners of that company, i.e. the shareholders. Continue reading “Step 37: Income Stream 5: Dividend Income”→
The fourth income stream that we’ll look at is that of capital gains. Whether or not you feel like working towards developing this income stream or not (some people don’t), capital gains in a key source of income to many people.
Capital gains are the profits one makes when selling something at a higher price than the original purchase price they paid. The difference with profit income is that profit income comes from something you made or created over time as part of your regular business activity, whereas a capital gain involves an original investment, and then the value of this investment increasing over time, but not a result of a regular business activity. Continue reading “Step 36: Income stream 4: Capital Gains”→
100 Steps Mission 