Investments are similar to high school grades. These don’t seem all that important as a freshman, but their value becomes evident your senior year when it’s time to consider college options. The lower your GPA, the more limited your options. Similarly, the less you invest in your younger years, the less likely you will experience financial growth as a seasoned adult.
But where to invest? Savings accounts, money markets, and certificates of deposit are currently plagued by horrible interest rates. These vehicles are perfectly fine for emergency funds, but what if you want to engage in a more aggressive long-term investment strategy?
Why Choose the Stock Market?
All investments are risky. Some investments are riskier than others. The stock market can be as safe, or as risky, as you want it to be. The stock market is just that, a common place for people to buy and sell as much as they can afford and as often as they choose.
You do not have to be wealthy to invest in the stock market. If you have $10 lying around, you can start investing today with platforms like Betterment. Betterment is a robo-advisor, which means the platform will automatically pick investments according to the financial goals you give it. The more money you put in, the more money you’ll get back, but don’t fall into the trap of believing the stock market is only for rich people.
I do not use Betterment, but only because I know my way around investments and am too much of a cheapskate to pay them for something I can manage myself.
The Basics of Stocks
To own stock in a company means you own a tiny piece of a company. Think of it as your piece of the company pie. The number of slices you decide to own are called shares.
The purpose of investing is to make your money grow. Therefore, in the stock market, you pick companies you think will do well moving forward. The better a company does, the more expensive their stock will become.
Hypothetically, let’s say it’s August and Apple stock is selling for $100 a share. You know that most years a new iPhone will come out in September. You buy five shares of Apple stock for a total of $500. September comes, the new iPhone is a hit, and the Apple stock jumps to $150 a share. The $500 you originally put in is now worth $750. At this point, you could pull your money out having earned a profit of $250.
Mind you, this is an extreme example for the sake of simplicity. Also, don’t forget the government will take its piece of your profit in the form of taxes.
The hypothetical example above is also simplistic, because while iPhone sales account for a large portion of Apple’s performance, it is not the only determining factor for success. Unless you’re going to devote a fair amount of time to review a company’s balance sheets, especially less familiar businesses, it does not make sense to gamble your money on that venture. Never invest in a business you cannot reasonably explain to others.
The Down Side to Owning Individual Stocks
Now let’s look at the reverse of the example above. What happens if the new iPhone is a bust? Apple doesn’t sell as many phones as it had hoped. Chances are good your fellow investors will start selling their shares, which means the value of the stock will drop. Shares fall from $100 per share to $75 per share. The $500 you originally put in could fall to $375.
It makes sense why you might be tempted to own individual stock. There’s a certain level of pride in claiming you own a small piece of McDonald’s, Disney, Coca-Cola or similar well-known companies. The problem with owning individual stock is that the strategy creates unnecessary risk.
Your money can only go so far. If you only have $100 to invest, you could be tempted to put it all in a company with whom you constantly do business, but if something were to happen to that company, your entire investment could be jeopardized.
Let’s say you love to eat at Chipotle Mexican Grill. You might be tempted to put all your money into Chipotle. You think the food is just that amazing, but in 2015 the restaurant experienced an awful E. coli breakout that spanned multiple states. By December of that year the company stock had dropped 11%.
Awful as this episode may have been for the restaurant chain, it’s a problem that could have affected any restaurant. This is why you don’t want to put all your eggs in one basket.
Diversification is Not Enough
Okay, so then you figure out that diversification is a better approach. Instead of putting your $100 all into a specific restaurant, you decide you’re going to put $25 into Chipotle, $25 into Nordstrom, $25 into Southwest Airlines, and $25 into CVS. You figure even if something happens in the restaurant business, you have three fourths of your money invested in other industries.
Now we’re getting closer to a sustainable strategy. But, we still have a problem. If it doesn’t make sense to put all your eggs into a single basket, why would it make sense to put a chunk of your cash into one industry representative?
COVID-19 dealt a blow to restaurants, retail, travel and tourism. Yet, not all hope was lost. Who did well during the pandemic? Grocery stores, pharmaceutical companies, and delivery services performed admirably during the pandemic. In the example above, only your shares in CVS would have thrived.
How were you supposed to know a pandemic would hit?
