Here I am in Part Four of this series, having set myself the task of showing how ordinary people can make money on Wall Street without learning how to pick stocks. Keep in mind, I did not say “get rich.” For that, you need to learn stock-picking or get lucky. What I have said is that you can make a brokerage account work better than a savings account by beating the rate of inflation.
Investors like yourself may opt for stocks or bonds. Stocks represent an ownership interest in the company and their value can move radically in either direction.
Bonds are issued by businesses to borrow money, and buying bonds does not make you an owner. The bonds have a face value for which you can cash them in at “maturity,” and in the mean time they pay an interest rate on the money you are lending, known as the “coupon.” Bonds, too, can fluctuate in value according to what Mr. Market thinks the face value will be worth on the date of maturity (because of changes in the value of money) or where the coupon stands in relation to other ways to put money to work that may have come up since the bonds were issued.
Bonds are considered safer than stocks because you stand to get the entire face amount back at maturity and because, if a company goes bust, the bond-holders have a high place in line to get paid, in front of just about everybody but “secured creditors,” whose debt is tied to a specific asset.
Bonds and stocks follow the general rule that a higher payoff means more risk. As a result, conventional financial planning holds that a young person’s portfolio should contain almost all stocks, adding bonds in middle age and increasing the amount of bonds in relation to stocks until an elderly person owns very few stocks. The conventional wisdom used to be that the percentage of bonds in your portfolio should be equal to your age. That made sense before the three-legged stool of retirement income got broken. Now it’s necessary to take more risk.
I’ve set out my situation in earlier installments. I came to investing way too late because of poor planning… make that no planning. I would own no bonds at all in my situation except that my wife has a lower risk tolerance than I and ignoring your spouse entirely can be riskier for your happiness than any Wall Street gamble.
Asset allocation is not very important until you have some assets to allocate, so let’s get back to that young person who wants to get started with $10 a week. How can that person beat inflation without risking everything?
Former hedge fund manager and current CNBC investment guru Jim Cramer says—and I agree – that the only free lunch on Wall Street is “diversification” That is, you must never put all your eggs in one basket. The problem to be addressed is how to diversify when you don’t have many eggs.
The Dutch—last seen in this series trying to buy Manhattan Island from the wrong Indian tribe – invented the “mutual fund” about 150 years after that real estate transaction. In the U.S., mutual funds became reasonably safe after the Great Depression, when they were regulated by the Securities and Exchange Commission (SEC).
I watched the growing popularity of mutual funds in the 1950s because I read the newspapers, but I thought that news only applied to people with money. I was wrong.
Mutual funds hold about a fourth of all stocks and bonds held by ordinary people and most 401(k) retirement plans involve choosing among mutual funds. The company managing the mutual funds owns a metaphorical “basket” of stocks or bonds and shares in the mutual fund represent shares of that basket rather than one company.
A modern refinement of the mutual fund is the “exchange traded fund” (ETF). The theory of owning a share of a basket of stocks or bonds is the same, but ETFs hold some additional advantages.
When you sell shares in a mutual fund, you get the price at the close of that business day. When you sell shares in an ETF, you get the price at that instant. Having done it both ways, I can attest that the latter is better for your blood pressure.
Now, what’s in the basket? Whatever you want. If I’m going to give examples, it’s time to introduce “ticker symbols.” This refers to that alphabet soup that scrolls along the bottom of your TV screen on business channels. That scroll resembles a “ticker,” which used to be the method of tracking the market. Tickers were located in the offices of people who needed them, such as stockbrokers or business reporters, and spewed out a tape that contained symbols referring to stocks and the price of the last transaction.
If you already knew about ticker symbols, read on. If you need to know more, go here.
As is explained in the link above, mutual funds and ETFs are traded with ticker symbols just like stocks, but you will seldom see fund symbols scrolled across the bottom of your TV screen.
A beginner who does not know how to pick individual stocks should pick a fund indexed to the general market with a low expense ratio. This is as close as you can get to a “set it and forget it” investment plan. All you have to do is make regular purchases, and for this style of investing market orders work just fine.
The variance in stock prices you get with market orders results over time in “dollar cost averaging.” You hope the price per share goes up over time but, when it dips, you keep buying. The profit you will pay taxes on when you sell (at a much lower rate than on money you worked to earn) is the difference between the average cost of your shares and what you get for them when you sell.
An Index fund that is keyed to the market should bring returns that equal the market.
What does it mean to equal the market? If you put one dollar on one share of the S&P on January 1, 1970 and reinvested all dividends, that buck would have been up to $77.79 last year, less the expense ratio, which ranges from .05% (VOO) to .11% (SPY). Multiply that by how many bucks you could have put in.
Has the S&P had down years? It has, in 1973, 1974, 1977, 1981, 1990, 2000, 2001, 2002 and 2008. There was a major market crash in 1973-74, then the Savings and Loan crisis of 1986-1995, when one-third of the S&Ls went under, and the explosion of the dot-com bubble combined with the economic fallout from 9/11 that trashed 2000-2002.
The dot-com bubble hit the NASDAQ hardest, because that is the exchange where most tech stocks are traded. The NASDAQ hit an all-time high of 5,408.60 on March 10, 2000. As of August 1, 2014, the NASDAQ is at 4,352.64. So you see, it never recovered from the bubble. Never forget that Wall Street is a casino.
The S&P, unlike the NASDAQ, is dominated by granny stocks that pay dividends, and that’s why it was only in negative territory for nine years out of 43 years we are eyeballing.
Remember, you have neither gained nor lost money until you sell, so what those down years mean is not that the S&P broke your nest-egg, but that you did not dare sell then. This is what I experienced when my 401(k) from my last job was down about 50% in the Great Recession. I did not sell. Two years later, it had come back and I rolled it over into an Individual Retirement Account (IRA) that I could manage, and it has since more than doubled in value as I’ve learned to pick stocks.
You can ride the market with very small investments and still stay diversified by using ETFs. Sharebuilder has a tool that allows you to express your risk tolerance and, based on your expression, will recommend a blend of ETFs that represent a mix of stocks and bonds tailored to not keeping you awake at night worrying about your nest egg. Sharebuilder will then accumulate fractional shares of that basket of ETFs, each of which represents a basket of stocks or bonds. This gives you instant diversification on the cheap.
Next week’s column might be titled “Here Be Dragons!” In it, I intend to go over the things I don’t do in the market because I consider them too risky. Your mileage may vary because your risk tolerance is greater than mine. I also want to discuss some common scams that prey on newbies. On avoiding scams, I assume we will agree without regard to one’s risk-tolerance.