That’s just it. You couldn’t have known. Rather than own individual companies, it is better to use your $100 to invest in a large collection of them.
Index Funds are a Better Alternative
Instead of creating pigeonholes for your money, you could invest your money in whole business categories. If one Mexican food chain stumbles, your money still has the benefit of being invested in a big swatch of the restaurant industry.
Index funds are a type of mutual fund. They are financial portfolios that follow specific markets. Instead of dividing your $100 between one or two Fortune 500 companies, you could invest your money in an index fund that follows the whole list of Fortune 500 companies. As of May 2020, the top five companies on the Fortune 500 were: Walmart, Amazon, Exxon Mobile, Apple, and CVS Health. The top five companies alone will give you better diversity than sticking to the four companies in the example above.
The advantages of index funds are broad market exposure, low operating expenses, and low portfolio turnover.
Your $100 will carry more weight the larger the industries your index fund represents. Also, the larger the exposure, the less of an impact an unforeseen development like the pandemic will have on your investment. A hit on one company, or even one industry, will not be as detrimental, because your money is spread across a large market.
The reason operating expenses can remain low on an index fund is that these types of funds require little oversight. Remember, they’re tracking a market benchmark. Therefore, an investment firm can afford to charge minimal fees for maintaining an index that is largely self-driven.
Portfolio turnover refers to the transactions in a fund. Anytime a manager sells shares, the transaction creates a service fee as well as a taxable event. These deductions come out of your profit.
The reason aggressive investors turn their nose up at index funds is that index funds generally follow the market as opposed to seeking to beat it. To put this in context, the S&P 500 enjoyed an average annual return of 13.6% between 2010 and 2020. 13.6% is a heck of a lot more than what you’ll generate by parking your money in a savings account, but aggressive investors will take their chances with actively managed mutual funds in hopes they can beat that 13.6%. They might get lucky one or two years, but there is no secret formula for consistent success. Besides, the extra gain is usually not worth it since it will likely be eaten by operational expenses and taxes.
The GameStop Phenomenon
We can’t close this post without acknowledging the GameStop event that is rocking Wall Street at the time of this writing. You may not take well to being told not to buy individual stock when you see how GameStop value surpassed 1,000%. By the time this post gets published, we may have a better since of the final outcome between retail investors and major hedge funds. Here are a few thoughts.
By the time such a phenomenon becomes news, the lucrative phase will have come and gone. Do not throw your hard earned money on a train that has already left the station. There is no way to predict the peak of this wave. If you want to become a part of the WSB community and align your investments with their future roadmap, by all means go for it, but educate yourself and read the next paragraph carefully.
We are human. From time to time we will be tempted by investments that feel speculative. I give you and me permission to take a few risks with our money but only within a tight constraint. I think it’s reasonable to set aside a small percentage of money you are willing to lose, similar to what some gamblers will do when entering a casino. One of my current investments under consideration is Fundrise. By all accounts, this type of real estate investment is no longer speculative, but until I can speak more coherently about what Fundrise does, I’m not jumping in.
Personally, I’m rooting for the little guy. Short selling stocks is not a new development. It’s a mechanism only large firms can exercise when they’re banking on a business dying. They do it for a profit, and while I am in favor of companies getting the most for their investors, it is my uneducated belief that the ones who profit most are the firms themselves. The subsequent blocks of everyday investors buying stock from certain companies feels wrong on several levels.
Saying you own Microsoft stock sounds pretty cool, doesn’t it? Saying you own index funds does not sound as sexy until you realize that by owning something like Vanguard’s Total Stock Market Fund, you own stock in Microsoft, Google, Target and all the other heavy hitters that keep our economy moving across multiple sectors.
Ultimately, it’s about getting more mileage out of your hard-earned money. The stock market can be risky. It’s made up of all stripes just like any other open exchange, but with a little education, you can pick a strategy that falls well within your risk tolerance. Index funds give you the opportunity to remain competitive while remaining largely shielded from unexpected setbacks.
There is always risk of course. Past performance may not be indicative of future results, etc. I can tell you index funds are what I use, and so far I have no regrets. If it’s good enough for Warren Buffett, it’s good enough for me.
Where do you fall on this discussion? What motivated your choices, or if you have not yet jumped in, what’s holding you back?